A January 28th report from Societe Generale’s Cross Asset Research suggests that local government financing may be the weak link that leads to China’s “day of reckoning.” Moreover, according to Societe Generale analyst Wei Yao, the current environment of slowing domestic growth and tightening global liquidity will clearly impact local governments’ ability to extend credit guarantees.

Yao emphasizes the urgent need for reform to avoid a “hard landing” for the Chinese economy. “However, while reform may finally cause credit risk to unwind on a larger scale, whether China can still avoid a systemic financial crisis also depends on reform. A restructuring plan for inefficient state enterprises is sorely needed, probably with the help of private investors.”

Chinese financial reform efforts shutting down local financing

China Hard Landing

The Societe Generale report highlights that in China a majority of creditors and borrowers are connected to the government, so the typical market dynamics of risk discovery are often suppressed. Furthermore, local governments play a key role in the credit risk chain. Their role is to provide credit guarantees to LGFVs, local SOEs and even large private companies based locally. When problems arise, local government officials are also usually seen at the negotiation table.

Yao notes the ongoing reform process is likely to cut off local government financing at the knees, which will in turn have serious systemic effects. “However, as the fiscal reform process progresses in a surprisingly strict manner, the guarantees extended by local governments look increasingly less certain. This will have profound implications for China’s financial market, and we believe this is not yet fully appreciated by market participants and investors.”

Unwinding of credit risks in China

China Hard Landing

She goes on to argue that as local government financing begins to wobble, credit risk may start to unwind in several other areas.

LGFVs: Yao starts by noting that the “market’s count of LGFV bonds is three times the size recognized by the central government.” She also notes that shortly after local governments submitted the debt figures to national authorities in early January, some government sources hinted that the new count of LGFVs could be “shocking”.

China Hard Landing

Local SOEs: There are more than 100,000 local SOEs in China, and as their profitability underperforms central SOEs who are less efficient than private firms, this could become a major problem. Given their poor financial performance, local government credit guarantees are the only reason a large chunk of these SOEs are still solvent. Long-term growth deceleration is pushing SOEs to financial brink. Yao notes: “In the industrial sector, 30% of SOEs were loss-making in 2014, up from 25.5% in 2013 and compared with 12.5% of private enterprises. The situation deteriorated sharply towards end-2014 as SOE profits contracted 21.8% yoy in Q4 14 (vs. -1.3% yoy of private enterprises). Their total liabilities stood at CNY31tn as of end-2014, much more sizeable than LGFVs.”

Private companies: Private firms are by far the most efficient sector in the Chinese economy, but many still enjoy a number of concessions from local governments or local government-related enterprises, in the form of inexpensive land, low utility rates, tax rebates and even credit guarantees. Yao points out that the ongoing tax reform and land reform will likely eliminate most of these “irregular” subsidies or discounts on industrial land and operations.

H/T Linette Lopez