Research analysts

Asia Economics

Zhiwei Zhang - NIHK
zhiwei.zhang@nomura.com
+852 2536 7433

Changchun Hua - NIHK
changchun.hua@nomura.com
+852 2252 2057

Wendy Chen - NIHK
wendy.chen@nomura.com
+86 21 6193 7237


In September last year we issued an Asia Special Report on China's heavy LGFV debt
burden (24 September 2013), in which we explained how we had compiled a unique
database that covers financial information on 869 local government financing vehicles
(LGFVs) and adopted a bottom-up approach to assess the financial risks of those
LGFVs. In that report, we estimated that total LGFV debt had reached RMB19.0trn (37%
of GDP) at end-2012, split between RMB14.3trn of interest-bearing debt and RMB4.7trn
of non-interest-bearing debt. We also estimated that without government support, over
half of LGFV debt would have been at risk of default on interest payments in 2012, let
alone principal repayment. In the case of a liquidity crisis, we estimated that 70% would
have defaulted without government support. Back then we concluded that some
individual LGFV defaults are likely in 2014, while a systemic default in LGFV debt in the
short term is unlikely as the central government has the financial capacity to intervene to
roll that debt over.
In this note we provide a follow-up to our major study and present our conclusions in a
Q&A format. We first provide our thoughts on the outlook for LGFV debt and the
economy in 2014. We have revised and update our estimates of LGFV debt by end-2013
based on new information from both official reports and LGFV balance sheet data. We
also update some of the indicators such as cash flow, profitability and financing
sources of LGFV financial conditions and comment on the differences between our
estimate of total government debt (especially LGFV debt) and data released in the
National Audit Offices 30 December 2013 report (hereafter referred to as the NAO 2013
report). Finally, we provide a summary of expected policy measures related to the LGFV
debt problem, drawing inferences from the reform package passed at the Third Plenary
Session of the 18th Chinese Communist Party (CCP) Congress which was held in
November.
Q1: What is your current stance on the LGFV debt problem? Do you still expect
defaults in 2014 and do you think it will lead to a systemic crisis?
We maintain our view that individual LGFV defaults will happen in 2014 (please see our
September report for our arguments). Liquidity stresses have been building on most of
the LGFVs in our database. Also, related to tighter liquidity conditions in the money
market, financing conditions for LGFVs tightened significantly in H2 2013, as indicated
by rising corporate bond yields (Figure 1). Moreover, we expect the clampdown on
shadow banking activity to continue in 2014, meaning bond yields may remain high in
the foreseeable future.
We also maintain our view that the LGFV debt problem is unlikely to lead to a systemic
financial crisis in 2014. We acknowledge that systemic risks are rising, but we believe
the central government has the intent and financial capacity to step in to avoid a
systemic crisis. The National Development and Reform Commission (NDRC) has
announced that it may allow some LGFVs to issue bonds to pay expiring debt this year.
Moreover, the fiscal subsides required to prevent a systemic default on interest
payments in 2014 is likely to be less than 1% of GDP (as we calculated in our
September report), which remains manageable for now.
While a systemic financial crisis is not our baseline case for 2014, we do expect the
LGFV problem to weaken infrastructure investment, slowing GDP growth to 7.1% in Q2.
Our GDP forecast is lower than the consensus in H1 (7.3% against 7.6%) but the same
in H2 (7.4%), resulting in quite a different quarterly trajectory consensus expects stable
growth in H2 while we expect a mild recovery from Q2 as a result of policy fine-tuning
when growth slows to 7.1% in Q2 (Figure 2).

