While Timing Remains Uncertain, China’s First Local Government Bond Is Expected To Default According to Fitch Ratings

Amid persistent concerns over high debt levels in the world second largest economy, Fitch Ratings said in a press release issued on Sunday that China may witness its first local government bond defaults, although the timing was uncertain.

Created by local authorities to bypass restrictions on borrowing, these bonds were issued by Chinese local government financing vehicles (LGFVs).

The financial markets could be impacted and a wave of contagion across the global economy could potentially be spread by a wave of defaults in China due to high local government debt and there are concerns about the potential such defaults.

And as official channels dried up due to the government’s crackdown on leverage, the LGFVs have also borrowed from the Chinese shadow banking sector.

Including loans from non-financial companies as well as investment products, shadow banking is a broad category of banking-like services from non-traditional players. And it largely goes unregulated because it is outside the bounds of normal banking regulation.

Fitch said that the first defaults “are becoming more likely and will probably trigger a repricing of the market” even though no Chinese LGFV has defaulted to date on its publicly traded debt so far.

Citing increasing risks from the country’s rapid build-up of credit, S&P Global Ratings downgraded China’s long-term sovereign credit rating by one notch last week to A+ from AA-, ad Fitch’s warning comes soon after that downgrading. China’s sovereign credit rating was also downgraded by Moody’s Investor Service in May.

the overall risks are likely limited due to the government’s “pervasive ownership and influence” across the financial system, despite the risk of LGFV bond defaults, Fitch said.

But a potential scenario with only a small probability of occurring or widespread defaults remained a tail risk, the ratings agency said.

“The authorities continue to rely on local government investment—supported by LGFVs—to hit economic growth targets, and have a broad spectrum of policy tools to limit default contagion,” Fitch added.

“The authorities are in a position to prevent systemic defaults,” said Fitch, including using the last resort of bailing out the LGFVs using fiscal resources.

Fitch added that to contain financial risks through means such as instituting debt ceilings and providing swaps to convert LGFV debt into explicit government debt, the central government has been trying to “disentangle” LGFVs from public-sector balance sheets.

However, outstanding, equivalent to 5.4 percent of China’s gross domestic product, LGFV debt has continued to rise with 4 trillion yuan ($605 billion) worth of LGFV bonds issued since 2015.

Fitch said that Chinese authorities will likely to allow the lower quality LGFV bonds to fail.

“These would be LGFVs deemed most financially stretched by the authorities, and consist mostly of lower-tier (non-provincial) LGFVs, particularly those that mix commercial with policy activities, such as property with urban development,” said Fitch.

As the central government seeks to instill greater budget and market discipline, China has already allowed some state-owned enterprises to default in the last few years.

(Adapted from CNBC)

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