(Bloomberg) — Defaults in an opaque corner of China’s local debt market have soared to a record high, trapping investors who assumed the securities had an implicit government guarantee.
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It wasn’t meant to be. Last year, the country’s central government took action, faced with a wave of bad debts issued by municipalities’ financing departments. It authorized local governments to raise about 2.2 trillion yuan ($309 billion) in new bonds to repay creditors and ordered state-owned banks to provide additional refinancing support.
These measures pushed borrowing costs to record lows and investors rushed back to the market, clamoring for bonds and loans. But one segment was not repaired. Failures of so-called non-standard products, which are fixed income investments that are not publicly traded, rose to record levels.
Although no official figures exist on the size of the sector, analysts estimate it to be around $800 billion. According to data provider Financial China Information & Technology Co. Sixty non-standard products linked to LGFVs defaulted or were warned of repayment risks in the first nine months of this year, an increase of 20% compared to the same period last year. The still relatively small but growing figure was a record in data going back to 2019.
The defaults have proven costly for many private investors.
Take Lulu Fang. The 60-year-old owner of a small trading company said she lost her savings of 15 million yuan when she bought so-called trust products linked to Guizhou province in the country’s southwest. She expected a stable return of about 8%, much higher than what she would earn if she deposited the money in a bank. Instead, her investment was wiped out when the products went bankrupt last year.
Facing a possible foreclosure from her Shenzhen apartment due to her inability to make mortgage payments, she joined more than 100 other investors on multiple trips to the trusts and government offices to plead for repayment.
“My life is a total mess now,” she said. “I’ve worked all my life and put all the money I saved for retirement into the products. I was told these were safe. That was a lie.”
The country’s towns, cities and provinces have used so-called local government financing vehicles (LGFVs) to finance infrastructure projects, including roads and ports. However, projects funded by the LGFVs do not necessarily make money. This makes them dependent on government support.
The issuers of the debt typically do not disclose the total amount. Of the 60 cases of non-standard products defaulting or warning of refund risk tallied this year by Chinese data provider FCI&T, 40 did not provide figures. The remaining 20 products totaled about 4.55 billion yuan.
This is in stark contrast to publicly traded bonds issued by LGFVs. Local governments have prioritized these securities, which are favored by institutional investors, and there has never been a default. Because non-standard products are typically sold to investors through private placements, local governments have less incentive to help them.
“Although China has introduced a series of policy measures to tackle LGFVs’ debt, the policy should guarantee the repayment of LGFVs’ government bonds as they are part of the capital market,” said Laura Li, managing director at S&P Global Ratings. “If they go bankrupt, it will endanger financial and social stability.”
There is some hope for investors who own the defaulted debt. The central government is considering allowing local governments to issue as much as 6 trillion yuan in bonds through 2027 to refinance off-balance sheet debt, people familiar with the matter said. If this happens, it opens the opportunity for LGFVs to broaden their support for non-standard products. Yet that is not a given and some analysts doubt it will happen.
“If the new round of pledges to reduce hidden debt actually materializes, local authorities will still prioritize LGFV bonds over non-standard debt when products need support,” said Wang Chen, co-founder of Belt & Road Origin (Beijing) Tech. Co., a credit risk analysis provider. “The impact of the new plan on the non-standard market would depend on the actual extent of policy support, and how such resources could be distributed among different regions and entities.”
Many of the defaults have occurred in the trust sector. Trust fund products are typically unlisted and sold through channels such as banks and securities firms to corporations, financial institutions and high-net-worth individuals with a minimum investment threshold of 1 million yuan. They typically offer regular fixed payments annually or semi-annually with a fixed period of six months to five years.
The LGFVs have turned to non-standard products as local governments become increasingly cash-strapped due to the country’s economic slowdown and a sharp decline in land sales. Regulators have tightened restrictions on bond sales by LGFVs, forcing them to look for alternatives. They typically pay 7-8% interest on non-standard products, compared to 3% interest on listed bonds.
“LGFVs certainly have a need to finance through non-standard channels, despite the high costs,” says S&P’s Li. “But their policy priority is low, so the number of bankruptcies remains at a high level.”
These defaults have left retail investors like Fang desperate for help, but the experience of a fellow retail investor suggests she doesn’t have much chance of getting her money back.
Jason Lai’s three million yuan investment in an LGFV-guaranteed asset management product went wrong five years ago. Lai, an employee at a Beijing-based state-owned company, has traveled to the regional city of Anshun four times to seek reimbursement.
“Since 2019, when the product first defaulted, I have only been able to recover about 10% of the principal amount,” Lai said. “I will not buy any such products in the future.”