Asia Insights
ECONOMICS

China: Revisiting the LGFV debt problem
Global Markets Research

8 January 2014
See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.

Nomura | Asia Insights 8 January 2014



2
Fig. 1: Government and corporate bond yield


Source: WIND and Nomura Global Economics.
Fig. 2: 2014 GDP growth outlook


Source: Bloomberg and Nomura Global Economics estimates.
Q2: Where do you think the LGFV debt level stands now?
We estimate total LGFV debt reached RMB21.8trn by June 2013 and RMB24.0trn
(around 41.9% of GDP) at end-2013 (Figure 3). This is a 9.8% and 19.6% increase,
respectively, from 2010. Compared to end-2010, it represents a 58.8% and 74.8%
accumulative increase, respectively.
The basic methodology we use remains broadly the same as in our September report.
We first estimate the stock of local government debt in 2010, taking data from various
government reports. We then estimate the growth rate of local government debt from
December 2010 to June 2013 based on the database of 869 LGFVs that we compiled.
Combining the growth rate and the level of debt stock in 2010, we come up with
estimates on the stock of debt by June 2013. We then extrapolate this to provide an end-
2013 estimate, assuming the rate of debt growth in H2 2013 is the same as in H1.
However, there is one technical difference between our current estimate and those in our
September report. In our September report, we assumed that the debt of those LGFVs
not in our database grew at the same speed as those in our database. We flagged in our
report that our estimates may be biased downward because of this assumption and the
NAO 2013 report suggests that this bias is real. LGFVs in our database are mostly
owned by provincial and city level governments. The NAO report shows county-level
government debt rose 26.6% pa on average from 2010, much faster than the 19.0%
estimated in our sample. Therefore we re-estimate the LGFV debt size as follows:
First, we break down the interest-bearing debt in 2010 to that of the LGFVs in our
sample (mostly provincial- and city-level) and to that of LGFVs not in our sample (mostly
county- and township-level LGFVs). We then apply different growth rates to the two
segments to estimate their dynamics and the outstanding amount in 2013. Finally, we
obtain total LGFV debt based on the structure of interest-bearing and non-interest-
bearing debt in our sample.
More specifically:
Part 1 of LGFV interest-bearing debt. Our estimate of total LGFV interest-bearing
debt in 2010 is RMB10.3trn (the full details of this estimate can be found on page 9
of the September report). The LGFVs in our database held debts of RMB7.5trn,
accounting for 73% of total LGFV debt. This segment of the interest-bearing debt
burden rose to RMB11.3trn as of mid-2013, growing by 50.8% accumulatively from
the 2010 level.
Part 2 of LGFV interest-bearing debt. This segment of LGFV interest-bearing debt
is calculated as the estimate of total interest-bearing debt minus the interest-
bearing debt of LGFVs in our sample. Due to the nature of the LGFVs in our
database sample, we can say that this part of the interest-bearing debt burden is
largely held by county- and township-level LGFVs. The NAO 2013 report shows
local government debt at these levels grew at a 26.6% annualized rate. We take this
2
4
6
8
10
12
Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14
Government bond (3yr)
Corporate bond (AAA, 3yr)
Corporate bond (AA, 3yr)
Corporate bond (A, 3yr)
% p.a.
6.5
7.0
7.5
8.0
8.5
% y-o-y
Consensus
Nomura
Forecast
Nomura | Asia Insights 8 January 2014



3
growth rate and estimate the debt for this level of LGFVs to be RMB5.0trn as of mid-
2013, an accumulative 80.3% rise from RMB2.8trn at end-2010.
Non-interest-bearing debt: This part of debt comprises mostly accounts and bills
payable, which occupies a stable 25% or so of total liabilities during 2010-June 2013
according to balance sheet information of the LGFVs in our sample. As we do not
have the date for those LGFVs out of our sample, we assume the same structure.
Total LGFV debt. Adding all three parts together gives a total LGFV debt estimate
of RMB21.8trn at mid-2013. We annualise the growth rates for each segment of the
debt in H1 2013 to obtain an estimate of the total outstanding debt level at end-
2013, which is RMB24.0trn (about 41.9% of GDP).

