| Global Research | 25 August 2017

China LGFVs Getting ready for a role change

Chinas authorities will likely further restrict local governments from financially supporting LGFVs
We expect LGFVs to continue to exist, but they will likely be transformed in the next 3-5 years
Existing LGFVs may be (1) dissolved, (2) re-defined as new LGFVs, or (3) commercialised as SOEs
We do not see the first LGFV default occurring in the next two years; redemption pressure is manageable
We see value in top-tier LGFV bonds over conventional corporate bonds, and expect their spread to tighten

Chinas local government financing vehicles (LGFVs) have played a key role in funding Jeffrey Zhang +852 3983 8540
Jeffrey.Zhang@sc.com
local infrastructure projects since 2008. Outstanding LGFV bonds stood at CNY 6.6tn Fixed Income Strategist
Standard Chartered Bank (HK) Limited
as of end-June 2017, accounting for 29% of Chinas onshore credit bonds. LGFV
bonds enjoyed strong implicit guarantees by local governments, with about a third Becky Liu +852 3983 8563
Becky.Liu@sc.com
considered as local-government contingent liabilities in previous national debt audits. Head, China Macro Strategy
Standard Chartered Bank (HK) Limited
Things have changed, however. Local government guarantees are no longer permitted
since 2015 following the Budget Law revision, and more regulations have been
introduced to restrict financial support from local governments.
Existing LGFVs will be transformed in three possible ways, in our view: (1) LGFVs
that perform a purely financing function with no business operations will likely be
dissolved after their debts are repaid in the next 1-2 years; (2) LGFVs dedicated to
public welfare project developments may be given sole operating rights in local
utilities and redefined as public welfare SOEs in 3-5 years; and (3) LGFVs that run
both public welfare and commercial projects may become commercialised SOEs
after their welfare functions are carved out.
There have never been any LGFV defaults, and we expect their default risk to stay
low in the next two years. While offshore financing will likely be insufficient to fund the
onshore funding shortfall (offshore LGFV issuance is only 7% of onshore issuance),
redemption pressure is relatively mild, with 18-19% of total liabilities coming due each
year from 2018-21. These entities have strong willingness to pay, and their debt
repayment will be partly funded by local governments re-purchasing of the underlying
assets. AAA-rated LGFV bonds are yielding a 10bps premium over their conventional
corporate bond peers. We see value in these LGFV bonds at current levels and
expect them to trade flat or inside of corporate bonds.
Figure 1: Chinas LGFV reform roadmap

Source: Standard Chartered Research

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On the Ground

The current picture

LGFVswere entities set up by Chinas local governments that exist
solely for the purpose of raising funds to support local infrastructure and welfare
projects. They played an important role in supporting local growth and have been the
major funding providers for local fixed asset investment (FAI). LGFV liabilities
accounted for the majority of local-government liabilities before 2015, as local
governments were prohibited from raising debt directly prior to the revision of Chinas
Budget Law at the end of 2014.

Things have changed since 2015. Local governments can now only be funded by (1)
issuance of general local government bonds (LGBs), (2) issuance of project LGBs,
and (3) public-private partnerships (PPPs). LGFV bonds and other liabilities raised
after 2015 are no longer considered as local-government contingent liabilities. Local
governments are prohibited from providing guarantees to LGFVs, and a number of
local governments have been penalised this year for debt-raising misconduct (see
section Declining support from local governments).

There are more than 10,000 LGFVs;
LGFV bonds account for 29% of
onshore credit bonds in terms of
amount
Defining LGFVs
The first LGFV was established in 1990s. There are c.11,700 operational LGFVs as
of Q2-2017, according to the China Bank Regulatory Commission (CBRC). Issuance
of LGFV bonds was very strong from 2010-16 before slowing in 2017.

Defining the scope of LGFVs is not a straightforward process, as the boundaries

between LGFVs and local state-owned entities (SOEs) are blurred. In this report, we
use the China Central Depository and Clearings (CCDCs) definition, which is well
accepted by market participants. Local SOEs who mainly run public welfare projects
(such as municipal road infrastructure and affordable housing construction) or sub-
public welfare projects (such as water, gas, toll roads, city rail transit), are defined as
LGFVs if one of the following criteria is met in any one of the most recent three years:

Low profitability: Annual operational cash flow < Long-term liabilities due in
one year;

Strong dependence on local governments: Annual fiscal subsidy is more than

30% of year-end long-term liabilities due in one year.

