Why 50,000 Chinese auditors are worrying the world's bond buyers

[HONG KONG] Global investors are wary of Chinese local government debt just as the nation's provinces start going overseas for fundraising amid state scrutiny.

Qingdao City Construction Investment Group Co, a local government financing vehicle on the country's east coast, sold a debut issue of US dollar-denominated bonds on Feb 5, raising US$800 million in a two-tranche sale. Some 20 per cent of the US$500 million portion was bought by money managers, compared with an average 54 per cent take-up for a US$1 billion offshore deal by Beijing Infrastructure Investment Co in November, people familiar with the matter said.

China has mobilised about 50,000 auditors to probe local government debt, according to Mizuho Securities Asia Ltd, after borrowings swelled to 17.9 trillion yuan (US$2.9 trillion) as of June 2013, from 10.7 trillion yuan at the end of 2010.

Funding arms for the nation's bridges, sewage systems and roads sold the least onshore yuan notes in 17 months in January, following moves by the State Council in October to cap the amount of debt regional authorities can take on.

"We're seeing funding vehicles from China that actually aren't able to borrow onshore any longer and are now coming to the offshore market," Endre Pedersen, who helps manage US$45 billion as chief investment officer for Asia fixed income outside Japan at Manulife Asset Management Ltd, a unit of Canada's largest life insurer, said in a Feb 10 interview in Singapore. "We don't think you are being paid at all for the risk that you're taking on."

LOW TAKEUP

Qingdao's US$300 million tranche of 10-year securities pays a 5.95 per cent coupon and a US$500 million five-year portion offers 4.75 per cent. Its previous bond, sold in China in August, was due within a year and paid 4.95 per cent.

Premier Li Keqiang is reining in borrowing by so-called LGFVs just as they must repay a record 558.7 billion yuan of bonds this year amid the slowest economic growth in more than two decades. China's Ministry of Finance released data on Jan 30 showing total revenues for LGFVs increased by 7.5 per cent in 2014, down sharply from a 22.8 per cent jump in 2013, Moody's Investors Service said.

LGFVs were set up in the thousands in China to fund infrastructure projects after a 1994 law banned regional authorities from issuing bonds directly. Three have so far tapped overseas markets, with Beijing Infrastructure the first to do so last March.

Lower rates and deeper liquidity will probably send more LGFVs offshore for funds, according to James Su, a Hong-Kong based executive director of asset management at Haitong International Securities Group Ltd. Such markets offer them an alternative funding channel, he said.

NOT CONVINCED

Investors are yet to be convinced. "We're waiting to see how these issues play out," said London-based Yerlan Syzdykov, the head of emerging markets and high-yield fixed income at Pioneer Investment Management Ltd, which oversees $210 billion euros (US$239 billion).

"We're trying to discriminate these funding vehicles from strategically important state-owned enterprises."

LGFV bond issuance fell 10 per cent since October's rule change through January, compared with the same period a year earlier, data from ChinaBond website show. The financing arms issued 73.3 billion yuan of notes in January, the least since August 2013, Bloomberg-compiled data show.

Provinces had until Jan 5 to submit reports classifying all local borrowings within their borders, including those of LGFVs, as either government debt or not. The finance ministry is now asking provinces to re-examine the submissions after some inflated their borrowings, two people familiar with the matter said Feb 16.

MORE CLARITY

"Investors are worried about the uncertainty that will come out of the debt reclassification exercise," said Haitong's Mr Su. "They are waiting for more clarity to assess the risk of those bonds." The southern province of Hainan was the first to announce the extent of its debt.

The country's smallest, which contains an island famous for beach resorts, had 171.9 billion yuan of debt at the end of 2014, according to a Feb 9 statement.

"The ministry of finance's additional scrutiny reflects the challenge that local governments face in managing their debt levels and points to the central government's desire to soften market reaction to news that regional local government debt has risen," Moody's said in a report published Monday.

Local government debt for 2014 is expected to be far higher than the previous year following the Chinese government's audit, according to Shen Jianguang, the chief Asia economist at Mizuho Securities Asia. "Everyone is waiting for the final tally," he said.

In the meantime, some of the biggest offshore investors will be steering clear of debt such as Qingdao's.

"That's a sector we have been discussing, looking at and saying not for us," Mr Pedersen said. "That's actually a sector that we are actively avoiding."

BLOOMBERG