Fig. 3: LGFV outstanding debt


Note: Part 1 of interest-bearing debt mainly refers to provincial- and city-level LGFVs
captured in our sample; Part 2 mainly refers to county- and township-level LGFVs not
captured in our sample. Source: WIND, NAO 2013 Audit Report and Nomura Global
Economics.
Fig. 4: A breakdown of total government debt
(RMB trn, % of total government debt, as of mid-2013)

Note: There may be double-counting between local government debt and LGFV debt.
Source: WIND, NAO 2013 Audit Report and Nomura Global Economics.
Q3: What is your estimate of Chinas total government debt?
Based on our estimate of LGFV debt and the NAO 2013 report we estimate total
government debt (including contingent debt) as of mid-2013 at RMB40.3trn, or 74.7% of
GDP(Figure 4).
We estimate central government debt was RMB14.4trn, or 26.7% of GDP at mid-2013,
consisting of RMB10.1trn of central government-issued debt, RMB2.9trn of railway
company debt and RMB1.4trn of asset management company (AMC) debt.
1

Total local government debt was RMB25.9trn, or 48.0% of GDP at mid-2013, consisting
of RMB21.8trn of LGFV debt (our estimate) and RMB4.1trn of local government-incurred
debt as revealed in the NAO 2013 report.
A caveat, however, to these estimates is that there may be some double-counting
between local government-incurred debt and LGFV total debt, as the former may include
some local government debt owed to LGFVs. In an extreme case, if we assume local
governments only borrowed from the bond market and LGFVs, we would obtain an
estimate of total government debt at mid-2013 of RMB36.9trn, or 68.4% of GDP.
Q4: How do you explain the differences between your estimates and official data?
Our estimate of total government debt (including contingent debt) is RMB40.3trn (74.7%
of GDP) as of mid-2013 much higher than the RMB30.3trn (56.2% of GDP) in the NAO
2013 report. The major difference lies in the estimates of total LGFV debt, which we put
at RMB21.8trn versus the NAOs RMB13.8trn. We also include the debt of the four
government AMCs, of RMB1.4trn, as part of the central government debt.

1
Central government-issued debt is measured as total central government debt (RMB 12.4trn) deducting railway
company debt (RMB2.3trn), both numbers reported in the NAO 2013 report. For railway company debt, we include
total liability (RMB2.9trn) as part of central government debt, instead of the number (RMB2.3trn) considered by the
NAO. For AMC debt, we take the Development Research Center of the State Councils estimate (RMB1.4trn) as
part of central government debt.
13.8
15.9
19.8
21.8
24.0
0
5
10
15
20
25
2010 2011 2012 Mid-2013 2013
RMB trn Non-interest-bearing debt
Interest-bearing debt: Part 2
Interest-bearing debt: Part 1
F
Central
govt-
issued
debt,
10.1 , 25%
Railway
company
debt,
2.9 , 7%
AMC debt,
1.4 , 4%
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4.1, 10%
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21.8 , 54%
Nomura | Asia Insights 8 January 2014



4
For LGFV debt, the differences may arise from our broader definition of LGFVs
compared to that used in the NAO report, as well as the extent to which LGFV debt is
counted as government debt (see China: Comments on the Government Debt Report by
the NAO, 30 December 2013).
Different definitions. To illustrate the difference, let us look at the amount of
LGFV bonds outstanding that we include in our estimate compared to the NAO
report. Our estimate of LGFV bonds outstanding (including corporate bonds,
medium-term notes and commercial paper) is RMB2.3trn as of mid-2013, which
we arrive at by compiling the existing individual LGFV bond data available from
WIND. The NAO 2013 report, in contrast, puts bonds outstanding at only
RMB1.1trn less than half our estimate.
Percent of LGFV debt counted as government debt. We assume 100% of
LGFV debt to be government debt as we cannot make a clear-cut distinction
between government-related projects and LGFV standalone projects simply
from the LGFV balance sheets. This may be another caveat in relation to our
estimates, but we highly doubt if government-related projects could be singled
out from other projects should an LGFV face financial difficulties.
We also note that the NAO 2013 report puts annual growth rates of provincial- and city-
government debt at 14.4% and 17.4%, respectively, since 2010. These growth rates are
lower than our estimate of 18.1% for the average growth rate of provincial- and city-level
LGFV debt based on our balanced sample. This may also reflect a difference in definition
for LGFVs.
Q5: What is the current financial situation of the LGFVs?
LGFVs cash flows are still tight and profitability remains poor. Operating cash flows
(OCF) are low and LGFVs continued to rely heavily on new borrowings to finance
existing and new projects in H1 2013 (Figure 5). LGFVs with negative OCF still stood at
around 32% in a sample of 448 LGFVs that disclosed their financial information for H1
2013, similar to that in 2012. Moreover, LGFV profitability weakened in H1 2013, with the
median return on equity falling to around 1.9% from 3.0% at H2 2012 and 2.1% in H1
2012 (Figure 6). This is also far below the 5.4% median ratio for A-share listed non-
financial companies.