Figure 2: LGFV bonds accounted for 9.5% of Chinas Figure 3: Amount of outstanding LGFV bonds was higher
onshore bond market at end-June 2017 than that of LGBs before 2015
Outstanding amount of bond market by type (CNY bn) Outstanding amount of LGFV bonds and LGBs (CNY bn)
Outstanding amount (CNY bn) 14,000
14,000 LGFV bond outstanding LGB outstanding 12,416
18.3% 18.1% 18.1% 18.1%
12,000 10,628
12,000
10,000
10,000
11.6%
8,000 9.5% 8,000 6,577 6,579
6,000 6,000 5,219
6.3% 4,244
4,000 4,000 2,747
2,000 1,895
2,000 722 1,034
464
0
PFBs CGBs LGBs Other NCDs LGFV Financial 0
corporate bonds credit 2009 2010 2011 2012 2013 2014 2015 2016 Jun
bonds bonds 2017
Source: Wind, Standard Chartered Research Source: Wind, Standard Chartered Research

25 August 2017 2
On the Ground

Under this definition, there are 6,720 LGFV bonds outstanding in the onshore market
as of June 2017, totalling CNY 6.6tn (Figure 2). The outstanding amount accounts for
9.5% of total onshore bonds, or 29% of outstanding credit bonds. Part of LGFV
bonds have been swapped into local government bonds (LGBs) since 2015, and the
current LGFV bonds outstanding is only 53% of outstanding LGBs at end-June 2017
(Figure 3).

LGFVs play an important role in
funding local utility FAI
Use of proceeds
The bulk of LGFV bond proceeds were used to fund local utility infrastructure
expenditure. We estimate that LGFV bonds have contributed 8% of utility FAI in 2015
(Figure 4), compared to the government budget and bank loans contributing 14%
each in the same year.

Funds raised by LGFVs are positively correlated to the utility FAI project amount
invested by the provinces (Figure 5). We compare the summary of utility FAI from
2010-15 in 31 provinces with their LGFV bond outstanding at end-2015. Jiangsu led
in both utility FAI and LGFV bond outstanding terms among all the provinces. Beijing,
Guangdong, Shandong and Zhejiang, which have had high amounts of utility FAI,
also ranked as top-tier provinces in terms of LGFV financing.

Declining support from local governments

LGFV debt issued after 2015 does not carry a local government guarantee. In
addition, still more regulations have been introduced to tighten financial support from
local governments.

Regulatory tightening restricts local government support

Recent regulations have broadly
limited financial support from local
governments to LGFVs
The authorities have issued a number of regulations to reduce support from local
governments to LGFVs. They are trying to cut links between LGFVs and their local
governments, by applying regulatory measures restricting debt bailouts, capital
injections, fiscal subsidies and business relationships. We provide a summary of the
key regulations below and we list the latest rules in Figure 6.

In October 2014, the Ministry of Finance (MoF) restricted LGFVs from funding
local government debt. Fiscal support to LGFVs was limited to the budget.
In December 2015, the MoF announced a swap of existing local government
debt into LGBs within three years.

Figure 4: LGFV bonds contributed c.8% to 2015 utility FAI Figure 5: LGFV bonds outstanding is positively related to
Net issuance of LGFV bonds (CNY bn) and estimates of their local utility FAI by provinces
contribution to utility FAI (%) Local FAI in utility sector and LGFV bonds (CNY bn)
Net increase in LGFV bonds 10,000 1,000
Utility FAI (2010-2015)
1,600 LGFV bonds contribution to utility FAI (%, RHS) 14% 9,000 900
13% LGFV bonds outstanding (RHS, end- 2015)
8,000 800
1,400 12% 7,000 700
1,200 11% 6,000 600
10% 5,000 500
8%
1,000 9% 4,000 400
8% 3,000 300
800 2,000 200
6% 1,000 100
600 4%
4% 0 0
4%
400
Shandong

