China’s turning to “tough gradualism” in discipling local government borrowing foretells higher risk of lgfv default

29 January 2018 Page | 1
RE04050100001
Sovereign and Public Finance
China
China’s Turning To “Tough Gradualism” In Discipling Local
Government Borrowing Foretells Higher Risk of LGFV Default
Creditors to China’s local government financing vehicles (LGFVs) may have some
reasons to worry about their investment in these entities. Ministry of Finance in
China vowed last month to break decisively the illusion of financial institutions
about government bailing them out of hidden debt incurred by local governments
(primarily through LGFVs). A central bank official even suggested to resort to a
Detroit-type bankruptcy of local government (LGT) to break moral hazard in
lending to LGFVs. These developments bring back the memory of the bankruptcy
of GITIC (Guangdong International Trust and Investment Company), a high profile
LGFV in China in 1999 amid mounting risk of local government hidden borrowing.
However, history progresses in spiral, according to the guiding philosophy of
Chinese policymakers. Thus, no wondering China appears to be getting closer to,
yet is quite away from point where central government has to resort to default on
LGFV bond to instill financial discipline and secure the systemic stability.
Pengyuan International believes Chinese government is indeed turning to “tough
gradualism” (gradually tightening discipline over LGT borrowing in practice) rather
than “shock therapy” (allow LGFV default up-front); Accordingly, the risk that the
first LGFV public bond default could strike in 2018 is picking up from very low level,
but is still less than 50% in our estimate. Nevertheless, further scrutiny over LGFV
creditworthiness becomes increasingly necessary.
LGFV Default This Year Possible but Not Probable
We see more than tail-risk chance that China’s first LGFV default on publicly
offered bond (“LGFV default” in this paper unless specified otherwise) could hit in
2018. After the central government’s seven-year soft-handed approach achieved
not much in dispelling investor belief in implicit government support to LGFVs and
taming hidden LGT borrowing, the government is tightening discipline over local
public-sector borrowing, which pushes up the risk of LGFV default from very low
level. However, we believe the odd of such default in 2018 is still less than 50%.
Bearing in mind the China’s need to balancing between achieving growth target
and securing financial stability, Chinese governments are likely to reserve drastic
measures like “allowing LGFV default” (“shock therapy”) for later stage in their
three-year battle on financial risk
There is no lack of weak LGFVs which local governments (LGTs) could let go
legitimately. Life and death of such LGFVs depends essentially on policy choice
of LGTs, or ultimately of central government. However, applying shock therapy
doesn’t appear to be urgent in the first year of the three-year battle on financial
risks. After all, the risk posed by the country’s total leverage— likely less than
250% total credit to GDP at the end of 2017 in our estimate— is still under control
according to the government. This is quite different from the circumstance of
GITIC default, where the hidden debt incurred by trust companied under LGTs
seemed to be growing out of control.
Contents
LGFV Default This Year Possible But
Not Probable.........................................1
Onshore LGFV Default likely precedes
Offshore LGFV default..........................3
Greater Focus on LGFV Credit Quality
Entails Greater Data Scrutiny ...............4
Credit Strength of Provincial
Government Matters For LGFV Default
Risk.......................................................7
First LGFV Default Likely Happened To
Mismanaged LGFV...............................8
“Tough Gradualism” Holds The Key To
Discipline Local Government Borrowing
in China.................................................8
Contact
Name Liang Zhong
Phone +852 3596 6140
Email liang.zhong@pyrating.com

RE04050100001
China
Besides, the rewarding of drastic measures against LGFVs seems to be limited in the near term, primarily as taming LGT
borrowing through LGFVs doesn’t really address the root cause of hidden LGT borrowing. We believe the governments have
realized that large chunk of hidden LGT debt stemmed from investment in infrastructure and urban facilities (especially a
sector of infrastructure investment classifies in China as “Management of Water Conservancy, Environment and Public
Facilities”, MWCEPF) that generates little revenue and entails LGTs financial support in one way or other (see chart 1).
