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Chinese local governments still look offshore for funding

[HONG KONG] Demand for debt from local government financing vehicles (LGFVs) may be red hot in China's domestic bond market, but some municipal issuers are choosing to sell more costly offshore bonds for reasons that go beyond simple arithmetic.

Despite favourable funding conditions at home, LGFVs are trying to diversify their funding channels to guard against any changes to domestic regulations, having suffered in the past when China froze issuance approvals.

They also appear to benefit from a surge in defaults that has scared investors away from state-owned issuers, especially in sectors facing overcapacity, such as coal and steel. This has fed demand for credits more closely tied to local governments, as these are seen as safer credits.

Three LGFVs have launched public US dollar bonds so far this year, ranking alongside financials and property developers as one of the main sources of supply. At least two other LGFVs have printed US dollar paper through private placements.

The interest in offshore borrowing has grown even as the onshore market has become more favourable for LGFVs.

In the first quarter, LGFVs raised around 650 billion yuan (S$135 billion) in the onshore bond market, up 8.5 per cent over the previous quarter, according to Wind, a Chinese financial data provider. In March alone, new issues from LGFVs reached the highest level on record at 337.3 billion yuan.

The spurt follows the National Development and Reform Commission's relaxation of regulations on LGFV funding late last year in a bid to stimulate economic growth. As part of these changes, issuance quotas were scrapped for LGFVs rated AA and above.

Today's favourable conditions, however, have not erased painful memories of the funding freeze the central government imposed in late 2014, at a time when it was trying to curtail local authorities' growing debt burden. "Conditions have improved for LGFV funding at home, but you never know when the door will be closed again to us," said an official with a local government investment arm. "That is why LGFVs have been looking to establish access to the offshore market and to diversify funding sources." Last week, Yunnan Provincial Energy Investment Group, a financing entity of China's southwestern Yunnan province, printed a debut three-year US dollar bond even as it cancelled a planned Rmb1bn onshore issue of 270-day commercial paper. "As market volatility grew recently, the company decided to choose another window to issue the bonds," it said.

Yunnan Energy's US$300m bond with a keepwell structure priced at Treasuries plus 215bp for a yield of 3.065 per cent.

The offshore financing came just one month after its parent, Yunnan Provincial Investment Holdings Group, made its own debut in the same currency with a US$300 million three-year bond on March 23 at Treasuries plus 240bp, or a yield of 3.464 per cent.

Worries of rising default rates among China's industrial issuers have enhanced the relative appeal of LGFV debt for overseas investors. "Offshore investors have avoided names in steel and coal since early last year and those names are hard to sell now. But we haven't seen a default event with a LGFV," said a Hong Kong-based credit trader with a foreign bank.

The same reasoning applies onshore. "For SOEs and LGFVs with the same ratings, LGFV bonds are more popular among onshore investors at the moment," said a Beijing-based underwriter with Guotai Junan Securities.

In the past two weeks, credit risk has grown beyond the steel and coal sectors, with China Railway Materials, a central SOE, suspending trading in all nine of its onshore bonds because of shrinking revenues and funding difficulties.

Between April 1 and 13, Chinese issuers cancelled about Rmb33.2bn of onshore bond offerings in the interbank bond market, according to a report from China International Capital Corp. Thirty of the 38 cancelled deals were from state-owned corporate issuers with domestic AA ratings. Not more than a handful were LGFVs.

IFR