Shanghai
Anhui

Guangxi
Chongqing

Shaanxi

Yunnan
Hunan

Liaoning

Henan
Heilongjiang

Hainan
Qinghai
Guangdong

Guizhou

Ningxia
Zhejiang

Sichuan

Hebei
Beijing

Inner Mongolia

Shanxi

Tibet
Jiangsu

Jiangxi

Xinjiang
Tianjin

Fujian

Gansu
Jilin

200 2%

0 0%
2010 2011 2012 2013 2014 2015
Source: Wind, Standard Chartered Research Source: Wind, Standard Chartered Research

25 August 2017 3
On the Ground

In November 2016, the MoF reiterated that local governments are restricted from
bailing out LGFV bonds in case of default.
In May 2017, a joint announcement by six regulators was released prohibiting
local governments from becoming involved in LGFV operations or injecting
public welfare assets into LGFVs.
In June 2017, the MoF restricted local governments from purchasing certain
services from LGFVs, thereby cutting LGFVs revenue generated directly from
local governments.

The authorities have started to
penalise local governments for
misconduct in debt-raising activity
Debt raised after 2015 does not carry a local government guarantee
Chinas local governments are now prohibited from bailing out LGFVs in case of a
default. This year, the MoF began to penalise local governments for misconduct in
local-government financing. Such misconduct included offering guarantee letters or
keep-well agreements to LGFVs, and preserving LGFVs borrowing proceeds
(Figure 7).

Debt raised before 2015 is partially supported

In the 2013 audit, 21% of LGFV Less than half of the LGFV bonds issued before 2015 were considered direct local-
bonds were considered direct government liabilities or contingent liabilities, and this breakdown was not publicly
government debt, and 23% as disclosed.
contingent liabilities

The latest available official details of local-government debt are as of end-June 2013
from the audit report. Only CNY 530bn (21% of CNY 2.5tn LGFV bonds outstanding)
was considered as direct local-government debt, and CNY 580bn (23%) as
contingent liabilities as of end-June 2017. The other 56% of outstanding LGFV bonds
carry no local government guarantee (China municipal bond market The next big
thing, 13 August 2015)

Figure 6: Selected regulations on LGFVs and local-government financing since 2016

Issue date Rule Regulation name Description of regulations and potential impact on LGFVs

The contingency plan of local

October State Council
government debt risk ( (1) Central government will not bail out local governments in the event of
2016 Article 88 default.
)
(2) Local governments are only responsible for direct local government
Guidance on classification of local liabilities, and can only partially help with payment on contingency debt.
November MoF Article
government debt risk ( (3) LGFVs should be mainly on their own in case of default.
2016 152
)

MoF, NDRC,
Notice on further regulating the (1) Reiterates that local governments should not become involved in
PBoC , LGFVs activity, especially in financial planning.
financing behaviour of local
May 2017 CBRC,
government ( (2) Public welfare assets, reserve land injection into LGFVs is prohibited
CSRC, DoJ
) (3) Amendments are required by end-August 2017.
Article 50

Notice on banning illegal financing

(1) A negative list is given to close loopholes. This should further cut
MoF Article behaviour in purchasing service by
June 2017 LGFVs revenue generated directly from local governments.
87 local government (
(2) Self-check and amendments are required by end-October 2017.
)

Abbreviation: National Development and Reform Commission (NDRC), People's Bank of China (PBoC), China Securities Regulatory Commission (CSRC), Department of Justice (DOJ)
Source: Standard Chartered Research

25 August 2017 4
On the Ground

LGFV reforms What we expect

As implicit support from local governments is being reduced gradually, LGFVs will
need to be transformed into a new model or be dissolved. Fiscal spending, project
bonds and PPPs will carry on the key function of funding local FAI in the meantime.
Some existing LGFV entities will also continue to support local infrastructure as a
supplement to fiscal expenditure after reforms. Local governments have recently
released guidelines on LGFV reforms, and we expect the reform process to
accelerate in the coming quarters.