Chart 1：Certain Infrastructure Project Generates Little Revenue
Data source: National and provincial Statistics Bureau of China;
China Financial Yearbook; Pengyuan International estimate.
We estimate that local non-government public sector investment in MWCEPF surpassed budget spending in this regard by
5.6 trillion yuan in 2016 (about 7.5% of GDP) and possibly about 6 trillion yuan in 2017 (see chart 2, possibly slightly lower in
relative to GDP). As the government is likely to target real GDP growth of no less than 6% this year but unwilling to see
headline fiscal deficit become much higher than 3% of GDP, it appears that local government would have to find somewhere
funding for investment in infrastructure and urban facilities (including MWCEPF). Such investment played a major role in
supporting China’s investment and economic growth (see chart 3). In such circumstances, pressing down one form of LGT
hidden borrowing would likely lead to transformation of hidden debt rather than its eradication.
Chart 2: Investment in MWCEPF Mostly Funded Outside Government Budget
Note: e - estimate. Data source: National and provincial Statistics
Bureau of China; Pengyuan International estimate.

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China
Chart 3: Infrastructure Investment Remains a Key Support to China’s Investment and Economic Growth
Data source: National and provincial Statistics Bureau of China;
Pengyuan International estimate.
The emergence of pseudo-PPP projects (Public-Private Partnership) illustrates the risk of hidden debt transformation. Central
government hoped to leverage on PPP to alleviate the financing needs and debt burden of LGTs while continuing to support
infrastructure investment. However quite some PPP projects ended in continuing creating debt obligation to LGTs by allowing
private sector creditors to disguise their lending to the underlying investment projects in equity investment.
Moreover, a LGFV bond default carries non-negligible risk of contagion as it invalidates the widely shared and entrenched
investor belief in no-LGFV-will-default. In a year of high refinancing need of LGFVs, a LGFV default may lead to marked
repercussion across financial market and endanger government target to ensure regional financial stability. This seems to be
just the scenario that the central government wanted to avoid when it assured not to trigger financial instability by the measures
meant to control financial risk. Meanwhile, LGTs still have strong incentive to prevent LGFV default happening, or at least
from happening first in their respective jurisdiction, as a LGFV default could potentially hurt the access to and cost of funding
for local government-linked borrowers across the board.
For the same reason, we expect the LGFV default is likely happen first to a LGFV with small size of bond outstanding (much
lower than 1 billion yuan). In addition, the probability of more LGFV default following suit in 2018 would be much lower.
Chinese governments are unlikely to stay aside to see consecutive LGFV defaults trigger investor fight out of the market and
push up systemic financial risk.
Onshore LGFV Default likely precedes Offshore LGFV default
If Chinese LGFVs do default in the next two years, we expect the first default on LGFV sector’s onshore bond to precede the
first default on the sector’s offshore bond.
This reflect primarily our estimate that the central government would start with potentially less disruptive measure and move
on to harsher and potentially more contagious ones in the fight against hidden LGT borrowing. Specifically, we estimate the
central government is likely to take measures or policy stances in the following order:
 Inflict heavier punishment on officials responsible for hidden local government borrowing. Although the central
government started to rein in LGFV borrowing in 2010, the punishment of officials responsible for uncompliant LGT
borrowing started only as late as 2017. Some punishment like light touch, and there is scope for harsher punishment.
 Tolerate LGFV default on debt to banks and trust companies and privately placed bond. Such defaults tend to have
limited scope of impact as creditors are less widespread than those of publicly placed bond. Indeed, a quasi-LGFV owned

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China
by Yunnan provincial government defaulted recently for short time period on debt under two trust schemes, supporting to
some extent our view on the sequence of upcoming LGFV credit events.
 Tolerate LGFVs default on bond publicly offered in onshore market. More specifically, default on bond registered with
National Association of Financial Market Institutional Investors (NAFMII, an industrial association controlled or supervised
by the central bank) is likely to happen before a default on bond approved by National Development and Reform
Commission (NDRC), as the central bank of China appears to be more willing to take a more hands-off pro-market
approach than NDRC.
