Chinese regulators are imploring local governments to issue bonds to finance infrastructure projects, and are encouraging activity by slowly loosening rules that have traditionally constricted municipalities from selling their debt. However, at a time when these policymakers are calling for greater issuance, analysts say it take time before China sees a pipeline of true project financing bonds.
Xu Lin, head of the National Development and Reform Commission’s (NDRC) fiscal and financial department, is the latest regulator to voice support for local municipalities to issue bonds to pay for the construction of infrastructure projects, China Daily reported. The call comes the same week that China’s National Association of Financial Market Institutional Investors (Nafmii) has re-launched a scheme allowing select local government vehicles to sell asset-backed notes (ABNs).
The programme, which was stopped in 2008 at the onset of the financial crisis, was reinstituted to give municipalities more flexibility to raise their own funding linked to projects, as well as minimise their reliance on bank lending.
Yet, while regulators are placing greater emphasis on municipalities and their financing vehicles to sell bonds, the emergence of true project financing bonds will be a long ways off. Instead, the market will see corporate bonds akin to project financing ones, though they will not have the same level of covenants and transparency or the defined structure that project bonds have.
“We’re obviously seeing greater focus on the infrastructure space in China, and we’ve seen a slew of recent approvals to speed up the infrastructure pipeline. We expect this will accelerate over the coming few quarters, especially given the weak domestic data,” said the head of project financing at a global bank. “But what we haven’t seen in China to date is what we as international banks would call real ‘project financing bonds’. What we see instead usually has some different form of implicit or explicit guarantees of how the bonds will be repaid, but they don’t have the same level of transparency that delineates where the cash flow is coming from.”
Local governments – which are the largest group backing China’s infrastructure projects - have traditionally had three main recourses to financing. First, they could approach the country’s state-backed banks for loans. However, these have fallen out of favour recently as the central government has sought to minimise banks’ exposure to non-performing loans and bad debt. Local governments’ loans weigh down banks by trillions of renminbi, many of which had to be rolled over earlier this year.
Further, these loans are typically less than five-years long, which will not nearly cover the life of the construction of China’s largest infrastructure projects.
Second, local municipalities, which have limited means to directly issue their own debt, will rely on the central government to sell bonds on their behalf. To gain this right, each local government would have to submit exactly how much financing they need for projects in each quarter, and the Ministry of Finance will sell bonds.
Third, municipalities can set up third-party local government financing vehicles (LGFVs) to issue bonds for them. These bonds are classified as corporates debt and therefore pay higher yield than direct government-issued debt.
Missing from the equation is the presence of project financing bonds, which are different from ABNs and other project-linked bonds.
“In project finance, the creditors only look to the assets as their collateral or source of repayment with no or limited recourse to equity sponsors or contracting parties. In addition, quite strong legal structure is built in the project finance transactions to protect the interest of the creditors,” explained Yvonne Zhang, an analyst at Moody’s in Beijing. “In contrast, most bonds issued by LGFVs are corporate bonds in which their legal set up is very loose and the covenants are light. The credit of these bonds relies heavily on the implicit local government support, instead of solely on the underlying assets. One risk that investors in these bonds face is that the bond proceeds or the cash flows from the projects may be misused for unintended purposes and the investors may not always know about it in a timely manner.”
Zhang explains that ABNs – which are viewed as corporate bonds - are the closest debt to project financing bonds, but even these have a looser legal structure than project financing bonds. Further, Nafmii’s plan with ABNs was to generate a specific amount of money to finance a particular project, yet in practice there’s no guarantee that capital will only be used on that project.
Also with ABNs, the proceeds are not issued to match the progress of the project. Instead, much of China’s infrastructure pipeline relies on a built-to-transfer system: a company will construct it and then sell it to the government. That means that the ultimate repayment of the bond depends on when the government will buy it.
According to the head of infrastructure financing, there needs to be tweaks in the system before there is any real incentive to sell project financing bonds, though there will surely be investor appetite for them.
“There isn’t a lot of confidence and visibility on a cash-flow profile of a project. You will need that transparency in order to introduce these project bonds, and that’s something investors will embrace because they’ll understand better where their money is being repaid from,” the banker said. “If the increase of infrastructure spending leads to improved transparency of where the cash flow is coming from – through contractual underpinning – and investors understand with greater certainty that the projects themselves are able to generate cash flow, then we expect the debt capital market will be a positive source of liquidity for these projects. These components are not there right now but this can be a real opportunity for the market someday.”
However, Zhang adds that the current situation suits investors, who are less concerned about the quality and income of the projects at hand and are more interested in the credit quality of the guarantors of these bonds – the municipalities themselves.
Until mindsets change in which investors will be more discerning of the quality of projects and their ability to generate revenue, project financing bonds – as well as the stricter covenants, structure and transparency that goes with them – will be rare in the market rather than the go-to form of financing.
“In the current developing stage of the bond markets and with a legal system not as robust as these in the mature markets, investors tend to look at the local governments behind the LGFVs for credit support,” she said. “Right now in the Chinese market, the strength of many projects are weak, but if a LGFV is associated with a strong local government from which government support for bond repayment is likely, then the domestic rating for the bond would be higher and the funding costs would be lower.
“If investors really do not believe that LGFVs with weak financial position have a strong external support from strong local governments, then they will demand higher bond yields to compensate for the risks they are taking. Weak issuers will find it difficult to issue their bonds,” she concluded.