Revisiting the LGFV debt issue

Transcription

1 Deutsche Bank Research Asia Asset Management: For institutional client and retail registered representative use. Not for public viewing or distribution. Date Economics China Revisiting the LGFV debt issue Zhiwei Zhang, PhD China s infrastructure investment accounted for 6% of global economic growth in This is equivalent to contribution from the whole economies of Germany, UK and France combined. Infrastructure accounted for 54% of China's investment growth in Q1-Q3 this year, a record high (Figure 1). It was only 36% in 9 when China rolled out the 4trn stimulus. How long can China continue to run an expansionary fiscal policy This series of reports look into China s fiscal issues, starting from the debt of local government financing vehicles (LGFVs). Chief Economist Figure 1: Infrastructure's contribution to investment growth LGFV debt grew by 15% in 15 and 13% in 16, compared to 21% on average in -14 (Figure 2). This estimate is based on a sample of 1844 LGFVs who issued bonds in China and released financial statements. We estimate the total LGFV debt is 32trn by 17H1. We estimate the slower growth of LGFV debt can be fully attributed to the debt swap program. 77% of this program's capacity have been utilized since 15. Its support will likely fade in coming years. Figure 2: LGFV debt stock New LGFVs tend to borrow at much faster pace than their elder peers (25.5% vs 9.4% in 16). Debt at county level LGFVs grew faster than those at prefecture and provincial levels (23%, 11%, and 8% respectively in 16). Financial condition of LGFVs continues to deteriorate in recent years (Figure 3). Source: Deutsche Bank, NAO, WIND LGFVs median ROE dropped to 1.8% in 16 from 4.4% in, debt to asset ratio rose to 56% from 49%, and free cash flow stayed negative. Excluding subsidies and capitalized interest, 69% of LGFVs have interest coverage ratio below 1 in 16, compared to 38% in. Figure 3: Deteriorating financials, median LGFV In 21 out of 27 provinces, average interest coverage ratio is below 1. 84% of LGFV debt on county level has interest rate coverage ratio below 1, compared to 79% and 52% on prefecture and provincial levels. We expect infrastructure investment growth to slow to % yoy in H1 18 from 14% in Q3. The central government started to tighten local government financing in Q2 17. GDP growth may drop only moderately below 6.5% in H1 18 as consumption and service help to balance the economy. With the labor market stable, the government has the option to tolerate slower growth and focus on the quality of growth, as President Xi said in the 19th Party Congress. Deutsche Bank AG/Hong Kong Note: EBIT based ICR, adjusted for interest expense and fiscal subsidy in the chart. Distributed on: 5/11/17 21:21:8 GMT DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 83/4/17. bed7b6cf11c

2 Revisiting the LGFV debt issue China's fiscal policy is important for global investors and policy makers for two reasons. First, it is a key driver for growth in China and the rest of the world. China contributed around % of global growth in 14-16, compared to 25% from the US, Euro area, and Japan combined. The IMF expects China to contribute 27% of global growth in , versus 24% contribution from other three large economies. China s infrastructure investment accounted for 6% of global economic growth in This is equivalent to contribution from the whole economies of Germany, UK and France combined. Its contribution to total investment growth in China rose to a record high of 54% in the first three quarters of this year. To put this into perspective, when China rolled out the 4trn stimulus in 9, infrastructure only contributed 36% to investment growth in China. The fiscal policy in China is also important for financial stability. Global investors have been concerned about the leverage issue in China. The optimistic view is that China's overall leverage is high, but government and households still have room to leverage up. But how much room does the government have to further push up infrastructure investment President Xi mentioned several times this year the importance of containing local government debt. The government rolled out policy measures to tighten control over local government financing in the summer, and infrastructure investment growth slowed since then. As President Xi goes into his second term, he seems to be more concerned about financial risks and less committed to the growth target (see our note: President Xi's speech at the Party Congress, October 17). In this "China fiscal series" we aim to provide an update on key fiscal issues in China. To start this series we look at the case of local government financing vehicles (LGFVs). This was a hot topic in the financial market several years ago, but not recently. As we illustrate in this report, it would be difficult to make judgment on fiscal condition and policy outlook without knowing the latest status of LGFVs. For readers not familiar with LGFVs, they are important vehicles for the financing and execution of local public infrastructure projects. LGFVs became active and widely used during the "4trn stimulus" period in 9-. Local governments were not allowed legally to borrow from banks or financial markets. They were pushed to build massive infrastructure projects to counter the shock from global financial crisis. To circumvent the legal constraint they utilized LGFVs to borrow instead. LGFVs are owned by local governments but they are registered as corporates. The CBRC reported that total outstanding LGFV loans was RMB9.1trn in. Another official report by the National Audit Office (NAO) stated that the total amount of local government debt was.9trn in 13, but it likely excluded a significant part of LGFV debt which the market regards as public debt. This report aims to answer the following questions. How large is LGFV debt as of today and how fast is it growing How is their financial condition, in terms of profitability, leverage, cash flows, and sustainability to repay debt by themselves Which part of the LGFVs are particularly vulnerable What happens to LGFVs if Page 2 Deutsche Bank AG/Hong Kong