 Tolerate LGFV default in offshore market. We believe central government set great store with maintaining largely stable
Renminbi exchange rate and cross-border capital flows, especially when the memory of large capital outflow in the months
following China’s fine-tune of Renminbi-USD fixing mechanism—accompanied by a not insignificant depreciation against
US dollar— on Aug 11, 2015 hasn’t faded for many investors. Thus, the government is unlikely to let LGFV default on
offshore bond to unsettle international investors before the exhaustion of other potentially less disruptive measures.
Besides, LGFV that issued offshore bond (including through their offshore vehicles) tend to be one of the largest LGFV under
the same LGT owner, enjoy relatively stronger LGT support, and have domestic rating higher than at least a couple of LGFVs
with publicly-placed bond outstanding, making it unlikely to default first among LGFVs.
Greater Focus on LGFV Credit Quality Entails Greater Data Scrutiny
We believe that further scrutiny of risk factors driving LGFV credit qualities are becoming increasing necessary as the
tightening of central government discipline brings about real risk of LGFV default.
To be sure, there seemed to be significant differentiation of perceived credit strength of LGFVs in the onshore market of China,
as illustrated by the dispersed distribution of issuer credit rating assigned by domestic rating firms on LGFVs by province (see
chart 4). However, these distributions are conditioned on the assumption that no LGFV would default based on LGT support,
thus almost all LGFVs carry during past several years issuer credit rating at or above “AA-“ (see chart 5). A document issued
by China’s central bank in 2006 specified that “AA” category rating on bond traded in the interbank market signaling very
strong debt service capacity, little susceptibility to adverse economic environment and very low risk of default. As the central
government tightens discipline over LGTs and makes greater effort to break the illusion of government bailout, LGFVs credit
would become more differentiated, with credit quality of some LGFVs weakened in line with challenging local economic
fundamentals and fiscal dynamics.
Chart 4: Domestic Credit Ratings On LGFVs Display Notable Differentiation
Data source: Winds; Pengyuan International calculation.

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China
Chart 5: Domestic Ratings on LGFVs Concentrates In High Grades
Note: Distribution of rating at the end of each year.
Data source: Winds; Pengyuan International calculation.
A key element in assessing credit quality LGT—and thus their capacity to support LGFVs—is to scrutinize the sometimes-
foggy local data and grasp the true economic and fiscal profile of LGTs. Market has been long suspected the quality of local
data in China. Recent confession of several provincial governments in northern China showed that the extent of overstatement
of key indicators such as Gross Regional Product (frequently called “local GDP”) and fiscal revenue could be as high as 20%
in some instance.
While cross-checking local data or piecing together scattered information entails complicated and sometimes LGT-specific
exercises, we do see a few simple rules applicable to LGTs in digesting local data:
 For assessment on economic strength: review local disposable income per head in addition to GDP per capita. Local
GDP and thus GDP per capita are subject to easier or frequent window-dressing than disposable income in our estimate,
as local GDP matters more for performance assessment on local officials but more difficult to test by personal experience
of citizens. The relatively low-ranking of Tianjin in terms of disposable income per capita could have suggested that the
published local GDP data was questionable (see chart 6).

RE04050100001
China
Chart 6: Selected Key Economic Indicators of Chinese Provinces
Note: (1) “-“ means increase in the ratio of “fixed assets investment/GDP” is greater than 2 percentage points; “+”
means the increase lower than 2 percentage points; otherwise labeled “stable”. (2) YoY change means change over
the same period of the previous year.
Data source: National and Provincial Statistics Bureau of China; Pengyuan International calculation.
 For fiscal analysis: while scale of fiscal revenue matters to credit strength of a LGT (e.g. affecting access to support
from higher level LGT), it should be complemented with analysis on fiscal balance. Fiscal revenue is easier to be
overstate than fiscal balance. LGT could simple collect more-than-justified revenue from local entities and return the
extra charge to the latter in form of fiscal expenditure.
