Aug 16, 2018 | 21:40 GMT

3 mins read

China: The Government Confronts the Increasing Risk of Default


What Happened

On Aug. 15, the Sixth Division of State-Owned Asset Management, a military-affiliated company in western China's Xinjiang region, said that it had made up the repayment of bonds worth 500 million yuan ($73 million), two days after it missed the deadline to repay the loan that could have left the company in default. According to a statement, the local government financing vehicle (LGFV) made the overdue principal and interest payment on the morning of Aug. 15, narrowly escaping the fate of being the first government-linked financing vehicle to default in a decade. 

Why It Matters

Despite the turn of events, the incident has increased concern about the growing risk of default on the enormous debts of many local governments and corporations, especially as the economy continues to slow. Corporate defaults are already on the rise this year, due to Beijing's deleveraging efforts, which were in effect until quite recently. And the risk to local government-linked borrowing is sharply growing, because of maturing bonds and declining asset returns — particularly in the property market.

The state-owned firm's late repayment prompts questions about how the company was able to raise so much money; it's unclear whether the firm's parent company, the Xinjiang local government or the state played a role in the repayment, given the implicit Chinese government guarantee on these bonds. With several similar LGFVs now under stress, it bears watching to see how the authorities manage the default and market confidence.

Reining In Debt

China is trying to slowly resolve the massive debt it has accumulated at a local level as a result of the 2008 global financial crisis. Since that time, local financing vehicles have served as the primary way for local governments to raise money and support their economies, especially since they were prohibited from directly borrowing from banks and from raising large bonds. Over the years, these pseudo-corporations continued to proliferate, and their total debt has reached as much as 20 trillion yuan and accounts for about half of local government-related debt (including official local bonds) — or a quarter of China's gross domestic product.

Over the past decade, LGFVs have commonly raised credit through various types of off-balance-sheet loans from banks, insurers or other financial institutions, promising high returns and often an implicit guarantee from local governments or real estate as collateral. However, this method left LGFVs largely unregulated. Over the past two years, Beijing has been working to limit these shadow financial vehicles, and the result is that much of the local government-linked debt is under major stress.

Although Beijing recently turned again to stimulus spending and easier credit, more defaults are still expected from local financing vehicles and other government-related financing platforms. Adding to the challenge is the fact that a lot of debt will be maturing in the coming months and will likely put stress on some central and western regions and provinces that have weaker economic foundations and higher debt burdens.

Given the likely sequential defaults and challenges to government-linked bonds, some financial experts, local governments and investors anticipate that political authorities will ultimately assist in preventing defaults. At this point, Beijing must walk a fine line financially, balancing its policy tools and further refinance challenges to these government-linked debts with the risk of contagion effects.  

What to Watch For

  • Did the Xinjiang government or the state play a role in the repayment? 
  • The Sixth Division of State-Owned Asset Management will have another 500 million yuan bond mature in the coming week. How will it manage that repayment? 
  • How will other central and western regions manage their local debts, and will defaults spread?

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