Can’t pay, won’t pay

If he had been born 2,500 years later, China’s most famous philosopher could easily have been referring to the problems engulfing China’s local government financing vehicles (LGFVs) when he said, “The man who moves mountains begins by carrying away small stones.”

Confucius was born in modern day Shandong province and it is there that a local bank has publicly foreclosed on its LGFV debt and highlighted the fact in its financial statements for the first time.

The move is prompting questions about just how many more cases may come to court as refinancing pressures mount in relation to the Rmb17.9 trillion ($2.88 trillion) of local government debt amassed.

At the beginning of July 21CN Business Herald reported that Qilu Bank had successfully sued a LGFV set up by the Licheng district in Jinan, after it defaulted on a loan relating to urban renewal projects. The guarantor of the loan, a separate LGFV set up by the city of Jinan, has also been found liable (it had tried to wriggle out of the guarantee by claiming it had not been told that the loan in question was a debt refinancing). The Wall Street Journal says Qilu Bank has now begun auctioning off the Licheng LGFV’s assets.

Qilu Bank was formerly known as Jinan City Commercial Bank. In 2009 it was rebranded into Qilu, an amalgam of two ancient states (Qi and Lu) that dated back to the time of Confucius. The idea was to reflect the bank’s expanded operations, which now spanned the whole of Shandong province.

One of the most striking aspects of the current litigation is how the provincial capital now appears to be at war with itself, pitting a major city commercial bank against a district level construction bureau, which in turn owns stock in the bank. (Another major Qilu shareholder is Commonwealth Bank of Australia, which has a 20% stake.)

At the heart of the LGFV crisis is a mismatch between the revenues (long term) and debt repayments (short term) of many of the borrowers. As 21CN recounts, Licheng district first took out a Rmb10 million loan with Qilu Bank in 2005, but was forced to roll it over in 2010 because it did not have the cashflow to pay it back. This refinancing occurred at a time when the central government was starting to crack down on LGFV fundraising, fearing widespread repayment problems.

Since 2010, banks began demanding guarantors for debt issued by lower level district and county-level fundraising entities. So Licheng brought on board the Jinan LGFV as a guarantor and Qilu Bank extended a further Rmb14.9 million loan, which fell due in April 2013.

However, by 2011, Licheng was having problems paying its employees and stopped paying interest on the loan in 2012. According to Reuters, Qilu is suing over Rmb35.4 million of outstanding debt.

Qilu’s litigation highlights an unusual aspect to the situation – its decision to make the issue public rather than smooth over the default in its financial accounts, as other banks have been doing. That also suggests Qilu has become exasperated by its failure to broker a behind-the-scenes solution with the local government.

Then again, Qilu (which longstanding readers will recall from an earlier controversy we reported in WiC91) seems displeased at the headlines created by the case. To confuse matters further it has backtracked by issuing a clarification that Licheng is an independent entity, and not an LGFV.

Nevertheless local media thinks this first case is a big deal.

Why so? It points to a shortcoming in a system that was supposed to see more senior levels of local government guarantee the credit of the districts and townships below. Four years after that system was devised – in a (belated) attempt to rein in the LGFV problem – the Licheng mess demonstrates its limitations.

Earlier this year, Lianhe Ratings issued warnings that Licheng’s guarantor, the Jinan city’s own LGFV, “has a certain risk relating to its contingent liabilities”.

One bond investor tells 21CN that its fund will be steering well clear of urban construction bonds – typically issued by LGFVs – from now on.

“They look glossy on the surface, but are very smelly inside,” he warned. The same investor was pretty scathing about the objectivity of China’s domestic rating agencies too, which have upgraded 126 construction bonds so far this year. “The reliability of their ratings is particularly worrying,” he concluded.

One person who rues his involvement in local government fundraising is Song Xueying, the secretary of the land bureau at Heilongjiang’s Jiamusi city. Currently in prison, Song accuses municipal government bosses of forcing him to issue land certificates as collateral for urban construction bonds.

Three bonds issued by a LGFV set up by Jiamusi – and which total Rmb3.3 billion – have been suspended by the Shanghai and Shenzhen stock exchanges, while one is still being traded. A State Land Supervision Bureau report discovered the land used as collateral had been improperly designated for construction purposes, as well as inflated in area from 70 hectares to 1,143 hectares.

As 21CN points out, Jiamusi’s situation isn’t unique. Qiqihar, another big city in Heilongjiang province, sanctioned in 2012 for a similar offence. The worry is that more incidents will come to light as cash-strapped local governments get more desperate to bridge the funding gap between their revenues (largely from land sales) and their expenditures.

At the end of June the National Audit Office issued a new report on local government debt, sampling nine provinces and nine city-level governments. Analysts welcomed the update as a sign of the government’s determination to bring more transparency to local government finance. The report revealed an Rmb57.9 billion increase in new debt for old. But it did not touch on one of the main issues worrying analysts – the upcoming wave of redemptions in trust fund debt (which is thought to have reached Rmb11.1 trillion). Banks have been using entrusted loans to protect their loan-to-value ratios by booking debt as an investment rather than a loan. Most of this money was lent to local governments too.

On July 7, 21CN said the government has suspended the public fundraising activities of Zhong Rong ITC, one of the largest government-related infrastructure investment trust companies, which had assets of Rmb488 billion at the end of 2013. Domestic commentators say the move reflects concerns about a spike in default risk over the second half of the year when Rmb2.7 trillion in investment trust debt comes due.

But at least the efforts to bring local government debt under control have taken one positive step. In late May, the central government expanded a pilot project allowing 10 provinces to issue bonds in their own names for the first time.

Since then, Guangdong province has raised Rmb14.8 billion from its inaugural domestic deal. At the same time, the government says that the 10 borrowers will be required to publish regular disclosures about their financial condition.

This represents an important step towards the kind of transparency that will enable banks, investors and rating agencies to price credit risk more accurately.

Amid that more optimistic trend, however, problems continue to build up. For example, Reuters reported in midweek that traders are bracing themselves for another landmark event in the bond market. There is speculation that Huatong Road and Bridge Group, a construction firm, might fail to pay investors interest and principal that are due on a one-year short-term bill that matures on July 23.

“If a default occurs, it would be the first public bond default in China’s interbank market, the country’s largest bond market, and would also be the first time a Chinese company is publicly known to have defaulted on both interest and principal due on a bond,” Reuters warns.

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