CHINA MONEY WEEK: Orderly Or Ugly Default For China LGFV Bonds

--Growing Number Of Investors See LGFV Default in 2018

     BEIJING (MNI) - Bonds issued in China by local government funding vehicles

(LGFVs) are widely expected to see a first default this year due to high

refinancing risks stemming from strict regulation policies, while local

governments' high reliance on LGFVs will likely cause the default to happen in

two possible ways -- orderly or ugly.

     A recent survey conducted by China International Capital Corp. (CICC)

showed 61% of investors believed the first LGFV bond default will happen in

2018, compared with just 9% of investors suggesting no default this year. The

concern was described by CICC analysts as the "most serious since the LGFV bonds

price plunge in 2011."

     Secondary market pricing reflects investors concerns. According to data

from Chinabond, five-year "AAA" and "AA" LGFV bonds saw their spread with same

maturity China Government Bonds (CGB) widen to 170.8 and 211.7 basis points as

of Wednesday, 2.07 and 8.07 bps higher than the spread on Dec 29, the last

trading day of 2017.

     Market concerns over LGFV bonds come from strict financial regulation and

tight monetary conditions, which increases LGFV refinancing risks.

     Regulators are severely clamping down on channel businesses, used in the

past to provide funding for LGFVs, causing falling demand for LGFV bonds and

higher refinancing risks.

     --LGFVS FUNDAMENTALLY WEAK

     The fundamental position of LGFVs remains weak. Total debt is 35 times

higher than the EBITDA of LGFVs in 2016, although that number will fall to 20

times after taking account subsidies from government, but remains high,

according to the CICC. Additionally, about 80% of LGFVs have negative free cash

flows. 

     Refinancing pressure is high this year, with a total CNY1.35 trillion in

LGFV bonds maturing, while a further CNY245.2 billion have options allowing

investors to choose whether to hold them or sell them back to issuers in 2018.

Combining the two, the total maturing LGFV bonds could reach as high as CNY1.6

trillion, higher than the CNY1.48 trillion in 2017.

     Despite the mounting pressures and Beijing's determination to curb LGFV

financing, the motivation for local government to see LGFVs default remain

limited, as they continue to rely on LGFVs to provide infrastructure funding.

     Guosen Securities estimated that the LGFVs provide around CNY5.3 trillion

in infrastructure investments, accounting for 31% of the total infrastructure

investment in 2017, lower than 2016's 37%. 

     Facing downward economic pressure, infrastructure investment remains

essential to stabilize China's economic growth. Given new measures for

government to raise debts, including special bonds, will not be able to gain

ground quickly enough to replace the role of LGFVs this year, it is reasonable

to assume LGFVs will still play a big funding role in 2018.

     --DEFAULT POSSIBILITIES

     If LGFVs do default, there are two likely ways it could happen: one good,

one bad.

     The first possibility is an orderly one. The government may allow an LGFV

bond default with no bail out. This may only happen if the defaulted LGFV is

weak enough and small enough, causing no market panic and no increased risks to

LGFV refinancing. 

     This is the scenario that Beijing would like to see. However, risks remain

in this scenario, as the process could hurt other low-rating LGFVs, causing them

increased refinancing pressures.

     The second scenario is the 'ugly' one. Regulation measures could cause

credit supplies to become tighter than regulators' actual intentions, causing

LGFVs to default unexpectedly, even in large scale, if local governments are not

able to step in. 

     This is the most dangerous outcome, potentially causing systemic risks by

triggering large scale sell-offs of LGFV bonds, with the selling pressure

quickly spreading to other asset classes. This will require central government

to intervene instantly, the outcome depending on the effect of such

interventions. 

     For some, overtightening could be one of the biggest 'grey rhinos' in China

this year.

--MNI Beijing Bureau; +86 10 85325998; email: he.wei@marketnews.com

--MNI London Bureau; tel: +44 203-586-2225; email: les.commons@marketnews.com

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