China’s growth hopes depend on faltering domestic government financing mechanisms

If the Chinese government can reach its 5.5 percent economic growth target this year, it will be in part because of retail investors like Jin Song.

In May, Song invested 200,000 RMB ($29,600) in a fixed-income wealth management product released by a local government finance institution in eastern Shandong Province. As a financial advisor in Shanghai, she was not deterred by the growing reluctance of large investors to support LGFVs, which play a vital role in financing infrastructure development across China.

“In the event that the WMP defaults, the local government will have trouble getting credit in the future,” said Song, who expects an 8.8 percent interest on the “medium risk” product. “They won’t let that happen.”

On Friday, the scale of the challenge China faces in reaching its annual growth target was underlined by data showing that the economy expanded just 0.4 percent year on year in the three months to June.

Achieving 5.5 percent growth for this year will only be possible if LGFVs accelerate construction activity. But local government vehicles are finding it difficult to borrow from banks and institutional bond investors, and are increasingly forced to offer high interest rates to retail investors to increase liquidity.

Exploiting retail investors directly, some for as little as RMB 50,000 each, is a fresh start for LGFVs. They have traditionally raised capital from institutions – mainly banks – or from wealthy individual investors working through third parties such as credit and brokerage firms with a minimum investment of 1 million renminbi.

But Beijing’s crackdown on the shadow banking system in recent years has made it difficult to access such individual investment. The outstanding value of infrastructure-backed trust products has almost halved from the 2017 peak of RMB 3.2 trillion.

Last month, Limin Construction Development Group, an LGFV company in Zoucheng City, Shandong, turned to social media platforms like WeChat in its effort to raise Rmb200 million from retail investors.

It promises an interest rate of 8.6 per cent – much more than it would pay if banks were willing to lend. The average annual interest rate charged by Chinese banks on business loans was 4.16 percent in June.

Limin’s prospectus does not specify how the proceeds will be spent, other than to say that it will help “replenish working capital.”

“I don’t need to know exactly how we’re going to spend the money,” said one Limin executive. “We’ll give you the money back on time and that’s all that matters.”

The executive, who requested anonymity because he was not authorized to speak to foreign media, added that the car was on the cusp of reaching its fundraising goal.

Similar calls have been issued on social media by hundreds of LGFVs across the country, raising concerns that already highly leveraged local governments are amassing potentially explosive debt burdens.

“This is another way [local governments] To postpone the inevitable, said Andrew Collier, managing director of Orient Capital Research in Hong Kong. “These are the last moments of a desperate economy trying to reconcile its growth.”

The issuance of high-cost short-term debt by several LGFV companies in China’s economically weaker regions was a sign of problems with refinancing, said Samuel Kwok, head of public finance for Asia Pacific at credit rating agency Fitch.

“The ability to refinance is key to LGFV, as it is supposed to finance local economic development on behalf of governments,” Kwok said.

Bond investors and other traditional creditors are becoming more wary of LGFVs even as Beijing makes it a policy priority to support infrastructure projects and boost an economy hard hit by President Xi Jinping’s “zero-Covid” lockdowns.

LGFV companies with credit ratings of AA or less collected a net 204 billion renminbi from the bond market in the first half of this year, down 50 percent from the same period in 2021, according to financial data provider East Money Information.

Several local banks, which are the biggest buyers of bonds across China, told the Financial Times that they are avoiding low-rated LGFV bonds. “We will not go for LGFV bonds rated below AA+,” said an investment manager at a lender in the eastern city of Suzhou. “There is a clear preference for bonds issued by strong economic regions.”

Limin’s company, Zoucheng-based LGFV, reported 2.9 billion renminbi in cash at the end of last year, and was unable to reach nearly 80 percent because it was pledged as a margin deposit to bank creditors.

“If you have 2.9 billion renminbi in cash and you’re quick to pay 9 percent for 200 million renminbi in private loans, it’s a matter of pretending you can repay when you are not,” said Orient Capital’s Collier.

Limin said it was “operating normally.”

It has been common for LGFVs to delay principal payments they owe to investors while meeting the annual interest owed — and convert their investments into perpetual bonds, said Yang Xiaoyi, a government financial analyst at consultancy Mingshu Data Technology in Beijing.

“You have to allow the investment to roll around indefinitely to avoid default,” Yang said.

Regional authorities are aware of the risks. In an internal circular issued last month by the Henan provincial finance bureau and seen by the Financial Times, the regulator said it would ban local LGFV companies from selling debt securities directly to individuals. The ban came after hundreds of investors invested in multiple platforms that offer annual returns ranging from 8.5 to 10 percent.

“This practice has led to severe disruption to economic and financial systems and can easily lead to social instability,” the office said.

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