Guidelines from local governments

Four provinces issued guidance on A number of local governments of provinces, including Guangdong, Jiangxi, Sichuan
LGFV reforms in early 2017 and Chongqing, released guidance on LGFV reforms earlier this year (Figure 8).
However, this guidance was vague in its implementation details and did not set a
timetable. No nationwide guidelines have been released so far.

There are commonalities in these guidelines. Local governments will first classify
existing LGFVs by type, given their different business models. Public welfare assets
will be stripped away from existing LGFVs. Mergers and acquisitions among LGFVs
are anticipated as part of reforms. The guidelines also reiterate that local
governments should avoid applying financial stress on LGFVs during reforms.

Figure 7: Recent penalties for misconduct in local-government debt-raising activity

City/Province Issue Penalties
(1) A record of the government meeting in September 2015
shows that the government will include the payment of a (1) The guarantee letter is withdrawn;

Zhumadian city, bank loan (CNY 640mn) and trust loan (CNY 178mn) from (2) LGFV prepaid the loans in 2016;
Henan province LGFVs into its budget; (3) The director of the LGFV is fired;
(2) Local finance bureau issued a guarantee letter for the (4) Warnings given to two officers in the finance bureau.
above bank loan.

(1) Local finance bureau of an economic developing zone (1) The mayor of the economic zone is fired and to be further
Huangshi city, Hubei borrowed CNY 110mn from a local SOE in August 2015; investigated by the judicial authorities;
province (2) Local government paid the above loan with the proceeds (2) CNY 110mn quota in debt-swap is withdrawn;
from a debt swap in 2016. (3) Warning given to four officers in the finance bureau.

Local department of transportation used the proceeds from

Inner Mongolia LGFVs bank loan (CNY 10.6bn) as own investment Not available
funding.
(1) Local government of Bazhong city issued guarantee
letters for a LGFV for bank loans, trust loans and bonds;
Sichuan province (2) A record of the government meeting in Xindu (a district Not available
in Chengdu city) shows that the government used funds of
LGFVs in government projects.
(1) All guarantee and keep-well documents are withdrawn;
The local finance bureau issued guarantee letters and keep- (2) LGFV prepaid the borrowed amount;
Qianjiang district,
well documents to support loans and financial leasing for (3) Both the director of the finance bureau in Qianjiang
Chongqing province
LGFVs, totalling CNY 275mn. district and the director of the LGFV are fired;
(4) Warning given to two officers in the finance bureau.
Source: Standard Chartered Research

25 August 2017 5
On the Ground

Reforms The way forward for LGFVs

There are currently three types of LGFVs, which vary significantly in terms of cash
flow and financing capacity. While LGFV breakdowns are not publicly disclosed,
anecdotal evidence shows that most are of Types 1 and 2, as explained below:

Type 1: These LGFVs are purely funding vehicles for local governments and do
not operate a business. Local governments inject land into such LGFVs for use
as borrowing collateral. The source of repayment for a Type 1 LGFV is fiscal
expenditure.

Type 2: These LGFVs raise funds to invest and run public welfare projects
themselves. Most of their assets are public welfare assets, including municipal
roads, parks, public hospitals and government office buildings. Barely any cash
flows can be generated from such assets. These LGFVs have been raising funds
with implicit local government guarantees, such as guarantee letters, keep-well
agreements, or backing with collateral of public welfare assets. The main source
of repayment is fiscal expenditure.

Type 3: These LGFVs run both public welfare projects and commercial businesses.
Debt raising for public welfare projects was backed by implicit local-government
guarantees. In practice, it is difficult to differentiate precisely the nature of Type 3
LGFVs funding (government borrowing or commercial borrowing).

LGFVs can be reformed in three We see three possible ways that LGFVs can be reformed. We would expect LGFVs
ways numbers to fall sharply post-reforms, either due to dissolution and/or M&A within the
existing entities. LGFVs may also be redefined as, and limited to, public welfare
SOEs in the future. We believe some support from local governments could still be
available if these entities fall into financial distress.

