China Bubble Bust: First Local Government Financing Vehicle (LGFV) Default

Defaults have percolated from the private sector to their local government counterparts. This marks as the first official local government default.

From the Fox Business News:

In the latest sign of the mounting risks to China’s debt market, a bank for the first time ever reportedly disclosed the default on a loan by a local government financing vehicle.

Over the weekend, the 21^st Century Business Herald, a Chinese-language newspaper, reported Qilu Bank in Shandong Province told investors in its 2013 annual report that the Urban Construction and Comprehensive Development Company of Licheng District, Jinan City (located on China’s east coast) defaulted on a bank loan, according to Nomura.

The loan itself consisted of about $5.7 million in principal and just south of $1 million in interest. The financing vehicle initially defaulted when it stopped making interest payments two years ago…

LGFV’s role in pumping China’s bubble economy:

While the loan itself is small, the disclosure of the default shines an unsettling spotlight on the complex market for local government financing vehicles (LGFVs).

"It highlights the credit bubble that China experienced and now the aftermath as it slowly deflates,” said Peter Boockvar, chief market analyst at The Lindsey Group. “This will not be the last news on this as so many local governments have relied on property sales to fund themselves and that business is obviously slowing.”

LGFVs are the “backbone of local governments in promoting infrastructure development” across China, according to the International Monetary Fund. The tool is favored by local governments as a means of additional fiscal stimulus since local governments are legally prohibited from borrowing directly on financial markets.

LGFVs plays a significant role in the complex chain of network in China’s political economy. 

Earlier I noted: Local government debt has reportedly reached 17.89 trillion yuan or about US $ 3 trillion. Lending restrictions by the central government on the local government has forced the latter to migrate and tap shadow banks consisting of trust securities, insurance and leasing companies, and other non-bank financial institutions, which accounted for 27.8% of new debt. Aside from shadow banks the local government has resorted to other financial engineering instruments too, they have used IOUs and shifted the use of local government financing vehicles (LGFV) into using State Owned Enterprises (SOE) who acquired loans in their behalf (backed by illicit guarantees by the borrowing local government).

So LFFV defaults will likely see a transmission to state banks, SOEs, shadow banks and other financial institutions. One's institution's problems will be carried over by another and so forth.

Oh by the way, this "historic" (as per fox news headlines) official default comes in the light of sustained weakness in China’s real estate market

From the Wall Street Journal: (bold mine)

China's housing prices fell in June for the second straight month as property developers cut prices to stoke sales amid a glut of housing in many cities.

Many home buyers have stayed on the sidelines in anticipation of further price cuts, while cases of default among smaller developers are rising as companies struggle to repay debt in a souring property market.

Average new-home prices fell 0.5% in June from May, data provider China Real Estate Index System said Monday. Prices declined 0.3% in May from April, the first month-to-month decline since June 2012.

Out of the 100 cities surveyed, 71 showed a decline in home prices, up from 62 in May.

The sustained and what seems as deepening momentum of sagging prices of the China's real estate markets only reveals that government nostrums, such as the recent credit "targeted'  easing by the PBOC and the loosening of property curbs by regional governments, seem to have failed to do their supposed therapeutic wonders. Balance sheet disorders have become more evident.

So the spreading weakness in housing prices will reinforce the debt problems which again will feed into prices: thus the liquidation spiral in process.

These developments highlights on the survival of the offsprings of credit inflation. Will the China’s huge bubble be contained?

Don't worry be happy stocks are meant to go up forever.