On Sept. 12, 2018, S&P Global Ratings lowered its long-term issuer ratings on seven Chinese local government financing vehicles (LGFVs). We see a weakening trend in the likelihood of LGFVs receiving timely and sufficient extraordinary support from local and regional governments (LRGs) in case of financial distress.
We believe the willingness of LRGs to provide support will remain largely intact over the next 24 months, given their close relationships with LGFVs and the platforms' function in carrying out local development policies. Nevertheless, their ultimate capacity to support could be constrained by their financial strength and external factors beyond their control. For example, pressure from the central government to separate the financing functions of LGFVs from their LRGs, as well as the growing hesitation of creditors, have added to the complexity of providing timely support, and addressing the refinancing needs of LGFVs.
Companies that deliver highly essential public services and have long-term funding support from state-owned financiers, such as metro and rail developer/operators in major cities, will likely continue to have an almost certain likelihood of extraordinary financial support from local governments in case of financial stress. However, the links and roles of many other LGFVs could weaken over time, given policy objectives to lower corporate leverage, and expansions by LGFVs into profit-oriented activities.
Our report aims to addresses some of the questions on investors' minds regarding the LGFV sector.
Frequently Asked Questions:
What prompted S&P Global Ratings to review the Chinese LGFV sector?
We believe the relationships between LGFVs and their government owners are evolving. Over the past 12-18 months, the Chinese central government has issued policy announcements aimed at separating the financing functions of LGFVs from their local and regional government (LRG) parents. While this process is undoubtedly a multi-year one, the direction is clear enough to warrant a reassessment of China's unique local-government financing structure.
LGFVs tend to be nonprofit and heavily leveraged, but are able to obtain funding due to explicit or implicit government guarantees. However, as the central government continues with its overall deleveraging campaign and the crackdown of off-balance sheet borrowings of LRGs, some new guidelines and rules seek to separate the links between governments and such financing vehicles. For example, a new rule implemented earlier this year prohibits LGFVs from mentioning government support in their bond offering documents, which we believe is a testament to a more restrictive position towards financial support.
This does not mean that we believe a government owner would not provide extraordinary support to its LGFV in times of financial distress or that the LGFV model will disappear overnight. LGFVs are still playing an important role in the economic and financial stability of China. That said, we see this link as less strong for certain LGFVs than previously assessed.
It is important to note that we see this as a transition, an ongoing process that will go through cycles driven by central government policies and market forces. For example, the central government tempered its language on LGFV discipline in July 2018, in an apparent relaxation of new guidelines. The State Council recommended that liquidity be provided to LGFVs to support their refinancing and promote local economic growth. However, in our view, growing debt and pressure on LGFV balance sheet will ultimately harden the central government's long-term objective to protect the credit quality of LRGs and deleverage the corporate sector.
If S&P Global Ratings feels this way, then why didn't it downgrade all 15 publicly rated LGFVs?
Five of the seven LGFVs we downgraded play critical roles to the local government and, in our view, have an almost certain likelihood of support if in need. The "almost certain" likelihood of extraordinary support, our highest assessment, means the ratings reflect and move in tandem with the credit profiles of their LRG owners. However, given the trend of a weakening relationship between the LGFVs and their government sponsors, we lowered the uplift by one notch.
That said, we believe these five LGFVs still have very significant roles and remain important government-related entities. Hence, their likelihood of receiving extraordinary support is still higher than most of their peers.
Why were metro/railway companies unaffected by this credit review?
We believe the government support for these two rated metro companies is much less exposed to the transitional weakening of some other LGFVs. This is due to our view that metro/railway services in China's major metropolitan areas are essential infrastructure for safe and economical mass transport that relieves congestion and air pollution, and supports a high-density urban economy and population.
In our view, local government support for metro operators remains strong and is unlikely to weaken in the foreseeable future. With sizeable upfront capital expenditure but low fares and inflexible fare adjustment mechanisms, the operations of the two rated metro companies are backed by strong long-term financing support from the government and the state-owned banking system. For Beijing Infrastructure Investment Co. Ltd., for example, all debt principle and interest repayments in relation to rail construction are covered under a 30-year Authorize-Build-Operate agreement with the government and the company receives nearly RMB30 billion in annual payments, which are enshrined in the government budget.
We believe the recent top management reshuffle at Tianjin Rail Transit Group Co. Ltd. shows the Tianjin municipal government is prioritizing metro development in the city. The company's previous chairman and president stepped down because the government believes Tianjin Rail is behind other major cities in metro development and financing. Tianjin Rail has made considerable investments already, with multiple lines in operation. We expect the direct extraordinary support from the government to Tianjin Rail to be more certain and accessible than for its local peers.
Will LGFVs become more profit-oriented, and if so, how would this impact the sector's credit profile?
Yes, we believe their business models will transform over time, with a mixed impact on credit profiles. Moving to operating models based on commercial principals is a long-term and formidable task for LGFVs. Moreover, forays into new businesses that are potentially more profitable can also expose LGFVs to more market risk. As an example, some larger LGFVs are engaged in financial services, such as providing micro financing to local small and midsized enterprises (SMEs). While these businesses may be more bankable and still important for local economy, the more market-based operations expose these entities to being replaced by other Government-related entities (GREs) or even private sector companies, thereby lessening the importance to the LRG.