Fig. 5: Overall cash flow in the sample of LGFVs


Note: Estimates done on a balanced sample of 448 LGFVs.
Source: WIND and Nomura Global Economics.
Fig. 6: Return on equity of LGFVs


Note: Estimates done on a balanced sample of 448 LGFVs.
Source: WIND and Nomura Global Economics.
Q6: How is the LGFV interest-bearing debt financially structured?
As explained in our September report, there are three major financing channels for LGFV
interest-bearing debt bank credit, bond issuance and shadow-banking (e.g. trust loans,
financing from securities and insurance companies, private lending). Based on analyses
on our sample data and the NAO 2013 report, we find that the share of bank credit in
LGFV interesting-bearing debt had fallen to 71.5% as of mid-2013 from 73.7% in 2012
and 88.3% in 2010, while the other two financing channels shares had risen accordingly.
This mainly reflects the regulatory arbitrage where bank credit to LGFVs is regulated
-800
-600
-400
-200
0
200
400
600
800
1,000
2012H1 2012H2 2013H1
By financing By investment
By operating Total
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0.8
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4
6
8
10
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2011 2012H1 2012 2013H1
%
90th percentile
75th percentile
Median
25th percentile
10th percentile
Nomura | Asia Insights 8 January 2014



5
more heavily than non-bank financing channels. Bank loans to LGFVs rose by 7.6% to
RMB11.7trn as of mid-2013 from RMB10.9trn in 2012; LGFV bonds outstanding surged
by 26.0% to RMB2.3trn from RMB1.8trn; and shadow-banking financing to LGFVs
increased by 14.6% to RMB2.4trn from RMB2.1trn (Figure 7).

Fig. 7: Financial channels for LGFV interest-bearing debt


Note: Estimates for 2010 and 2012 made based on our sample and for H1 2013
based on the NAO 2013 report. Source: WIND, NAO 2013 Audit Report and Nomura
Global Economics.
Fig. 8: Change of interest-bearing debt for LGFVs in Q3 2013


Note: Estimates done on a sample of 267 LGFVs. Source: WIND and Nomura Global
Economics.