To be dissolved: Local governments will likely close most Type 1 LGFVs. The
bulk of these LGFVs outstanding debt has been classified as direct local
government liabilities, and will be swapped into LGBs by end-2018. The rest of
the outstanding debt is likely to be repaid by asset sales in the next 1-2 years.

To be redefined into public welfare SOEs: Most Type 2 LGFVs will fall in this
category, in our view. Public welfare SOEs will continue to focus on supporting
public welfare infrastructure by signing infrastructure or operational contracts
with local governments, but they will have to become fully self-funded. As we
understand, public welfare SOEs will be redefined LGFVs and will continue to
issue LGFV bonds.

Figure 8: Selected guidelines of LGFV reform in four provinces

Province Highlights of LGFV reforms

Guangdong LGFVs with operational profit and cash flows will be turned into commercialised corporates.

Jiangxi Selected entities will act as the pilot of LGFV reforms.

(1) LGFVs without real businesses will be dissolved after the payment of existing debt;
(2) LGFVs running public welfare projects will be merged into different utility SOEs, grouped by sector;
Sichuan
(3) LGFVs with advantages in asset size or market position will be turned into commercialised corporates;
(4) Local governments will undertake limited liability to LGFVs within the scope of invested capital.

(1) LGFVs that are fully reliant on fiscal expenditure for debt payment will be dissolved;
Chongqing (2) LGFVs running public welfare projects will be merged into different utility SOEs, grouped by sector;
(3) Only three public welfare SOEs will be permitted to run for each district.

Source: Standard Chartered Research

25 August 2017 6
On the Ground

Sole operational rights or licenses, such as in the areas of gas, water, parking
lots, public transport and stadiums, will be given to Type 2 LGFVs to
compensate for the withdrawal of direct government guarantees. These entities
existing public welfare assets, which generate no cash flows, will be gradually
repurchased by their local governments. Fiscal subsidies and project revenue
will be the main sources of debt repayment thereafter.

We expect the local governments to broadly merge existing Type 2 LGFVs within
the same region, and focus on a few public welfare SOEs in specific sectors.
This transformation will take 3-5 years, in our view.

Developed into commercialised SOEs: Most Type 3 LGFVs will be further

developed as commercial entities and their direct fund-raising activities for social
welfare projects will be reduced. We should see these entities developed as
general corporate SOEs with no government guarantee after reform. They may
become PPP partners if their projects are considered profitable.

Refinancing pressure is manageable

We expect LGFVs refinancing channels to become more limited given more
restrictive bond issuance and a lack of alternative financing channels. But near-term
refinancing pressure appears to be manageable, despite a rise in exchange-traded
LGFV bond maturities in 2018 and 2019.

Redemption of outstanding LGFV
bonds ranges from CNY 1-1.2tn per
year from 2018-21
Bond redemptions
The maturity of the outstanding LGFV bonds (CNY 6.6tn at end-June 2017) is
relatively spread out. The redemption amount ranges from CNY 1.0-1.2tn (18-19% of
outstanding) for each year from 2018-21 (Figure 9). LGFV bond redemptions on the
exchange are concentrated in 2018 and 2019. Redemptions on the exchange begin
to increase sharply in 2018 (CNY 224bn) and peak in 2019 (CNY 467.4bn). These
redemption amounts will account for 21% and 40% of total LGFV bond redemptions
in 2018 and 2019, respectively.

The redemption amount of LGFV bonds issued after 2015 increases gradually over
the subsequent few years. Redemption of LGFV bonds (issued after 2015) is CNY
495bn and CNY 540bn in 2018 and 2019, and higher at CNY 909bn and CNY

Figure 9: LGFV bond redemptions are increasing gradually

Redemptions (CNY bn) and proportion to outstanding (%)
Redemption (Enterprise bonds and other interbank issues)
1,400 Redemption (Corporate bonds)
19% 19%
1,200 18%
18%

1,000 15%

800 11%

600

400

200

0
2017 H2 2018 2019 2020 2021 2022 or after
Source: Wind, Standard Chartered Research

25 August 2017 7
On the Ground

1,045bn in 2020 and 2021 (Figure 10), respectively. Of the above, redemption from
lower-rated (AA+ or below) issues and private placement is c.CNY 400bn in 2018
and 2019, rising to CNY 501bn and CNY 610bn in 2020 and 2021, respectively
(Figure 11).

