SIVs? Subprime?
Meet China’s Local Government Investment/Financing Vehicles (LGIVs/LGFVs).
Independent Strategy came up with one of the most headline-worthy characterisations of the vehicles, dubbing them China’s own brand of SIV-like structures. This was the quote:
LGFVs are conduits, like the Special Investment Vehicles (SIVs) were for western banks, used by local government to borrow and spend on infrastructure and other projects (like real estate).
Local Chinese governments share relatively meagre incomes from the country’s central tax pot, yet they’re charged with some pretty huge infrastructure and stimulus projects. What’s more they’re unable to run deficits, or get bank loans, or issue bonds without special central authority permission.
Enter the LGFV. Using these conduits, local governments are able to finance their projects in a rather roundabout way, borrowing money from banks in exchange for some collateral –often local land.
In that way, the LGFV essentially allows the government to spend beyond its budget. Sort of like what SIVs did for bank leverage before they were eliminated.
To wit, the basic (convoluted) LGFV structure:
That diagram is from a recent note by Merrill Lynch analyst Winnie Wu. The whole thing is well worth reading, not least because it starkly illustrates the recent paucity of local government funding.
In the meantime though, here’s where Wu says the subprime stuff comes in:
Reckless lending to borrowers with sub-prime credit worthiness; excessive borrowing in a low rate environment with interest-only initial payments; making assumptions based on ever-rising property prices – sound familiar? We believe that the LGFV issue shares some similarities with the US sub-prime crisis. Luckily China’s excessive credit growth lasted for a relatively short period & regulators have started to contain the issue by securing payment sources to existing loans, curbing new loans & nullifying government guarantees. In the mid term, local government bonds, ABS & infrastructure REITs could also help buy some time . . .
Investors’ key concern is whether minority shareholders could end up paying for it. In our view, China would try everything to prevent a GITIC type default, which could damage its credibility for decades. Nonetheless, the system risk is high and banks may have to share some pain. Market could discount the risks, and the upward pre-rating potential for the sector may be limited until better clarity on the issue. That said, we do not expect the risk to materialize in the short term, until we see key triggers of a major credit event or clear leading indicators.
Others of course think the outcome may be very different.
Back to Independent Strategy:
This LGFV edifice will not survive credit tightening, because it is a Ponzi-type pyramid built upon borrowing more to service existing borrowings. However, timing the day of reckoning is complicated by the fact that China’s credit bubble is domesticated, because it is built on debts owned and borrowed at home. The LGFV scheme is credit borrowed and lent between state entities or, in the case of banks, between semi-state entities.
So the authorities can fudge and fiddle as they did when a similar, but smaller and foreign-financed, ITIC (investment trust) credit bubble collapsed in the mid-1990s. LGFV bad debts will be surgically removed together with collateral to state-owned Asset Management Corporations where they will linger unresolved for a goodly time (old debts still there today).
This is a nice rosy scenario, which will undoubtedly be pedalled under the “we believe in the China story mantra” by all those institutions with an interest in doing so. And there’s no doubt that ultimately the Chinese will try and navigate this course.
But we can’t share such optimism about the outcome. That’s because the problem is economically huge. LGFVs are not going to be borrowing and spending any more. And if infrastructure investment drove 90% of 2009 GDP growth and 70-80% of this was down to insolvent LGFVs, where will the growth in credit and GDP come from now?
China is in for a big fall in growth and better pray that exports save it. Land and real estate asset sales are about the only way for LGFVs and local governments (that guarantee LGFV borrowings) to raise cash to service their debts if they cannot borrow. So stand by for falling land/real estate prices! This will lead to the discovery of other Ponzi-type schemes and bankruptcies, as well as more bank non-performing loans.
Chinese SIVs — mostly definitely something to watch.
Related links:
China’s great central economy, and big local problems – FT Alphaville
Frayed string for China’s property balloon – Andy Xie
China’s muni mess – Forbes