3 growth slows sharply What is the latest policy stance on LGFV debt and what is the policy outlook What is the implication for growth in 18 LGFV debt still growing but its pace slowed Our estimates are based on firm-level data of 1844 LGFVs that have issued bonds in the domestic market some time during All these LGFVs with outstanding bonds are required to disclose financial information on a regular basis. The financial statements published by them have all been externally audited, and thus are comparable across LGFVs in the sample. The sample does not cover all LGFVs, as detailed financial information is not publicly available for LGFVs that have not issued any bond. Total debt of LGFVs in our sample in is about 8% of the aggregate LGFV debt reported by the CBRC in. LGFV debt is still growing, though its pace has moderated. Within our sample, interest-bearing LGFV debt grew by 15% in 15 and 13% in 16, compared to of 21% on average in -14. In H1 17, LGFV debt growth further edged down to 11% yoy (Figure 4). Based on the growth rates, we estimated that LGFV debt stock was at RMB32.4tn as of end-h1 17. LGFV debt continued to increase as a share of GDP: it was at 41% of GDP in H1 17, up from 36% in 14 (Figure 5). The pace of increase in LGFV debt-to-gdp ratio has slowed down; in previous years (11-14), debt was increasing by 4-5% of GDP on average each year. Figure 4: Growth rate of interest bearing debt % LGFV interest-bearing debt growth, yoy H1 Note: The growth rates are estimated using LGFVs with observations of two consecutive years. Figure 5: LGFVs' debt to GDP ratio Trillion RMB LGFV debt % of GDP, rhs H1 % Debt grew faster in new LGFVs. We separated our sample into 2 groups: (1) "old" LGFVs, for which we have their financial information in 11; and (2) "new" LGFVs, for which we do not have financial information in 11. This is most likely because they did not publically issue any bond before 14, and therefore are not required to make financial disclosures for the year 11. We found that debt grew much faster in the "new" LGFV group (Figure 6). Even if we exclude all bond issuances for the "new" group, their debt is still growing faster than the "elder" group. This may reflect a strategy the local governments circumvent central government's fiscal discipline "old" LGFVs have been under central Deutsche Bank AG/Hong Kong Page 3

4 government's radar screen, hence the "new" LGFVs were set up to keep the ball rolling. Debt also grew faster for LGFVs at lower administrative levels. County level LGFV debt grew at 23% in 16, much faster than prefecture (11%) and province (8%) levels (Figure 7). 1 Figure 6: Debt growth rate for new entrants Figure 7: Interest bearing debt growth rate by administrative levels % Interest bearing debt, new LGFVs Interest bearing debt, old LGFVs 4.5 Loans, new LGFVs County Prefecture Province Note: The orange line is estimated on a balanced panel of 837 LGFVs for The other lines are estimated on LGFVs with observations of two consecutive years but not does not have full information between Note: The growth rates are estimated on LGFVs with observations of two consecutive years. Loans remained the largest source of financing for LGFVs, though their share declined gradually to 57.4% in 16 from 75% in. Bond financing have increased to 26% in 16 (Figure 8). Province, prefecture and county level LGFVs each accounted for about 1/3 of LGFV debt (Figure 9). 2 1 Whether an LGFV is at province, prefecture or county level is determined by matching the county or city name that appeared in the names of the LGFVs. Classifications from the data vendor WIND is adopted when neither city or county name is included in the name of the LGFV. Judgment was applied for the rest; the majority of them are determined to be at province level. 2 It is worth noting that our sample may be biased towards bond financing and higher administrative level LGFVs, as it only includes LGFVs that have issued bonds at some time. Page 4 Deutsche Bank AG/Hong Kong