 For debt burden: reasonable analysis should focus on debt plus payment obligations under government-mandated
investment projects that are in nature not-for-profit (and normally not profitable excluding revenue and subsidy from the
government). Such payment obligation of LGTs would give rise to similar drainage on fiscal resource of LGTs as the
direct debt of LGT. Specifically, investment in MWCEPF not financed by budgetary appropriation should be added to
direct debt of LGTs in debt analysis (see chart 7). A broad LGT debt burden indicator constructed in such way should
be more relevant to assessment on fiscal sustainability in general than direct debt. However, it serves for like a starting
point to detailed analysis on debt burden of LGTs.
Level of Wealth Growth Momentum Dependent on Investment for Growth
GDP per capita
($)
Disposable
Income Per
capita ($)
GDP growth
Value-added
by Industries
Fixed Assest
Formation/GDP
Fixed Assets
Investment/GDP
2016 2016
2017Q1-Q3 YoY
change
2017 Jan-Nov
YoY change
2014 ~ 2016
2017Jan-Nov YoY
change
Beijing 17,795 7,908 6.8% 5.6% 38% +
Tianjin 17,321 5,130 6.0% 2.8% 67% -
Hebei 6,483 2,970 6.7% 3.2% 58% stable
Shanxi 5,349 2,868 7.2% 7.2% 73% +
Neimonggu 10,849 3,632 5.0% 3.5% 75% -
Liaoning 7,647 3,920 2.5% 2.4% 50% stable
Jilin 8,110 3,006 5.7% 5.5% 70% -
Heilongjiang 6,087 2,987 6.3% 2.2% 62% stable
Shanghai 17,548 8,135 7.0% 8.0% 38% +
Jiangsu 14,586 4,828 7.2% 7.5% 44% +
Zhejiang 12,784 5,801 8.1% 8.4% 45% stable
Anhui 5,956 3,011 8.3% 8.8% 52% +
Fujian 11,247 4,156 7.9% 7.9% 58% -
Jiangxi 6,082 3,028 9.0% 9.0% 50% -
Shandong 10,348 3,716 7.5% 6.9% 55% +
Henan 6,410 2,777 8.1% 8.1% 76% +
Hubei 8,380 3,280 7.8% 7.4% 56% -
Hunan 6,983 3,179 7.5% 7.1% 55% +
Guangdong 11,143 4,561 7.6% 7.2% 42% +
Guangxi 5,725 2,756 7.0% 7.0% 68% -
Hainan 6,676 3,109 7.5% 2.5% 67% +
Chongqing 8,807 3,317 10.0% 9.6% 54% +
Sichuan 6,022 2,832 8.1% 8.4% 50% stable
Guizhou 5,005 2,276 10.1% 9.3% 68% +
Yunnan 4,681 2,517 9.0% 9.5% 93% -
Xizang 5,297 2,053 10.1% 14.1% 105% -
Shaanxi 7,680 2,841 8.1% 8.0% 67% -
Gansu 4,162 2,209 3.6% -1.7% 65% +
Qinghai 6,554 2,605 7.0% 7.1% 136% -
Ningxia 7,105 2,835 7.8% 8.6% 119% +
Xinjiang 6,107 2,763 7.5% 6.3% 91% -

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China
Chart 7: Selected Fiscal Indicators of China Provinces
Note: (1) For general budget performance, “-“ means growth in spending outpaced growth in revenue. “+” means the
opposite. (2) Ranking on broadly defined LGT debt and debt-like payment obligation factors in LGFV bond and investment
in MWCEPF not covered by budget appropriation, smaller ranking number means lower debt burden. The lower ranking on
Gansu reflects mainly the province’s relatively lower investment in MWCEPF and to a less extent lower LGFV debt.(4) For
investment in MWCEPF during 2017 Jan-Nov, “- - ” means growth above 40% year-over-year; “-“ means just above 20%;
“+” means investment in the segment declined in 2017; the rest labeled “stable”.