The incremental rollover amount from the short-term bonds (no more than one year)
is roughly a quarter of yearly gross issuance. According to the term structure of
LGFV bond issuance in 2016, 22% of LGFV gross issuance is in tenors of 1 year or
below; 60% is in tenors of 5 years or above; and 17% is in a tenor of 3 years.

80% of LGFVs existing debt is above 1 year

In LGFV samples, 80% of debt is
long-term (above 1 year) and nearly
two-thirds of long-term debt is from
bank loans
We studied financial data from 1,891 LGFV entities (whose balance sheets for 2014-
16 are available) as samples for a debt structure study. By tenor, nearly 80% of
LGFV liabilities are long-term (above 1 year), made up of loans, bonds payable, trust
loans and financing leasing payable. The rest are short-term debt, consisting of
short-term borrowings (under 1 year); see Figure 12. Bank loans account for nearly
two-thirds of total long-term debt outstanding in 2014-16 (Figure 13), followed by
bonds (27% in average).

Figure 10: Redemptions (issued after 2015) pick up Figure 11: Redemption structure of LGFV bonds issued
slightly in 2018-19, before rising sharply in 2020 after 2015
Redemption of LGFV bonds in selected issue date (CNY bn) Redemption breakdown by credit rating (CNY bn)
1,200 350
Redemption from LGFV bonds issued after 2015 AA or below no ratings
300
1,000
250
800 216
200 166 189
600 117
150 146
1,045 153
909 144 113
400 100 175

495 540 50 102 117 110

200 95
61 71 66
46
234 0 20
0 2017 H22018 H12018 H22019 H12019 H22020 H12020 H22021 H12021 H2
2017 H2 2018 2019 2020 2021
Source: Wind, Standard Chartered Research Source: Wind, Standard Chartered Research

Figure 12: Long-term debt accounts for c.80% of debt Figure 13: Bank loans account for two-thirds of long-term
outstanding debt
Debt structure of LGFV in samples (CNY bn) Debt structure of LGFV in samples (CNY bn)

Short-term debt Long-term debt long-term share (%) 35,000

30,000 80%
30,000 Other long-
25,000 79% term debt
79% 25,000
20,000 78%
20,000 Loans
78%
15,000 77% 15,000
10,000 76% 10,000 Bonds
76%
5,000 75% 5,000 Short-term
debt
0 74% 0
2014 2015 2016 2014 2015 2016
Source: Wind, Standard Chartered Research Source: Wind, Standard Chartered Research

25 August 2017 8
On the Ground

Decline in financial activity

Onshore LGFV bond issuance will
likely drop, and offshore issuance is
of little help given its small size
LGFVs financing via existing channels is unsustainable, in our view.
LGFV onshore bond issuance likely to drop in 2017 and thereafter. Onshore
LGFV bond issuance may stay light in the foreseeable future as regulations are
not expected to loosen (Figure 14). Among LGFV bond issuance, corporate
bond issuance could drop more significantly compared with other bond types.

The China Securities Regulatory Commission (CSRC) materially tightened

LGFVs eligibility to issue exchange-traded bonds in August 2016. LGFVs with
more than half their revenue coming from local governments can no longer issue
corporate bonds. Under the revised regulations, more than 70% of LGFVs are no
longer eligible to issue bonds on the exchange, according to 21st Century
Business Heralds estimates.

Corporate bonds share of LGFV bond issuance surged to 14.5% and 28.4% in
2015 and 2016, respectively, from only 1.6% in 2014. Such issuance slid
materially in Q4-2016 and the declining trend continues in 2017 (Figure 15).

