When we gave China’s local government finance vehicles (LGFV) their first mention seven years ago (see WiC48), they were a pretty novel concept for most investors. Local governments were using these obscure platforms to raise funds (largely for construction projects) but keeping the debt off their balance sheets.
Last week Bloomberg reported that the outstanding liabilities of the LGFVs amount to Rmb5.6 trillion ($818 billion). That figure looks smaller than the estimate in 2015, when the debt was thought to be closer to Rmb12 trillion, a situation that led Beijing to order local governments to clean up the mess.
So is the problem now under control? Or has the burden been shifted elsewhere? ‘Exhibit One’ for a potential reshuffling of the original debt is another innovation in the shadow banking sector: regional financial asset exchanges (RFAE).
Since 2015 the State Council has allowed provincial governments to set up their own “regional equity exchanges” (REE). Known as “the fourth board” (the Third Board being the volatile over-the-counter share market in Beijing), the REEs offer another way for unlisted firms to raise funds. According to 21CN Business Herald, there were 40 REEs operating in September last year (roughly one for each province). They had raised nearly Rmb645 billion for 13,500 companies via sales of equities or bonds. The central government envisaged that the REEs could provide alternative financing for small and medium-sized enterprises deprived of bank loans. But the power to approve these transactions was given to the local governments, Caixin Weekly says, which means that the policy has been spawning “countless regional financial asset exchanges (RFAEs)” as more of the platforms are set up at municipal and district level.
On paper these RFAEs are designed to help growing private sector firms find finance. But Caixin Weekly says that they have been pairing up with peer-to-peer lending firms to sell much riskier debt to retail investors via wealth management products (WMP).
This shadow banking activity came to light last month following a Rmb312 million default involving a WMP sold via Alibaba’s Zhaocaibao to more than 21,000 retail investors. (Alibaba’s P2P platform has handled more than $85 billion of fundraising since it was launched in April 2014.)
At the root of the default was a Rmb1.1 billion, two-year bond issued by Guangzhou-based phone maker Cosun which matured this month.
It isn’t clear who bought the bonds originally but the risk of non-repayment was somehow transferred to an RFAE called the Guangdong Finance and Innovation New District Equity Exchange.
Caixin Weekly said the RFAE signed an agreement with Zhaocaibao to distribute the WMP in question, which has now defaulted.
Zheshang P&C, a Zhejiang-based insurer, underwrote the investment product while Guangdong Development Bank was involved in parts of the underwriting process.
Now the counterparties are disputing who is to blame. But even if a short-term fix is found that protects baffled investors, both 21CN and Caixin Weekly agree that a long overdue regulatory crackdown on the RFAEs is inevitable.
The problem, as 21CN notes, is that the credit risk is being “restructured over the counter, wrapped up in different inscrutable layers and packaged as attractive WMPs”. The theory now doing the rounds: some of the toxic assets sitting on the books of the LGFVs could be finding their way into the RFAEs (and hence to unwitting retail investors).
Indeed, the newspaper speculated that financial firms have been offloading their own bad debts to the RFAEs, which are then sold through the P2P lenders.
So far no one has come up with a reliable estimate for the debt sitting on the RFAEs. Nevertheless if the problem worsens, remember you read that nasty acronym here first.
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