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Ark, what are LGFVs and why is everybody talking about them?
LGFV stands for local government financing vehicles. They became widely established after the 2008 global financial crisis, developing rapidly as a workaround in lieu of traditional municipal bonds. This was because most local governments in China weren’t allowed to borrow directly, so they incorporated these quasi-official vehicles to raise the funds needed to execute a whole range of infrastructure or other projects that you might otherwise associate with local fiscal spending. They have helped drive up China's urbanisation ratio, from 36 per cent at the turn of the century to 65 per cent now. The metros that we ride on, the highways we drive on, the parking lots, the urban facilities- many were built by LGFVs. But their roles are evolving.
What they do now is more like a city operator and a manager of state-owned assets.
How big a market are we talking about?
The total amount of LGFV debt is nearly $10 trillion. But it really depends on how you define LGFVs. Some of them have debt that was raised for commercialised businesses and the estimated total of LGFV debt accounts for 50 per cent of China’s GDP, while the loan backing provided to LGFVs accounts for about 20 per cent of the loan balance of Chinese banks. So, they do have systemic importance to the economy and banking system stability.
How do you think about that as an investor?
First, the LGFV sector is the largest sector in China’s bond market, accounting for like 40 per cent to 50 per cent of the non-government, non-FI [financial institution] bonds.
40 to 50 per cent of the corporate bond market?
Yeah, the corporate bond market.
Right! So, if you ever wanted to consider investing in China’s credit market, this is definitely a sector that you need to look at. But in terms of credit selection, I would say that overall credit differentiation is getting more and more obvious.
There are better and worse borrowers.
It’s just because the support capabilities of local governments are different. You can think of provincial governments, for example, like mini sovereigns. The larger provinces like Guangdong or Jiangsu have a GDP closer to that of Italy or Spain. And the economies of smaller provinces like Ningxia or Qinghai account for like five 5 per cent of the GDP of those larger provinces. So you can quickly get a sense of the different financial support capabilities of these provinces, and the fact they are in different development phases. Some are accelerating investment, some are deleveraging because of population outflows and the loss of economic growth momentum, and some are more stable.
Some LGFVs are struggling to service their debts, how concerned should we be about this?
It’s true that yields on some weaker LGFV bonds have been rising and this increases their refinancing burdens. But the PBOC [the central bank] is keeping rates low, which helps. While we could see some defaults among the weakest borrowers, we don’t think this would approach a scale that threatens the system by triggering a broader funding squeeze or a liquidity crunch. In the meantime, the slowing property sector and the slump in revenues from land sales do tend to limit the potential for local governments to expand infrastructure investment, or to introduce more fiscal stimulus. Their near-term focus is likely to stay on resolving their debt burdens.
Why doesn’t the central government just step in and provide support?
In short, because they don’t need to. At least not yet. Currently the central government’s stance is to let provincial governments be the key entities responsible for local government debt risk. As long as the current stresses in the sector don’t lead to any contagion impact on China’s bond or equity markets, we think there is little reason why national policymakers would feel compelled to step in. For any problematic cases where defaults do happen there are still plenty of options for resolving matters at the local level. They can enlist support from local state-owned enterprises, negotiate extensions, or find other solutions that bring down refinancing costs or extend the tenure of the repayment period.
You mentioned that the role of LGFVs is evolving. What’s it evolving into?
I think the intention is to make LGFVs more of an execution arm of the government. Some of the businesses they fund do not have short-term profitability, but they are doing long-term good for local economic development - and supporting that is an important role that LGFVs perform.