5 Figure 8: LGFV debt decomposition by type of debt Bonds Loans Other interest bearing debt % 9% 8% 7% 6% 5% 4% % % % % Figure 9: LGFV debt decomposition, by administrative level Province, 297 LGFVs, 9. trillion yuan, County, 769 LGFVs, 7.9 trillion yuan, Prefecture, 625 LGFVs, 8. trillion yuan, 32% A policy driven slowdown The slowdown of LGFV debt growth was largely policy driven. A debt swap program has been in place since 15 to help lower LGFVs debt burden. Under this program, local governments may issue bonds to swap out debt of LGFVs and other entities that were deemed to be the government's responsibility to repay. The debt swap would alleviate LGFV's debt burden by migrating the debt from their balance sheet to the government s. It also significantly lowers borrowing cost, as government bonds are much cheaper than LGFV debt. The scale of the debt swap was large. RMB8.1tn of government bonds were subsequently issued in for debt swaps, about half of which went to LGFVs. Another RMB2.6tn have been issued so far in 17 (Figure ). We estimate that the debt swap lowered LGFV debt growth by about 5 percentage points each year. The debt swap explains the bulk of the slowdown in LGFV debt growth (Figure 11). Under the current plan, debt swap in 18 and onwards would not likely exceed 3tn. 3 Other policy changes may have also contributed to the slowdown of LGFV borrowing. Policies have been tightened for local governments to use LGFVs as financing vehicles to carry out new public investment projects, in particular those projects that rely on government guarantees or subsidies. In turn, publicprivate partnerships (PPPs) have been used as an alternative financing platform for local governments to implement urban investment projects, reducing the need for LGFVs to borrow. Some PPP projects went into execution stage during 15-17, with the total planned investment at RMB4.1tn. 3 A total amount of about 14tn of local government debt are eligible for the debt swap, all of them accumulated on or before 14. Any debt accumulated after 14 would not be eligible for the debt swap. Deutsche Bank AG/Hong Kong Page 5

6 Figure : Local government bonds issued Trillion RMB Bonds issued for debt swap Other bonds Figure 11: Debt swap and LGFV debt growth 5 4 Trillion RMB Baseline With debt swap Actual Oct YTD H1 Source: Deutsche Bank, MoF, WIND Note: "baseline" assumes debt growth in to be the same as average growth in "With debt swap" assumes, on top of the baseline scenario, 3.2tn, 4.9tn and 2.6tn of debt swap in 15, 16 and 17. Deteriorated financials The firm-level data allows us to take a closer look at LGFV's financial conditions. Almost all financial indicators have deteriorated in recent years. Leverage continued to increase, despite the slowdown in debt growth. Median debt to asset ratio increased to 56% in 16 from 49% in. The ratio is 71% at the top decile; in other words, debt is more than double of their equity. (Figure 12) Earnings have further deteriorated. The median LGFV's return on assets (ROA) dropped to merely.8% in 16 from 1.1% in 14 and 2.2% in (Figure 13). Similarly, return on equity (ROE) fell below 2% in 16 (Figure 14). As such, LGFVs are among the most inefficient users of capital. Listed SOEs in comparable sectors 4, by contrast, have ROA and ROE at 2.5% and 6.3%, respectively, in 16. Cash flows also paint an alarming picture. The advantage of looking at cash flows is that they are less vulnerable to accounting manipulations, and better capture companies liquidity conditions. Between 14 and 16, about 7% of all LGFVs in the sample ran negative free cash flows to the firm (FCFF). In addition, there has been a divergence in 16 where the FCFF of the bottom quartile has further deteriorated (Figure 15). 4 Public utility, real estate, and energy. Page 6 Deutsche Bank AG/Hong Kong

