China bond default has positive effect on local government groups

March 17, 2014 3:15 pm

China bond default has positive effect on local government groups

By Simon Rabinovitch in Shanghai

It looks like a colossal accident waiting to happen: China’s first true bond default has laid bare the country’s financial risks just as $400bn in debt comes due this year for cash-strapped local governments.

But a curious thing has happened in recent days. Far from triggering a wave of defaults, the concerns about the Chinese bond market have instead nudged local governments closer to financial safety.

Bonds issued by local government financing companies – long seen as one of the big problems hanging over the Chinese economy – have found favour among domestic investors and brokerages. Credit costs for provinces and cities have declined as a result, making it easier for them to obtain the cash to pay off their maturing debts.

When Chaori, a struggling solar cell maker, missed an interest payment this month – the first real domestic default in the modern era of China’s bond market – it was seen as a sign that the government would finally allow companies to fail. Analysts predicted that investors would start to pick between borrowers in the bond market, flocking to safe, lower-yielding paper and demanding higher rates from riskier companies.

Yet such predictions failed to grasp the political realities of China’s financial system. And those are that Beijing will draw a line between weak private companies and weak government-backed companies; it will let the former default but not the latter.

“People believe that if you let a LGFV [local government financing vehicle] default, there could be a chain reaction. So they believe the government will do something and not let them go under at this moment,” said Ivan Chung, a credit officer with Moody’s.

One fixed-income trader with a foreign bank in Shanghai said that the market is not worried about local government debt any more, saying “it’s become like a safe haven”.

The yield on local government five-year AA notes – the most common rating for LGFV issuers – has fallen 72 basis points from a record high of 8.07 per cent on January 20, and is now running near a four-month low.

Chinese bond yields have declined in general over the past few weeks as the central bank has eased liquidity conditions, but local governments have benefited more than most. The spread between the yields of their AA bonds and top-rated central government bonds has narrowed by more than 50 basis points, a sign that investors view the local debt as safer than before.

Leading domestic brokerages have recommended to clients over the past week that they increase their exposure to local government bonds. “If there is any short-term fall in LGFV prices, it would make a good entry point for investors,” Guotai Junan, a domestic brokerage, said.

China International Capital Corp agreed: “The perception that companies with government backgrounds are low risk has, if anything, been strengthened.”

The perception that companies with government backgrounds are low risk has, if anything, been strengthened

– China International Capital Corp

The optimistic view of LGFV bonds comes at a crucial time for China. An official audit at the end of last year showed that local government debts had soared to Rmb17.9tn ($2.9tn), up 70 per cent from 2010. More than 40 per cent of those debts were to mature by the end of this year, the peak for repayments.

The pressure on local governments was evident in January. Huaihua, a city in the central province of Hunan, issued a medium-term note with a coupon of 8.99 per cent, a record high for an LGFV bond. But new issues at the start of March such as Jilin Railway have been successful with coupons more than 100 basis points lower.

That has fuelled a surge in LGFV bond issuance, and market appetite has been strong. In January, Chinese local governments issued just 70 bonds, according to data provider Wind. The pace has doubled since then, with 82 bonds issued in just two weeks from the end of February to the start of March.

“The problem of the debt rollover is gradually being solved,” analysts at Huarong Securities wrote last week.

A handful of Chinese bonds across a range of industries are still sure to face trouble. XE Flavour, a restaurant chain, was downgraded to an A rating in February after its profits shrivelled last year. Securities Daily, a state-owned newspaper, asked last week whether Sinovel, a lossmaking wind company, would be the next Chaori. Meanwhile, a bond issued by Tianwei Baobian, a solar cell maker, was suspended from public trading last week after it posted its second consecutive year of losses.

But the case of Tianwei may also be instructive about the government’s tolerance for defaults. Unlike Chaori, Tianwei’s controlling shareholder is a company owned by the central government. When Chaori was delisted last year, its bond had already been downgraded twice and was just three notches above a junk rating. Tianwei, though placed on negative watch, has retained its AA rating thanks to its government backing, just two levels below a top AAA grade.

“The rating reflects Tianwei’s political standing, not its financial health,” said the fixed-income trader. “That is still an accurate way of looking at things in China.”