Changsha Pilot Investment Holdings Co. Ltd. is an example of an LGFV that is moving quickly into more market-based businesses, such as commercial real estate and gas stations. As a result, we lowered our long-term issuer credit rating on the company to 'BB+' from 'BBB-' to reflect its increasing exposure to commercial activities, and the gradual downward transition in the likelihood of extraordinary government support toward the company. Unlike most of peers, Changsha Pilot is classified by its local government as a "market competitive" state-owned enterprise (SOE). In addition, it is located in Hunan province, which has taken a stringent stance on stripping out the financing role of its LGFVs.
In other cases stand-alone credit strength could be enhanced as LGFVs transform, if the companies can improve their cash flows to debt leverage metrics without resorting to large-scale investments. But business transformation will be a lengthy and bumpy process, given LGFVs generally have less experience and fewer advantages in competitive sectors, and their businesses are geographically concentrated. On top of that, most LGFVs are still deeply leveraged, even though some benefited from the government's debt-for-bond swap to extend maturities.
Why is liquidity analysis so important to LGFVs and what is the trend so far?
A common feature of LGFVs is very high leverage and weak cash flow. Most of them are not able to even service interest payments without ongoing support from their parents, and depend on refinancing to meet short-term debt maturities.
In assessing the liquidity position of any company, we look at the sources of liquidity and how certain they are. Historically, state-owned banks refinanced LGFV debt based on their view of solid government backing for the LGFV borrower. However, the sector has had to increasingly turn to nonbank sources such as trust loans and finance leasing. Since the central government is now cracking down on alternative financing, liquidity risks are rising for borrowers who have come to rely on these funding sources. This risk can be exacerbated in times of increasing funding costs as we saw for LGFV borrowers earlier this year.
Similar to any corporate borrower, liquidity for LGFVs can deteriorate due to significant short-term debt maturities, delays in receiving payments for services provided, high committed capital expenditures, or sudden loss of capital-market access. In particular, many LGFVs face large short-term debt maturities without committed sources of refinancing. This means that lenders are making policy-based lending decisions as to the ability and willingness of an LRG to provide support to the LGFVs on a timely basis. In the event of heightened liquidity or refinancing risk at an LGFV, we believe this could signal diminishing government support.
As part of our review, we have lowered the likelihood of extraordinary support of Zhenjiang Transportation Industry Group Co. Ltd. to very high from extremely high and the issuer rating to 'BB-' from 'BB'. The negative rating outlook on the company reflects our view that the capital structure may not be sustainable without significant overhaul over the next 12 months. Failure to restore the company's balance sheet and extend its debt maturities could lead its stand-alone credit profile being further downgraded to the 'ccc' category, lowering the final rating to single 'B' category.
This rating action is based on our assessment that Zhenjiang Transportation's refinancing risk has heightened significantly. The company has huge short-term debt maturities, soaring funding costs, and a high reliance on unconventional instruments such as finance leases and trust loans. We assess the company's liquidity as weak, indicating a material deficit between liquidity sources and uses and the lack of a visible refinancing plan in the coming 12 months. We also believe the heightened refinancing risk implies a lack of clear and robust monitoring and control of the company by the Zhenjiang municipal government. This despite the allocation of certain government bond proceeds to the company this year.
How does China's deleveraging campaign affect the credit outlook for the LGFV sector?
In China, the credit stability of the LGFV sector is highly subject to policy cycles and government priorities. Another source of complexity is that LGFVs are susceptible to refinancing risk and market sentiment because of their extremely high leverage and increasing reliance on unconventional financing channels outside the banking system. The policy tightening in 2017 aimed to keep local bureaucrats accountable for increasing off-balance sheet government borrowing and also put constraints on trust loans, finance leases, and other shadow banking products. In the first half of 2018, such restrictions were extended to state-owned financial institutions, which together with the deleveraging campaign in the financial sector led to tightening liquidity for LGFVs and increased their funding costs significantly.
However, we believe this deleveraging is a longer-term process and the policies are likely to continue to evolve. Against the backdrop of U.S-China trade tensions and the record-low growth of infrastructure spending in the first seven months of the year, policymakers are again looking to boost China's cooling economy by encouraging new infrastructure projects along with other measures. This recent policy focus shift helped to ease funding restrictions and credit costs. State-owned companies generally benefit the most from easing monetary conditions.
Over a longer period, we anticipate the role and link of LGFVs to local governments may weaken along with their progressive business transformation. On top of that, LGFV financing, which has been dubbed the "back door" of local governments is being gradually replaced by more direct government borrowings, although the "front door" is not open wide enough.
Local governments have been urged to issue more special-purpose bonds and to finance social infrastructure or public-welfare projects on their own balance sheets, rather than through LGFVs. The central government is setting more stringent thresholds for using public-private-partnerships (PPP) or industrial funds, and limiting the scope of government procurement of services. While authorities have eased pressure on LGFVs recently, we believe deleveraging of the corporate sector will remain a key objective of the Chinese central government. As such, there will be longer term pressure on LRGs and LGFVs to figure out how to reduce debt levels, even if such actions impact economic growth.