Q7: What is the maturity structure for LGFV debt? What are the financial risk
implications?
Overall, LGFVs to a large extent borrow short-term funds from banks and trusts and
invest in long-term infrastructure projects, leaving themselves exposed to a maturity
mismatch problem and huge refinancing risks. We do not have data for the exact
maturity structure of the LGFV debt stock, but we can get a sense of it from the maturity
structure of local government debt, revealed in the 2013 NAO report. According to the
report, 22.9% of local government direct debt matured in H2 2013, 46.1% of which was
debt that was already overdue. The report also shows that 21.9% of local government
direct debt will mature in 2014. We believe the majority of this (especially of LGFVs) has
been rolled over, and that this practice will continue in 2014 as LGFVs financial
conditions are very tight. As we demonstrated in the September report, the majority of
LGFVs did not have the financial capacity to pay the interest on their debt, let alone the
principle. We estimated that 33% of LGFVs in our sample has an interest coverage ratio
of less than one in 2012. The data for 2013 show that financial conditions continue to be
weak. Many LGFVs managed to avoid default by getting subsidies from local
governments and borrowing new debt to pay maturing debt.
Financial data reported by LGFVs in 2013 also suggest that the majority of maturing debt
was likely rolled over. There are 267 LGFVs in our database that have so far reported
Q3 financial information and aggregating these data we estimate that total interest-
bearing debt rose to RMB7.5trn in Q3 from RMB7.3trn in Q2 2013. Of these 267 LGFVs,
only 86 experienced a decline of interest-bearing debt over this period (Figure 8) and
their debt only dropped marginally, by 2.6%, from RMB1.97trn to RMB 1.92trn.
Rolling over debt helps to avoid a broad-based default, but it also adds stress to LGFVs
and makes individual defaults more likely. Note that interest rates have risen sharply
since May last year (Figure 1), hence the financing cost for LGFVs is rising as well,
particularly for those who have to roll over their debt. We conducted a stress test in our
September report and found that if interest rates rose 100bp, the potential non-
performing debt ratio for LGFV debt rises by around 10 percentage points.
Q8: Why are you concerned about rising government debt given Chinas still
relatively high debt-servicing capacity?
The key issue is the sustainability of investment and debt growth at the local government
level. We believe the central government could sustain LGFV debt at current levels via
subsidies and capital injections, but we doubt if it has either the capacity or the
10.3
14.8
16.4
0
2
4
6
8
10
12
14
16
18
2010 2012 2013H1
RMB trn
Other non-bank credit (e.g. trust loans)
Bond issuance
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-6
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8
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Nomura | Asia Insights 8 January 2014



6
inclination to allow the growth of debt to continue at this rapid pace for years to come
for if it does, the cost of a government bailout will grow exponentially. In other words, the
stock of debt is manageable for now, but the flow of debt in coming years is hard to
maintain.
We are also concerned because the rapid growth of government debt has eroded much
of Chinas long-perceived fiscal strength that could be utilised when the economy faces
difficulties. Although Chinas capacity to absorb the debt stock remains reasonable, the
government debt-to-GDP ratio has risen too fast, leaving less financial resources for
future use, bearing in mind that China still faces a lot of other challenges (such as a
rapidly aging population and its pollution problems).
Q9: What measures can we expect to contain the LGFV debt risk?
There is little detail in the NAO audit report on what measures the government will
undertake to contain local government debt risk. We believe the long-term solution will
require much reform, as indicated in the Third Plenum, but the implementation will be
very gradual and slow due to the complexity of the problem (see China: Reform outlook
remains uncertain, 17 November 2013). These measures include revising official
performance evaluation standards to downplay GDP growth, fiscal reform to provide
more revenue to local governments, enhancing accountability of debt-raising at the local
government level, setting up a financing mechanism for urban infrastructure investment,
and much-needed land reform.
In the short term, we believe the government will likely sell some state-owned assets to
cover losses at LGFVs, allow debt rollover and restructuring, and continue to provide
subsidies at the local government level to avoid a broad-based default.
The central government may also allow a number of individual defaults to take place,
thus correcting the moral hazard problem in the financial market. According to the
Financial Investment Journal, the government has recently issued a set of guidelines
(referred to as document #107 in the news) to intensify its supervision of shadow
banking activity by making it clear which regulatory authority is responsible for which
type of shadow banking activity, while strengthening the collection and sharing of
information for the whole sector. We expect this clampdown to continue through 2014.
Not only this is likely to continue to push up bond yields for the foreseeable future, but
also make it hard for non-viable LGFVs to raise funds. Under these circumstances, we
expect some individual defaults this year.



Nomura | Asia Insights 8 January 2014



7
Appendix A-1
Analyst Certification
We, Zhiwei Zhang, Changchun Hua and Jia Yao Wendy Chen, hereby certify (1) that the views expressed in this Research
report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this Research
report, (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views
expressed in this Research report and (3) no part of our compensation is tied to any specific investment banking transactions
performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.
Important Disclosures
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