7 Figure 12: Distribution of LGFV debt to asset ratio Figure 13: Distribution of LGFV return on asset % % th percentile th percentile 64.1 median 25th percentile th percentile % % th percentile 75th percentile 2.2 median 25th percentile th percentile Note: The ratio is estimated on a balanced panel of 19 LGFVs. Note: The ratio is estimated on a balanced panel of 16 LGFVs. Figure 14: Distribution of LGFV return on equity 14 % % th percentile th percentile Figure 15: Distribution of LGFV free cash flow to the firm Billion yuan th percentile median th percentile Billion yuan th percentile median th percentile 1.3 th percentile th percentile Note: The ratio is estimated on a balanced panel of 16 LGFVs. Note: FCFF is based on a balanced panel of 87 LGFVs. Can LGFVs pay their debt The important question remains whether LGFVs would be able to service their debt on their own; and, if not, how large is the gap. One hypothesis is that, with the large scale debt swap targeted at financially weak LGFVs and the subsequent tightening of borrowing, LGFVs should now be in a better position to repay their debt. An alternative hypothesis is that, driven by the pressure to sustain GDP growth, LGFV would continue to serve as investment vehicles for local governments. Their goal remains to be maximizing investment rather than improving their capacity to service debt. Any marginal improvement in their financial conditions would be exploited to obtain new financing. Calculating the interest coverage ratio We apply the interest coverage ratio (ICR) approach to measure LGFV's capacity to repay. This is a common approach to measure debt servicing capacity and Deutsche Bank AG/Hong Kong Page 7

8 potential NPLs. 5 ICR is the ratio of corporate earnings to interest expense. An ICR ratio of less than 1 means that the firm's profit from regular operations is not sufficient to cover interest expenses on its debt; it is often regarded as a signal of debt distress, as the firm's debt would be unsustainable, absent any outside interventions. We calculated three different ICRs: ICR1 = earnings / interest expenses ICR2 = earnings / adjusted interest expenses ICR3 = (earnings - subsidies) / adjusted interest expenses earnings: There are three candidates for measuring earnings: EBITDA, EBIT, and operating cash flow (OCF). A shortcoming of EBITDA is that it excludes the cost of depreciation and amortization. These costs can be large for LGFVs, and cannot be postponed indefinitely. In this regard, EBIT-based ICR is a better measure for debt servicing capacity in the long run. Finally, OCF captures actual cash flow and is less subject to accounting manipulation, but it may underestimate earnings of long term projects with front-loaded costs in its initial years. While we chose EBITbased ICR as our baseline, we also calculated ICRs based on EBITDA and OCF as robustness checks for our results. adjusted interest expenses: LGFVs tend to capitalize a significant amount of interest expenses. This resulted in artificially low interest expenses in the income statement. The effective interest rate, calculated as the ratio of interest expense to interest-bearing debt, was well below market rates. LGFVs and listed SOEs should have similar credit worthiness, yet the effective interest rate was much lower in LGFVs. Using the reported interest expense would significantly the underestimate LGFVs' actual borrowing cost. Lacking the information to back out the amount of capitalized interest expenses, we applied the benchmark lending rate as a proxy. We set.8x benchmark lending rate as the floor effective rate for all LGFVs in the sample, and adjust up interest expenses accordingly (Figure 16). subsidies: Many LGFVs receive regular subsidies from the government. It is not, however, standard accounting practice to report government subsidies, and only a small portion of LGFVs do so. Using available observations 6, we found very strong correlation between subsidies and non-operating income: on average subsidies is about 88% of non-operating income, with a correlation coefficient at.98. To be conservative, we used 8% of non-operating income as a proxy for fiscal subsidies received by LGFVs. Our estimate show that subsidies continued to increase as a share of earnings, and accounted for almost percent of LGFV's EBITDA by 16 (Figure 17). 5 See, for example, IMF (15), Corporate leverage in emerging markets--a concern Global Financial Stability Report, October 15, pp Our database contains 2,327 observations of government subsidies, or less than percent of the full sample. Page 8 Deutsche Bank AG/Hong Kong

