China growth hopes rest on troubled local government financing vehicles

If the Chinese government is able to reach its economic growth target of 5.5 per cent this year, it will be due in part to retail investors such as Jane Song.

In May, Song invested Rmb200,000 ($29,600) in a fixed-income wealth management product issued by a local government financing vehicle in eastern Shandong province. A financial adviser in Shanghai, she was undeterred by the growing reluctance of bigger investors to back LGFVs, which play a vital role in funding infrastructure development across China.

“If the WMP defaults, the local government will have trouble accessing credit in future,” said Song, who expects to get 8.8 per cent interest on the “medium risk” product. “They are not going to let that happen.”

The scale of the challenge China faces in reaching its annual growth target was underlined on Friday by data showing that the economy expanded just 0.4 per cent year-on-year in the three months to June.

Hitting 5.5 per cent growth for the year will only be possible if LGFVs accelerate construction activity. But the local government vehicles are finding it difficult to borrow from banks and institutional bond investors, and are increasingly being forced to offer retail investors high interest rates to raise cash.

Tapping retail investors directly, some for as little as Rmb50,000 each, is a new departure for LGFVs. They have traditionally raised capital from institutions — mainly banks — or from rich individual investors acting through third parties such as trust firms and brokerages and with minimum investments set at Rmb1mn.

But Beijing’s crackdown on shadow banking over recent years has made it more difficult to access such individual investment. The outstanding value of infrastructure-backed trust products has dropped by almost half from a 2017 peak of Rmb3.2tn.

Last month, Limin Construction Development Group, an LGFV in Zoucheng city in Shandong, turned to social media platforms such as WeChat in its effort to raise Rmb200mn from retail investors.

It is promising 8.6 per cent interest — much more than it would pay if banks were willing to lend. The average annual interest rate charged by Chinese banks for business loans was 4.16 per cent in June.

Limin’s prospectus does not specify how the proceeds will be spent, other than saying they will help “replenish working capital”.

“You don’t need to know how exactly we are going to spend the money,” said a Limin executive. “We will pay you back on time and that’s all that matters.”

The executive, who asked not to be identified because he was not authorised to speak to foreign media, added the vehicle was close to reaching its fundraising target.

Similar appeals have been issued on social media by hundreds of LGFVs across the country, raising concerns that local governments that are already highly leveraged are amassing potentially explosive debt loads.

“This is another way for [local governments] to delay the inevitable,” said Andrew Collier, managing director of Orient Capital Research in Hong Kong. “This is the last gasp of a desperate economy trying to paper together its growth.”

Samuel Kwok, head of Asia-Pacific public finance at Fitch Ratings, said issuance of short-term, high-cost debt by many LGFVs in China’s economically weaker regions was a sign they were having refinancing issues.

“The ability to refinance is key to LGFVs, as they are supposed to finance the local economic development on behalf of the governments,” Kwok said.

Bond investors and other more traditional creditors have become more wary of LGFVs even as Beijing makes it a policy priority to support infrastructure projects and boost an economy hit hard by president Xi Jinping’s “zero-Covid” lockdowns.

LGFVs with credit ratings of AA or below raised only a net Rmb204bn from the bond market in the first half of this year, down 50 per cent from the same period in 2021, according to East Money Information, a financial data provider.

Multiple local banks, which across China are the biggest bond buyers, told the Financial Times they were shunning low-rated LGFV bonds. “We won’t go for LGFV bonds rated below AA+,” said an investment manager at a lender in the eastern city of Suzhou. “And there is a clear preference towards bonds issued by economically strong regions.”

Limin, the Zoucheng-based LGFV, reported Rmb2.9bn in cash at the end of last year, almost 80 per cent of which it could not access because it was pledged as margin deposit for bank creditors.

“If you have Rmb2.9bn worth of cash and are rushing to pay 9 per cent for Rmb200mn in private loans, it is about pretending you are solvent when you are not,” said Collier at Orient Capital.

Limin said it was “operating normally”.

Yang Xiaoyi, a government finance analyst at Beijing consultancy Mingshu Data Technology, said it was increasingly common for LGFVs to delay repayments of the principal they owe investors while making good on the annual interest owed — essentially turning their investments into perpetual bonds.

“You have to allow the investment to roll over indefinitely to avoid a default,” said Yang.

Regional authorities are aware of the risks. In an internal circular issued last month by Henan province’s finance bureau and seen by the FT, the regulator said it would ban local LGFVs from directly selling debt securities to individuals. The ban came after hundreds of investors invested in multiple platforms offering annual returns of 8.5 to 10 per cent.

“The practice,” the bureau said, “has severely disrupted economic and financial order and could easily lead to social instability.”