China banks-LGFV debt: a tug of war

Highlights of conference call with CCXI on the bond marketWhen you owe somebody $1m, you are in trouble. But when the debtgrows to $1bn, it becomes their problem. This is how we feel about LGFVswaps. The platform companies are still active borrowers in the bondmarket. Local government debt, despite unattractive yields, may still findbuyers in banks as the latter can’t risk having any LGFV default. Our callswith CCXI, China’s largest credit-rating agency, this week shed more lighton the reform and its obstacles.

No deleveraging from LGFV yet.

.State Council’s document 43 last September and the audit on local governmentliabilities have filled the market with hope of deleveraging at local governmentfinancing vehicles (LGFVs).

.Not yet, according to CCXI. Bond issuance by LGFVs is still going strong. Butthey’ve moved away from enterprise bonds to MTNs, CP and corporate bonds.

.Regulators do not want any defaults while LGFVs have refinancing needs. CCXIexpects only 20-30% of LGFV liabilities can be swapped into local governmentdebt.

Shortfall in LGFV swaps.

.So far Rmb1tn of LGFV swaps have been announced, vs Rmb1.86tn of debt set tomature this year (from 1H13 last audit result), representing about 53% coverage.

.The MOF may need to raise this year’s quota for LGFV swaps. Local governmentsalso get a Rmb500bn quota for general obligation bonds and Rmb100bn forrevenue bonds.

.The initial plan to launch local government debt has been delayed by a lack ofinvestor interest and expectations for lower interest rates.

Local governments vs banks.

.The credit spread with treasury is likely to be less than 50bps. The low yield isn’tattractive to banks, despite tax and capital benefits.

.But they will eventually have to take up the issue so the proceeds can be used tohelp LGFVs pay down their debt. Between NIM and NPL, the choice is obvious.

.Whil e bond default risk in general has been going up, most distress is in SMEs andthe likelihood of systemic failure is low.

A multi-year debate.

.With SOE reform, the government will use mergers and consolidation to helpaddress distressed situations.

.Credit quality has been the biggest stumbling block to investing in Chinese banks.

.It will remain so, until the market gets clarity on the extent of LGFV liabilities.