9 Figure 16: Weighted effective interest rate based on reported interest expense % Listed SOEs LGFVs Note: The effective interest rates are weighted against interest bearing debt Figure 17: Size of reported fiscal subsidy and nonoperating income Subsidy, % of EBITDA Non-operating income, % of EBITDA ICR Results ICR1, the EBIT-based ICR before any adjustments, deteriorated across the aboard over the recent years. For the median LGFV, earnings have fallen from 6.9x interest expense in to 4.4x in 16 (Figure 18, left panel). The Figure also illustrates great disparity among LGFVs: while most LGFVs seem to have more than sufficient earnings to cover its interest expenses, the bottom % still have LCR ratios of less than one in 16. Interest coverage dropped dramatically for all LGFVs once capitalization of interest expenses are adjusted for (Figure 18, mid panel). ICR2 was merely above 1 for the median LGFV in % of the LGFVs did not have sufficient earnings to cover their interest payments falling due. The aggressive capitalization of interest expenses helped paint a rosy picture on the accounting books, but the reality is much more alarming. If we substract subsidies from LGFV earnings, ICR3 would be reduced further to.7x for the median LGFV. 69% of LGFV's ICR was below 1 in 16. Furthermore, ICR was close to zero for the bottom % - 25% of the LGFVs, suggesting that they were not profitable at all once government subsidies are removed from their income. (Figure 18, right panel) All the ICR calculations are based on a balanced panel of 636 LGFVs from -16 to ensure comparability over time and across different ICR definitions. Deutsche Bank AG/Hong Kong Page 9

10 Figure 18: Distribution of EBIT-based interest coverage ratio Note: The ratio is estimated on a balanced panel of 636 LGFVs. Which ICR best reflects the future debt servicing capacity of LGFVs It largely depends on future government policies. If LGFVs are to be fully regarded as commercial entities and cut-off from subsidies, ICR3 would be the most accurate indicator. If the fiscal subsidies continue to increase at the same pace of LGFV debt, ICR2 would be more accurate. The most likely scenario, in our view, is continued subsidies at reduced, or even negative, growth rates. In this scenario, future interest coverage should be somewhere in between ICR2 and ICR3. Our results are robust to the choice of earnings indicator and sample selection. ICRs based on different earnings indicators all show the same trend, and the median ICR are all at or below one in (Figure 19). The level and distribution of ICRs are very similar under different samples (balanced panel or full sample) (Figure ). To sum up, once the true borrowing cost and subsidies are taken into account, our calculations show that LGFV interest coverage are at alarmingly low levels. Without subsidies, most LGFVs do not have sufficient earnings to cover their true interest expenses. One may rightfully question whether LGFVs are sustainable on their own, even after all the policy changes and debt swaps. It is likely that the LGFVs would demand further transfers from fiscal resources in the future. Page Deutsche Bank AG/Hong Kong

11 Figure 19: Median LGFV ICR based on EBIT, EBITDA and OCF EBIT EBITDA OCF Note: Medians in the charts. The ratio is estimated on a balanced panel of 632 LGFVs for EBIT, 559 LGFVs for EBITDA and 632 LGFVs for operating cashflow. Capitalized interest expense and fiscal subsidy are adjusted in estimation..3.3 Figure : ICR distribution: balanced panel and full sample, Interest expense and fiscal subsidy adjusted EBIT-ICR Balanced panel of 636 LGFVs Full sample of 158 LGFVs, Percentile 2.4 Not all LGFVs are the same Our interest coverage calculations also unveil huge disparities across LGFVs. One important determinant of such differences is geographical location. Average interest expenses adjusted ICR could range from.4 (Gansu) to 1.9 (Jilin) among different provinces (Figure 21). Once government subsidies are also excluded, only a few provinces still have their ICRs above one, mostly the richer provinces and cities such as Beijing, Shanghai, Guangdong and Fujian (Figure 22). On the other end of the spectrum, Heilongjiang stands out as having a negative ICR on average. Disparities are also large across local government levels. Unsurprisingly, LGFVs in higher administrative levels are financially healthier than those at lower levels. At county level, 84% of LGFV debt has ICR below one. The share decreases to 79% and 52% at prefecture and province levels (Figure 23). Despite the high interest repayment burden and lower ICR, county level LGFVs continue to accumulate debt faster than prefecture and province level LGFVs. This is an alarming signal. Deutsche Bank AG/Hong Kong Page 11