Figure 14: LGFV gross issuance has dropped significantly in 2017

Gross issuance of LGFV bond onshore (CNY bn)

3,000 Enterprise bonds Corporate bonds MTN/CP/SCP Others

2,500

2,000

1,500

1,000

500

0
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 H1
Source: Wind, Standard Chartered Research

Figure 15: LGFV bond issuance on the exchange has Figure 16: Size of offshore LGFV bond issuance is
decreased sharply since Q4-2016 materially small compared with onshore
Gross issuance of LGFV corporate bonds (CNY bn) Net issuance of LGFV bond (CNY bn)
LGFV corporate bonds (public offering)
800 1,800 Onshore net issuance Offshore net issuance
LGFV corporate bonds (private placement)
700 1,600
1,400
600
+166% 1,200
500
510 1,000
400
800
300 600
+786%
200 400
184
100 109 200 21.2 59.4 87.5
19 185 10.6 8.7 6.8 2.2
77 40 0
0 10
2014 2015 2016 2017 YTD 2011 2012 2013 2014 2015 2016 H1 2017

Note: As of June 2017; Source: Wind, Standard Chartered Research Source: Wind, Bloomberg, Standard Chartered Research

25 August 2017 9
On the Ground

Offshore bond issuance is insufficient to fund the gap. It is unlikely that the
authorities will loosen restrictions on LGFVs overseas bond issuance. The
issuance amount in overseas markets (CNY 86bn in 2016) is much smaller than
in the onshore market (CNY 2.47tn; Figure 16). Net issuance from offshore
LGFV bonds was only 7% of onshore bond issuance in 2016.

Growth in bank loans and trust loans remains light. LGFV loans will likely be
rolled over within banks and trusts. However, banks or trusts have been cautious
in increasing their risk exposure to LGFVs. Cooperation between banks and
local governments ( ), and between trust companies and local
governments () are key concerns for the regulator in managing the
local-government debt problem.

Gauging the funding gap for existing entities

Refinancing pressure from existing We expect net onshore LGFV bond issuance to drop after 2017 and potentially stay
LGFVs is manageable near-term, in light in the next few years. However, bond refinancing pressure for existing LGFVs
our view will be manageable, in our view.

We expect net issuance from the existing entities to stay positive for the most part
before 2019. We forecast net issuance of below CNY 500bn in both 2017 and 2018,
versus averaging CNY 1.2tn per year for the four years since 2013. Net issuance
could trend lower to c.CNY 200bn after 2019, or even turn negative if we make
conservative assumptions (Figure 17).

We calculate the low and high cases of net issuance schedule as below, after
adjusting redemption amounts with increased redemption from new issuance:

Low case: We assume drops in LGFV gross issuance growth in 2017 and 2018
before growth picks up in 2019. We assume issuance growth of -30% in 2017, -
10% in 2018, +5% in 2019, +5% in 2020, and +5% in 2021.

High case: We assume that LGFV gross issuance growth will drop in 2017, stay
unchanged in 2018 and begin to pick up in 2019. We assume issuance growth of
-30% in 2017, 0% in 2018, +5% in 2019, +10% in 2020, and +10% in 2021.

Figure 17: LGFV bond net issuance could turn negative in 2020 under
conservative assumptions
History and forecast of net issuance in onshore LGFV bonds (CNY bn)

1,600 1,501 Low case High case

1,373
1,400
1,200
990
1,000 843
800
600 352
352 401
400
228 152
163
200 53
24
0
-200 -180 -144
2013 2014 2015 2016 2017F 2018F 2019F 2020F 2021F

Source: Wind, Standard Chartered Research

25 August 2017 10
On the Ground

Default risk and valuation

Default risk to stay low in next two years
Existing LGFVs default risk will There have been never been any LGFV defaults. We expect LGFV default risk to
likely stay light in the next two stay low in the next two years during LGFV reforms on relatively mild redemption
years with likely manageable pressure and a higher willingness to pay. On the other hand, we expect the
redemption pressure
default rate of conventional corporate bonds to pick up further. High leverage and
a heavy debt burden will remain key concerns for most SOEs. Only top-tier
corporates may benefit from supply-side reforms and debt-swap programmes
between SOEs and banks.

