China’s LGFVs could be a new and bigger grey rhino than real estate
In 2018, we first warned that Chinese real estate developers can be a "grey rhino". The risk is embedded in the vulnerable repayment ability due to excessive reliance on pre-sales, heavy leverage and fragile cash flows. Six years later, we argue China's local government financial vehicles (LGFVs) is the next "grey rhino" with a potential spillover larger than the real estate drama started from the fall of Evergrande in 2021.
Biggest property-related exposure to banks
LGFVs emerged as the largest type of government debt, at 47% of GDP in 2023, higher than 32% in local government bonds and 23% in treasury bonds. Beyond the size, they serve as an extension of fiscal and monetary policies, such as infrastructure investment and real estate projects including affordable housing. It should be noted that LGFVs do not have an official backing from local governments but there is hardly any default so far. The question is whether local governments can support LGFVs under wider fiscal deficits.
For banks, LGFVs, mortgages, and loans to developers are the largest source of real estate exposure. Developers have received much attention because of a series of credit events, but they only account for 2% of banks' assets. Mortgages, on the other hand, make up 10% of banks' assets. Despite a slight increase in the default rate, most Chinese households are unlikely to give up their properties easily. As a result, the exposure to LGFVs is the most overlooked and accounts for 14% of banks' assets.
LGFVs’ financial stability seems stable but hides increasing polarization
Therefore, the performance of LGFVs is important for China’s financial stability and the banking sector, given their role in fiscal policy transmission and the linkages to real estate. In this note, we analyze the LGFVs’ financial statements between 2018 and 2023, focusing on profitability, leverage, liquidity, and repayment ability.
Our analysis shows that LGFVs' financial health is stable on the aggregate level, but there is a risk of credit polarization. Although the return on asset (ROA) has declined with lower cash buffer, LGFVs have improved operating cash flows, unchanged leverage and steady repayment ability. However, the divergence among LGFVs is growing shown in worsening median than average values.
The aggregate repayment ability measured by EBITDA-to-interest expense has improved slowly but steadily in the past four years. The ratio increased from 1.94x in 2022 to 2.03x in 2023 lately. Conversely, the median EBITDA-to-interest expense has declined from 2.15x in 2022 to 1.91x in 2023, the lowest level since 2018 and the beginning of our coverage. Another sign of the polarization among LGFVs is on the share of zombie firms (EBITDA-to-interest expense lower than one) has reached 12.4% in 2023, the highest since the COVID-19 pandemic hit the Chinese economy in 2020.
Divergence across provinces may put some LGFVs in trouble
Given the closer connection between LGFVs and local governments, we find there is also a strong correlation between the repayment ability of LGFVs and the local government fiscal deficit with pressure on Qinghai, Gansu, Jilin, Liaoning, and Guizhou. Another problem is the LGFV’s definition is unclear, which can lead to events in uncertain guarantee. The chance can be higher if local governments face higher fiscal stress and need to prioritize its bonds with explicit guarantee.
Commercial paper shows higher credit risk among LGFVs
Still, the credit risk may be higher than it looks on the surface if we move away from the banking sector to commercial paper, an unsecured, short-term instrument. Our calculation shows the share of issuers who have defaulted on commercial paper has surged sharply from 2.34% in January 2023 to 4.63% in August 2024. At least 53 LGFVs have overdue repayment, rising from 7 for the same period.
Conclusion: A bigger and new “grey rhino” in sight
The recent policy changes may help stabilizing the real estate sector, but the absence of growth mean the negative spillover may not be over. The good news is the LGFV sector remains stable on the aggregate level, meaning the impact is muted for the whole asset class. But the problem is on the firm level. More LGFVs will see pressure in revenue and repayment debt due to the credit polarization and provincial divergence in fiscal deficits. The higher credit risk will affect local government and the banking sector, becoming another “grey rhino” if not property handled.
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