12 Figure 21: Average ICR2 by province Gansu (12) Tianjin (34) Guangxi (37) Yunnan (32) Chongqing (71) Heilongjiang (21) Guizhou (5) Jiangsu (264) Shaanxi (39) Shanxi (13) Liaoning (51) Hubei (66) Inner Mongolia (19) Shandong (96) Henan (47) Zhejiang (14) Xinjiang (41) Jiangxi (48) Hunan (89) Hubei () Siquan (74) Beijing (33) Fujian (61) Shanghai (42) Guangdong (7) Anhui (64) Jilin (18) Figure 22: Average ICR3 by province Heilongjiang (21) Gansu (12) Tianjin (34) Liaoning (51) Guangxi (37) Jilin (18) Jiangsu (264) Yunnan (32) Chongqing (71) Shanxi (13) Zhejiang (14) Hunan (89) Guizhou (5) Shaanxi (39) Inner Mongolia (19) Xinjiang (41) Hubei (66) Shandong (96) Jiangxi (48) Hebei () Henan (47) Siquan (74) Beijing (33) Shanghai (42) Fujian (61) Anhui (64) Guangdong (7) Note: ICRs are weighted against interest bearing debt. Number of LGFVs in the parentheses. Only provinces with more than LGFVs are shown in the chart. Note: ICRs are weighted against interest bearing debt. Number of LGFVs in the parentheses. Only provinces with more than LGFVs are shown in the chart. Figure 23: Share of LGFV debt with ICR < 1 by administrative level % EBIT-ICR Adjusted for interest expense Adjusted for interest expense and fiscal subsidy Province (228) Prefecture (631) County (745) 9.1 Page 12 Deutsche Bank AG/Hong Kong

13 A stress test for LGFVs What happens to LGFVs if growth economic slows sharply We look into the case of five provinces as a natural experiment. This sample includes the three provinces from the Northeastern part of China, Heilongjiang, Jilin, Liaoning, as well as the major steel producer Hebei and the main coal supplier Shanxi. Their average economic growth slowed from 8.4% in 13 to 4.4% in 16, while the national GDP growth slowed only from 7.8% to 6.7%. This is one way to "simulate" a stress test for the LGFVs. Our analysis shows indeed the economic slowdown took toll on the LGFVs in these provinces. Their profitability, as measured by ROA and ROE, were close to the other provinces in 13, but declined visibly faster than the other provinces in (Figures 24 and 25); They relied more on government subsidies even before 14, but they became much more dependent in recent years. 48% of their earnings came from non-operating income in 16, compared to 36% in 13. Meanwhile this share barely changed in other provinces (25% in 13, 27% in 16) (Figure 26); They used to enjoy lower effective interest rate than other provinces, but the gap disappeared by 16, which may reflect higher credit risk (Figure 27). Figure 24: Median return on equity, by province groups Liaoning, Shanxi, Heilongjiang, Jilin and Hebei Others Figure 25: Median return on asset, by province groups Liaoning, Shanxi, Heilongjiang, Jilin and Hebei Others Note: The median ROE is estimated on a balanced panel for the two groups, with 81 LGFVs for the five provinces, and 773 provinces for the others. Note: The median ROE is estimated on a balanced panel for the two groups, with 8 LGFVs for the five provinces, and provinces for the others. Deutsche Bank AG/Hong Kong Page 13

14 Figure 26: Share of non-operating income in EBITDA 6 Liaoning, Shanxi, Heilongjiang, Jilin and Hebei Others Figure 27: Weighted average effective interest rate based on reported interest expense Liaoning, Shanxi, Heilongjiang, Jilin and Hebei Others Note: Estimated effective interest rates are weighted against interest bearing debt. ICR of LGFVs in these five provinces also deteriorated in recent years. The pace of worsening is similar with the other provinces if we look at the average LGFVs in these two group. But if we look at the bottom deciles of the samples, weak LGFVs in these five provinces deteriorated more than those in other provinces (Figure 28). Nonetheless LGFVs in these five provinces did not default. This suggests the local governments managed to find resources to help them survive. It appears that the worse financials did not result in any visible difficulties for these LGFVs to get financing prior to 14. If anything, their debt was growing faster. From 15 onwards, however, financial constraints have indeed become more binding for them. Effective interest rate increased, and debt growth rate fell sharply to 5.6% in 16 (Figure 29). Figure 28: EBIT ICR, adjusted for interest expense and fiscal subsidy, by province groups Liaoning, Shanxi, Heilongjiang, Jilin and Hebei Other provinces Median Median th percentile.7.4. Figure 29: Interest bearing debt growth, by province groups % Liaoning, Shanxi, Heilongjiang, Jilin and Hebei Other provinces th percentile Note: The ratio is estimated on a balanced panel of 1 LGFVs for Liaoning, Shanxi, Heilongjiang, Jilin and Hebei, and 1185 LGFVs for other provinces. Note: The growth rates are estimated on LGFVs with observations of two consecutive years. Page 14 Deutsche Bank AG/Hong Kong

