HONG KONG, 28 May 2020. Pengyuan International has today published a report on identifying and picking a quality LGFV. Local governments in China started actively setting up local government financing vehicles (LGFVs) after they were barred from direct borrowing under a 1994 budget law. However, each LGFV operates within the jurisdiction of its respective local government, and do not directly compete against each other. Under a typical LGFV structure, a local government injects assets, usually in the form of land or cash, to capitalise a legal entity that will subsequently raise funds via bank loans, bonds, or the shadow banking market, and undertakes infrastructure investments for public welfare and/or primary land development in its coverage area. In this article, we try to analyse the common characteristics of a quality LGFV.
Dominant exposure in public welfare. The core business of a LGFV is to provide financing for the local government to conduct infrastructure construction for public social welfare and primary land development, which we see as credit positive. Some LGFVs may also be involved in semi-social welfare sectors: public utilities that includes water, electricity, gas, heat and public transport. However, there is a growing trend for LGFVs to engage in more market-oriented businesses, including property development (residential, commercial and industrial), which we see as a potential risk if they have significant exposure in the same way a developer has. LGFV’s primary aim is to perform government functions rather than seeking profit. In order to differentiate a LGFV from an ordinary state-owned enterprise (SOE), we believe the company’s exposure to the public social welfare sector is the most important criterion. In other words, we assess whether the source of its income and operating cash inflows come from governments or the markets.
Factors affecting the credit profile of a LGFV. We see a number of factors that could have an impact on the credit profile of a LGFV: a) In general, the higher the government administrative level, the better the credit of a LGFV; b) We prefer a LGFV with large-scale assets, and its respective local government to have financial strength; c) We prefer LGFV’s main source of operating income to be from the local Ministry of Finance (MoF), and the major counterparty to be the local government; d) We prefer LGFVs to have quality assets (with receivables largely from the local government), profit and support records (government repurchases and government subsidies track record), and sufficient bank facilities with diverse financing channels. We provide a detailed discussion in the latter section of this report.
No explicit mechanism for bail out. The capital needs of local governments soared in the years following the global financial crisis as they were called upon to provide economic stimulus via increased infrastructure spending. The profitability of the infrastructure projects that LGFVs invest in, however, is low, and there is no explicit mechanism for local governments to bail out the LGFVs. Contractual agreements on government service purchases are in place to support LGFV’s cashflow and earnings. On a standalone basis, most LGFVs are financially very weak. Should LGFVs extend their operations into more profitable, commercial-based businesses rather than their existing welfare-based businesses, where the LGFVs do not have any track-record, government support will be weakened.
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