Data source: National and Provincial Statistics Bureau of China; People’s Bank of China; Winds; Pengyuan International.
Credit Strength of Provincial Government Matters for LGFV Default Risk
We believe provincial governments in China generally have strong willingness to support lower-level LGTs in their respective
jurisdiction in 2018 for the least, which in turn supports the creditworthiness of LGFVs. In case a high-profile LGFV default
may greatly impact on access to and cost of funding for companies in a province across the board, provincial government
may even provide direct support to the LGFV in our estimate to prevent regional financial turmoil.
A recent and explicit evidence supporting our “province matters” judgement is a recent NDRC notice on managing risk of bond
the Commission approved. The swap of some hidden LGT debt incurred through LGFVs for provincial government bond in
the past two years is another evidence. Besides, a provincial government could influence the creditworthiness of subprovincial
LGTs in its jurisdiction and the capability of later to support local LGFVs: provincial government has great say in shaping and
reshaping intergovernmental relations, monopolize the power to issue bond and on-lend some or all proceeds to subprovincial
governments and is responsible for managing the risk of local government sector in the province.
As the Chinese provinces fare differently on economic front during the country’s transition to “New Economic Norm” for their
different economic structure and institutional strength, not all provincial governments have the same capacity to support LGTs
within their respective jurisdiction.
We believe government of provinces with relatively high level of wealth, balanced economic structure, low reliance on
investment, more developed financial and productive service sector, favorable demographics supporting property market
would have stronger fiscal capacity to support LGFVs one way or other.
General Budget
Spending
Gap/GDP
General
Budget
Performance*
Ranking of LGT
Debt Burden
(broad
definition)*
MWCEPF
Investment*
Fiscal deposit
(year
end)/general
bduget
spending (next
year)
Fiscal deposit Fiscal deposit
LGFVs debt
growth*
2017
compared to
2016
2016
2017 Jan-Nov YoY
change
2015/2016
2016/2015 YoY
change
2017 end-Nov
YoY change
2017
Beijing -1.6% + 6 - 23% -4% 21% 11%
Tianjin -3.0% - 24 N.A. 12% N.A. N.A. 9%
Hebei -1.7% + 14 - 18% 10% 22% 11%
Shanxi -2.2% + 13 N.A. 24% N.A. N.A. 7%
Neimonggu -0.8% - 24 N.A. 15% 29% N.A. 3%
Liaoning -1.5% + 30 N.A. 17% N.A. N.A. 0%
Jilin -2.9% - 17 N.A. 11% N.A. N.A. 10%
Heilongjiang -1.8% + 7 N.A. 20% N.A. N.A. 11%
Shanghai 0.0% + 2 N.A. 44% -10% N.A. 3%
Jiangsu -0.6% - 19 N.A. 12% 28% 6% 13%
Zhejiang -1.6% + 19 stable 20% N.A. N.A. 15%
Anhui -1.1% - 14 - 13% N.A. N.A. 14%
Fujian -1.7% - 24 - 27% N.A. N.A. 8%
Jiangxi -1.8% - 17 N.A. 11% N.A. N.A. 11%
Shandong -0.8% + 8 N.A. 11% N.A. 27% 5%
Henan -1.4% - 10 - 11% N.A. N.A. 12%
Hubei -0.4% + 9 - 20% N.A. N.A. 15%
Hunan -1.7% - 29 - 15% N.A. 6% 13%
Guangdong -2.1% - 3 stable 42% -4% -19% 7%
Guangxi -2.7% - 23 N.A. 8% N.A. 17% 13%
Hainan -2.7% + 4 - 23% N.A. N.A. -21%
Chongqing -1.6% - 22 N.A. 8% 9% N.A. 7%
Sichuan -1.8% + 21 N.A. 17% 8% 19% 9%
Guizhou -1.1% - 30 -- 18% N.A. N.A. 4%
Yunnan -3.5% - 28 -- 13% -16% 32% 13%
Xizang -6.8% + 1 N.A. 15% 19% 76% 22%
Shaanxi -2.3% + 27 N.A. 21% -23% 15% 10%
Gansu -4.4% - 4 + 7% 58% 24% 10%
Qinghai -8.0% - 12 -- 12% 33% 6% 14%
Ningxia -8.5% + 16 N.A. 5% 95% N.A. -1%
Xinjiang -3.9% + 10 N.A. 14% 4% 11% 27%

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Our preliminary assessment on available information at this stage suggest that provinces such as Liaoning, Guizhou, Yunnan
are likely to have weakest fiscal capacity and least ability to support LGFVs there.
