Will Shadow Banking Crackdown Trigger Local Government Bond Defaults?


Beijing’s ongoing crackdown on the shadow banking sector is triggering concerns about the ability of local governments financing vehicles to service their debts, with some analysts foreseeing inevitable defaults.

Bloomberg reports recent efforts by regulators to shut down avenues for off-balance sheet financing have created concerns amongst investors that local government financing vehicles will be unable to make the payments on an unprecedented 1.8 trillion yuan in notes that are set to mature this year.

On January 18 the insurance regulator and the Ministry of Finance announced that local governments are prohibited from using insurance funds in ways that conceal their true purpose, while on 13 January the banking regulator placed a ban on lenders providing debt financing to local governments or ailing zombie enterprises.

Investor sentiment over local government bonds has taken a further hit from the revelation that a number of regional authorities have inflated their economic figures, including Inner Mongolia, Liaoning province and the municipality of Tianjin.

As a result the yield premiums for AAA rated LGFV notes are now approaching a three year high, while Bloomberg data indicates that sales of LGFV bonds are on track for a precipitous decline this month, eking out 32 billion yuan by 26 January as compared to 130 billion in December.

Analysts expect these developments to make defaults on local government bonds all but inevitable.

“The first default is likely to occur following regulatory restrictions on local government guarantees and bailouts,” said strategists Becky Liu and Jeffrey Zhang from Standard Chartered Plc in a research note last week.

“One can’t underestimate the refinancing pressure on LGFVs, as it’s become increasingly difficult for non-standardized borrowings and as banks become prudent in lending,” said Liang Shichao, analyst at CIB Economic Research & Consulting Co., to Bloomberg.

“The latest credit events are damaging investors’ trust in LGFVs, at a pace faster than expected.”

Beijing has signalled that local government debt will one of its key focal points for 2018, with the National Financial Work Conference flagging a crackdown on “illicit financing” by government, as well as the use of investment funds, public-private partnerships and purchases of services by local government to “covertly raise debt.”

Despite these concerns observers such as Qiao Baoyun, head of the Academy of Public Finance and Public Policy at the Central University of Finance and Economics, nonetheless, argue that China is firmly on track to become the world’s biggest issuer of local government bonds within a five year period.

“In 2018, local governments are predicted to issue more new bonds than last year, with a larger proportion, or up to 50 percent, being the special bond, which may lead to a rise of the debt ceiling to more than 20 trillion yuan,” said Qiao to The China Daily.