15 A new round of tightening The history of LGFV borrowing and policy regulation is a repeated game of cat and mouse between central and local governments. To briefly review the history (Figure ): Following the rapid growth of LGFV debt during the 4tn stimulus package, the central government issued its first policy document on LGFVs in June. The so called document 19 tasked the MoF and the central bank, among other ministries, with the responsibility of regulating LGFV borrowing. Infrastructure investment fell sharply in 11 with tightening of LGFV bank credit. However, LGFVs found its way into the bond market as an alternative source of funding, and infrastructure investment growth resumed in 12. The 2nd round of tightening happened during late with the issuance of NAO s auditing report on LGFVs and the document 43. The new policy forbid LGFVs from borrowing with government guarantees. But the policy became ineffective in H2 15 when growth slowdown forced the government to loosen control over LGFVs.. The most recent round of tightening started in Q2 17 and is still ongoing. Finance Minister Xiao Jie, who took over the Ministry in late 16, made it clear that managing local government borrowing was among his top priorities. Mr. Xiao worked for many years on public finance and is considered an expert in this field. Under his term a series of new policies were issued, mostly notably the document 5 in April and the document 87 in May 17. What these policies have in common is they provide detailed and technical guidance on all aspects of local government operations, closing many loopholes local governments could find to borrow outside the budget, including through LGFVs. 7 With the new policies in place, investment growth stalled. FAI and infrastructure investment growth were both falling in Q3. LGFVs net bond financing so far this year was much lower than in previous years (Figure 31), and borrowing cost also increased by about 8bps from end 16. We believe that tightened LGFV borrowing policy will remain a headwind for investment. Although Mr. Xiao Jie has recently moved on from the post of the Finance Minister in the post-party Congress reshuffle, he will likely hold an important State Council position in the next government and continue to influence policy making in public finances. Tighter policy on local government borrowing will also likely receive support from the leadership. In a July speech, President Xi stated that government officials should be hold accountable for local government debt problem on a lifetime basis, even if they have moved to other posts. He also downplayed the importance of growth target in the 19th Party Congress (see our note President Xi s speech at the party congress). 7 These loopholes include, among others, project financing through highly leveraged government investment funds ; and infrastructure investment financing disguised as government procurement of services. Deutsche Bank AG/Hong Kong Page 15

16 8/1 8/7 9/1 9/7 /1 /7 11/1 11/7 12/1 12/7 13/1 13/7 14/1 14/7 15/1 15/7 16/1 16/7 17/1 17/7 Figure : Infrastructure investment growth mma yoy% 4tn Stimulus 1st tightening "document 19" 2nd tightening "document 43" 3rd tightening "document 5, 87" Figure 31: LGFV net bond financing Billion yuan Issued Matured Net financing - Source: Source: ytd 18E19EE We expect growth of infrastructure investment growth to drop to 12% in Q4 and % in H1 18 from 14% in Q3. This will drive GDP growth slightly below 6.5% in H1 18. We expect government policy stance will loosen slightly in Q2 and stabilize GDP growth at 6.4% in H2 18. Looking beyond the next six months, we expect an intensive bargaining process between the central and local governments about the debt issue. As financing pressure heightens in 18 local governments will likely try to push central government to loosen financing restrictions again. One issue to watch next year is the alternative financing channels for local governments. They include PPP (public private partnership) and local government industrial funds, among others. They are less transparent than LGFVs and harder to track. The local governments may turn to rely more on these instruments. We acknowledge the contribution made by Yi Xiong, Deutsche Bank economist, and Xinyu Ji, an employee of Evalueserve, a third-party provider to Deutsche Bank of offshore research support service. Page 16 Deutsche Bank AG/Hong Kong

17 Appendix 1 Important Disclosures *Other information available upon request *Prices are current as of the end of the previous trading session unless otherwise indicated and are sourced from local exchanges via Reuters, Bloomberg, and other vendors. Other information is sourced from Deutsche Bank, subject companies, and other sources. For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at Aside from within this report, important conflict disclosures can also be found at under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing. Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Zhiwei Zhang Deutsche Bank AG/Hong Kong Page 17

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