Meanwhile, we do recognize further investigation is necessary to spot risky and strong spots regarding LGT and LGFV
creditworthiness. For instance, additional data collection and analysis about liquid position of LGTs and about financial
soundness of local SOE sector are warranted. SOEs engaging in commercial activities could either be (if profitable) source of
usable funds for LGTs to support lower level LGTs and LGFVs, or could be source of liabilities to LGTs if SOEs are loss-
making.
In this regard, Maotai, a listed company mostly owned by Guizhou Provincial Government provides an interesting case.
Guizhou scores poorly on many measurements of economic and fiscal strengths, yet Maotai, one of China’s most famous
spirit makers enjoy high market capitalization. Assuming the provincial government could sell half of its holding in the company
at haircut no higher than 50% based on market price at the end of 2017, it could raise more than 80 billion yuan, more than
enough to cover debt service on all LGFV bond in the province in 2018.
First LGFV Default Likely Happened to Mismanaged LGFV
Our base case scenario is that provincial governments are most likely to have willingness and capacity to preempt LGFV
default in 2018. Meanwhile, although central government vowed to “break the illusion of bailout” recently, central government
is likely to achieve this by not providing financial support— when it becomes necessary— to LGTs to bail out LGFVs than by
preventing capable LGTs from supporting LGFVs beyond legally required. This appears to be what happened in the case of
GITIC bankruptcy in 1999. At that time, media reported that the willing-to-support Guangdong provincial government didn’t
have sufficient financial resource to save GITIC by its own means, while central government didn’t see justification for the
bailout. The first LGFV default carries tail risk of triggering significant financial repercussion in the market, thus actively
engineering one seems to be undesirable.
In unlikely case that, central government does forbid LGTs to provide support to LGFVs beyond legally required minimum this
year, we expect first LGFV default would come from a LGFV suffering from serious mismanagement. Now that LGFVs derive
revenue from LGTs mostly on the basis that LGTs pay them on the basis of “construction cost plus margin”, their net present
values are unlikely to drop below zero unless the later are mismanage.
a LGFV could become insolvent in cases such as: (1) poor management left the LGT-mandated infrastructure uncompleted
(thus not qualified to receive payment from LGT under a build-and-transfer or other type of contract with LGT); (2) guarantee
provided to other companies give rise to payment obligation that doesn’t qualify for full reimbursement by LGT owner, or (3)
embezzlement or other kinds of corruption led to significant asset loss. Allowing such LGFVs fail first may be less controversial
among policy makers than closing LGFVs run by diligent management but weakened by economic shocks beyond their control.
The problem of serious mismanagement may occur more likely to subprovincial LGFVs in the less developed inlands. However,
even a coastal province might have such weak LGFVs. Detailed screening is necessary to identify the high risk LGFV
candidates.
“Tough Gradualism” Holds the Key to Discipline Local Government Borrowing in
China
If China’s central government adheres to “tough gradualism” (steadily tightening discipline over local government borrowing),
there it is good chance that the once relentless hidden LGT borrowing could be tamed markedly within three years.
Otherwise, if discipline over hidden LGT borrowing could become loosened in implementation once investment and economic
growth slows significantly, the hidden borrowing problem may become more entrenched. The longer the reliance on hidden
borrowing persists, the greater the risk of disruption when it has to be broken in the end. It’s high time for China to favor long-
term institution building over short-term discretion in this regard.

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China’s turning to “tough gradualism” in discipling local government borrowing foretells higher risk of lgfv default

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