Institutional Background

4.1.1. The Development of LGFVs and Chengtou Bonds

Local government financing vehicles (LGFVs) are state-owned companies whose controlling or sole shareholders are local governments. Specifically, the shareholders are mainly the State-owned Assets Supervision and Administration Committees (SASACs) of local governments. Prior to the Tax Sharing Reform of 1994, local governments in China were free to allocate their tax revenue to infrastructure and urban development projects of their choice. However, the reform removed the rights of local governments to control their tax revenue. In response, they were obligated to seek other sources of funding (Zhang and Barnett, 2014; Ambrose, Deng, and Wu, 2015). Along with the tax reform, the updated Budget Law in 1994 prohibited local governments from running budget deficits, thereby motivating them to run implicit budget deficits through their LGFVs. Thus, the aforementioned policy changes resulted in an abundance of LGFVs. Nevertheless, before 2009, the

financing activities of LGFVs were severely regulated by China’s central government.

In 2009, in response to the global financial crisis, the Chinese government issued a four-trillion

Chinese yuan stimulus package to prompt China’s economic growth. Local infrastructure projects

were the major component of the stimulus package, meaning that local governments were burdened with the financing. Because the central government only provided 25% of the four-trillion yuan

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package, it left a shortfall of three trillion for local governments to find (Bai, Hsieh, and Zheng, 2016; Chen, He and Liu, 2017). As noted above, due to the 1994 Budget Law, local governments

were forced to finance their investments through LGFVs. Nevertheless, China’s lawmakers

alleviated the regulations and allowed some flexibility with regard to financing using LGFVs. In particular, local governments were permitted to finance infrastructure projects by acquiring bank loans through their LGFVs and consequently, such loans grew at an unprecedented rate32_{. In turn,}

LGFVs issued a large number of bonds to finance the massive bank debt. In 2008, there were only 12 LGFVs that issued these bonds, a figure that increased to 516 in 2013 (Chen, He, and Liu, 2017).

The percentage of China’s aggregate corporate bonds accounted for by Chengtou bonds rose from

13% in 2008 to 61.5% by the end of 2016 (Chen, He and Liu, 2017). Chengtou bonds are not only traded on the Shanghai and Shenzhen stock exchanges, but also in a specific market called the

“interbank market”33_{. The bondholders are mostly qualified financial institutions including banks,}

mutual funds, and insurance companies (Borst, 2016).

The nature of Chengtou bonds is controversial. Legally, Chengtou bonds are classified as corporate bonds, but the Chinese media and academics often consider them to be municipal debt. The related uncertainty largely stems from the fact that the rules and regulations are continually in flux. Chengtou bond investors are uncertain of the extent to which local governments are liable for the Chengtou bonds issued by their LGFVs. Because of the natural tie between local governments

and LGFVs, and the fact that China’s lawmakers encouraged local governments to raise funds for

the stimulus package through LGFVs, it is reasonable for investors in quasi-municipal corporate bonds to expect an implicit governmental guarantee in the case of default (Chen, He, and Liu, 2017).

1 _{Bai, Hsieh, and Zheng (2016) estimate that about 90% of local government infrastructure projects were financed with} bank loans in 2009. In addition, Chen et al. (2017) show that LGFVs took out approximately 2.3 trillion Chinese yuan in new bank loans in 2009, accounting for 27.5% of China’s GDP. The average proportion of bank loans to GDP in

previous years was only around 15%.

2 _{Unlike the exchange-traded corporate-bond market, which is regulated by China’s Securities Regulatory Commission,}

the interbank bond market is regulated by China’s central bank (the People’s Bank of China). The corporate bonds

issued in the interbank market are called enterprise bonds. Only high quality state-owned companies can issue corporate bonds in the interbank market (Huang and Zhu, 2009).

60 4.1.2. Policy Changes Regarding LGFVs

Even if an implicit governmental guarantee is assumed, Chengtou bond investors may be worried about the ability of local governments to bail out the debt in the case of default. Their worries may

well stem from local governments’ massive debt accumulation, China’s slowing economic growth,

and the large number of corporate bond defaults in recent years (Schweizer, Walker, and Zhang, 2017). Furthermore, Gao, Liao, and Wang (2017) provide direct evidence that LGFVs have defaulted on their bank loans (at least before 2014), suggesting that Chengtou bonds could also be at risk.

Recent policy changes reducing the liabilities of local governments for their LGFVs are likely

to have further curtailed investors’ bail-out expectations. On September 2014, the State Council of

China (SCC) issued Document 43, which (a) prohibited local governments from providing guarantees for the corporate bonds issued by their LGFVs and (b) revoked the option of local governments raising funds through their LGFVs (Chen, He, and Liu, 2017).

In addition to Document 43, the SCC issued another document, Document 88, in November 2016. This document further limited local governments from offering implicit guarantees for

Chengtou debts. It states that if the Chengtou bondholders do not agree to a “swap program” which

would replace their Chengtou bonds with newly issued municipal bonds, they should assume that their Chengtou debts no longer carry any government guarantees (Sina Finance, 2017a).

Finally, in April 2017, the Ministry of Finance issued Document 50, which specified the

following rules to further limit local governments’ guarantees for their LGFVs. Firstly, local

governments cannot inject their assets of public welfare, nor their land reserves, into their LGFVs. Moreover, local governments cannot promise to use revenue from expected land sales as a

guarantee for LGFVs’ debt repayment. Secondly, LGFVs must declare to Chengtou bondholders

that local governments are not responsible for new Chengtou debts. Thirdly, financial institutions are not permitted to ask for or accept any sort of guarantee from local governments when providing financing to LGFVs (Sina Finance, 2017b). It is widely agreed by the Chinese media that

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Document 50 completely stalled the possibility for local governments to offer guarantees for

LGFVs’ Chengtou debts. A news article on a well-known Chinese website (Sohu Finance, 2017)

reported that the yield spread of both AA+ and AA Chengtou bonds increased by 1.5 basis points after the announcement of Document 50.