We expect LGFVs willingness to repay debt to become stronger than that of

other general SOEs. LGFVs are unlikely to voluntarily default during reforms, in
our view, as local governments will be managing the debt repayment by existing
Type 1 and 2 LGFVs during this period. We therefore expect no defaults from the
above entities in the next two years. Defaults by one LGFV could also trigger a
sharp rise in the funding costs of other LGFVs in the same region. This would be
a worst-case scenario that we believe local governments will prefer to avoid in
the beginning years of reforms. Previously, conventional SOEs lack of
willingness to repay debt was a key reason for them to default.

We do not expect a materially negative change in LGFVs financial positions

during the reform period. It is difficult to compare the financial positions of the
majority of LGFVs with those of other conventional corporates given LGFVs
varied business models. In general, the probability of a default among utility-
sector issuers, which we expect will be classified as public welfare SOEs post-
reforms, is lower than among issuers in cyclical and capital-intensive industries
(the majority of onshore bond issuers).

We see value in top-tier LGFV bonds versus other corporate bonds

We see value in AAA-rated LGFV Top-tier LGFV bonds present better value than similarly rated conventional corporate
bonds, compared with other bonds. The current (16 August 2017) yield spread of AAA-rated LGFV bonds over
conventional corporate bonds other general corporate bonds is 10bps and over corporate bonds in the utility sector
is 18bps. We note a significant narrowing trend in yield spreads since 2015, which
we expect will continue in the foreseeable future as LGFVs financial positions solidify
and primary supply falls during the reform period (Figure 18).

Figure 18: AAA-rated LGFV bonds are yielding higher Figure 19: Yield spread differences between LGFVs and
than comparable general corporate bonds general corporate bonds to rise from negative near-term
Yield difference (bps) Yield difference (bps)
LGFV - general corporate (AAA) LGFV - general corporate (AA)
70
LGFV - utility corporate (AAA) 60 LGFV - utility corporate (AA)
60 40
50 20
0
40 -20
30 -40
-60
20 -80
10 -100
-120
0 -140
-10 -160
Jan-14

Jan-15

Jan-16

Jan-17

Jan-18
Apr-14

Oct-14

Apr-15

Oct-15

Apr-16

Oct-16

Apr-17

Oct-17

Apr-18
Jul-14

Jul-16
Jul-15

Jul-17
Jan-16
Jan-14

Jan-15

Jan-17

Jan-18
Apr-14

Oct-14

Apr-15

Oct-15

Apr-16

Oct-16

Apr-17

Oct-17

Apr-18
Jul-14

Jul-15

Jul-16

Jul-17

Source: Wind, Standard Chartered Research Source: Wind, Standard Chartered Research

25 August 2017 11
On the Ground

Other AA+ or below-rated LGFV bonds are now yielding lower than comparable utility
corporate issuers. We do not see a strong catalyst for such yield differences to trend
further down from the current negative territory. On the flip side, the yield difference
could narrow, with further shocks from the upcoming tightening of regulations. Low-
rated LGFV bonds will likely underperform other comparable conventional corporate
bonds in the next two years (Figure 19).

25 August 2017 12
On the Ground

Disclosures appendix
Recommendations structure
Standard Chartered terminology Impact Definition
Positive Improve
Issuer We expect the fundamental credit profile of the
Stable Remain stable
Credit outlook issuer to <Impact> over the next 12 months
Negative Deteriorate

Standard Chartered Research offers trade ideas with outright Buy or Sell recommendations on bonds as well as pair trade recommendations
among bonds and/or CDS. In Trading Recommendations/Ideas/Notes, the time horizon is dependent on prevailing market conditions and may
or may not include price targets.

Credit trend distribution (as of 25 August 2017)

Coverage total (IB%)
Positive 6 (33.3%)
Stable 300 (25.7%)
Negative 91 (36.3%)
Total (IB%) 397 (28.2%)

For recommendations history from both Research and other departments within SCB in the past 12 months, please see
https://www.sc.com/en/banking-services/market-abuse-regulation-disclosures/.

For other information of any securities referred to herein are available upon request to scgr@sc.com.

25 August 2017 13
On the Ground

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25 August 2017 14
On the Ground

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Document approved by Document is released at

Eric Robertsen 12:30 GMT 25 August 2017
Head, Global Macro Strategy and FX Research

25 August 2017 15