Overview
To understand how stimulus is feeding through, two key developments bear watching: buoyant new bond issuance by local government financing vehicles (LGFVs), and whether this ultimately translates to stronger demand for steel and other commodities.
Our onshore China fixed income team sees a 12 per cent to 16 per cent year-on-year increase in total outstanding local government debt this year, including borrowing by LGFVs. Why is this important? We expect about a third of the funds will flow into infrastructure, but the key for commodities, like steel, is how much of the rest flows into new real estate investment and construction activity.
Nonetheless, steel equities are now so cheap that despite some uncertainties related to land sales and new property construction starts, the risk-reward is skewed to the upside for some stocks in the sector. Demand after Lunar New Year has been picking up, with mills seeing orders improving, and inventories destocking at a healthy rate.
Source: Wind, Fidelity International, March 2019
Short-term gain, longer-term pain?
Of course, short-term credit stimulus raises longer-term risks in onshore credit markets, as the government allows leverage to expand. While it’s become easier to raise or refinance debt in the near-term, local government entities may struggle to meet obligations further down the road.
Patchy credit transmission could mean more private company defaults and festering risks related to LGFV issuance. China’s onshore bonds are in bullish mode this year as signaled by tightening spreads and strong new issuance, but LGFVs are absorbing a lot of the new demand due to their implicit guarantees, crowding out private companies and lower-rated borrowers.
Source: Wind, Fidelity International, March 2019
In other words, credit transmission to the real economy remains patchy - we are on track to see more defaults this year than in 2018, and all of them so far have involved private companies. That said, LGFVs - which account for 30 per cent to 40 per cent of all onshore bonds and are often tied to infrastructure projects - could be a bigger tail risk for the global economy in the longer term, especially if their implicit state backing gets put to the test.
Source: Wind, Fidelity International, March 2019
We have yet to see what will happen in the event that one of these bonds defaults, but local governments are already subsidizing many LGFVs, since some of the vehicles cannot fully meet interest payments. It’s also unclear what will happen when - not if - they face difficulties refinancing. Most LGFV bonds are due within five years, while their underlying assets could require twice that long to generate the cashflows necessary to meet their obligations. That is, if they ever do.
