China property crisis threatens US$1.6t of local state debt

CHINA’S deepening property crisis is piling pressure on a US$1.6 trillion corner of the country’s onshore bond market, as cities and local administrations step in as white knights to bail out troubled developers in a state-backed bid to aid the sector.

After replacing builders as the biggest buyers of land earlier this year, the nation’s so-called local government financing vehicles, or LGFVs, have now become the main purchasers of half-finished projects of defaulters including China Evergrande Group. Their increasing involvement in real estate has analysts raising red flags.

Moody’s Investors Service says that could weigh on the credit profile of these state funding agencies. While no LGFV has defaulted in the current cycle, Bloomberg Economics isn’t ruling out one ahead, as its data show average credit spreads on some of the worst-performing LGFV local bonds have almost doubled to nearly 10 percentage points since mid-January.

Such direct rescue efforts and tighter ties to property are raising new concerns over the health of the weakest links in China’s state sector, as a record housing slump and surging Covid-induced expenditures squeeze the already strained finances of companies reliant on government funding. A potential default could cause another convulsion in a market, where LGFVs’ 11.6 trillion yuan (S$2.2 trillion) of notes account for about a third of China’s local corporate bonds.

The government needs to rely on LGFVs during an economic downturn, but “once the policy wind turns, we don’t rule out the possibility of LGFV public bond defaults”, said Zerlina Zeng, senior credit analyst at CreditSights in Singapore. “China will likely refocus on cleaning up local government debt” when growth picks up, she said, adding default risks aren’t elevated over the next six months.

David Qu and Chang Shu at Bloomberg Economics estimate total LGFV debt, including bank borrowings, to be as much as 60 trillion yuan, or about half of China’s GDP. Defaults would have major consequences, they said.

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LGFVs rose to prominence in the wake of the global financial crisis, when they played a crucial role in funding roads, bridges and subways as the central government stepped up stimulus to keep the world’s No 2 economy humming.

The phenomenon of LGFVs buying pending projects is especially acute in the southern Guangdong province, a trading hub with relatively stronger fiscal health.

Guangzhou City Construction Investment Group, backed by the city of Guangzhou, in October purchased the plot meant for a 80,000-seat football stadium after Evergrande returned it. The property giant, which is at the centre of the credit crunch that’s rippled through the sector, has a significant number of projects in the city.

With the deal, the LGFV is now responsible for finishing the sports complex, one Evergrande estimated to cost 12 billion yuan but in which it had only invested 2 billion yuan. That means extra spending on top of the 57 billion yuan of real estate projects as of March. China Lianhe Credit Rating warned that the expenditure needs to be borne by the LGFV.

The types of LGFVs helping out are expanding to entities affiliated to lower levels of governments as well. In adjacent Shenzhen city, a district LGFV extended help to four key projects Evergrande owns in the jurisdiction, according to the developer. While the vehicle doesn’t raise funds in the open market, bond sales by its largest shareholder Shenzhen Talents Housing Group Co. picked up pace this year, according to Bloomberg-compiled data.

Little experience with construction comes with another set of risks for LGFVs. Sales could end up being lacklustre if quality standards aren’t met, denting cash flows, Zhou Yue, a bond analyst at Zhongtai Securities, wrote in a note.

Before turning into white knights, LGFVs were already lending to distressed builders. Days before Shanghai-based Greenland Holdings repaid a dollar bond in August, its LGFV shareholder Shanghai Chengtou lent 1.5 billion yuan to the company.

For now, taking on the crucial role of residential project construction reinforces investor belief that LGFVs have implicit guarantees from local governments - which have helped LGFVs avoid defaults on public bonds, according to Tianfeng Securities analysts led by Sun Binbin.

As long as more developers slip into distress with China’s longest-ever home-market slump showing no signs of abating, there will be more pressure on LGFVs to help, said Ivan Chung, an analyst at Moody’s. Cities with strained finances will feel the pinch, he added.

“LGFVs in economically weaker cities already carry higher credit risks,” Chung said. “If halted projects there have big cash holes to fill, it may bring further risks to the LGFVs overseeing their deliveries.” BLOOMBERG