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Tuesday, 12 April 2016

Disparity in local government credit risk across China belies AAA ratings, according to new EIU report

Nascent municipal bond market promises rewards for investors possessing the right analytical tools to help navigate risk

The Economist Intelligence Unit (The EIU) today launches Opening the books: assessing local government credit risk in China, one of the first comprehensive assessments of local government credit risk in China. In the paper, The EIU ranks 30-province-level authorities in China in terms of credit risk.

The municipal bond market in China is experiencing rapid growth, but there is no reliable and independent source for assessment of the creditworthiness of local governments. Regional administrations in China issued around RMB 4 trillion (US$ 642 billion) in bonds in 2015 and a further RMB 15 trillion is expected to be issued in the period to 2020. Issuance of this volume would place the Chinese municipal bond market alongside that of the United States, which was worth US$ 3.7 trillion in 2015.

The framework designed by The EIU for assessing risk is based on proprietary data and forecasts, alongside bottom-up research and is spread across macroeconomic, fiscal, financial and policymaking indicators. The findings include:

  • The data on which The EIU bases its rankings point to significant disparities in credit risk. The economic and financial characteristics of provinces vary widely across nearly every indicator, suggesting there should be significant credit pricing differentiation.
  • All provinces have weaknesses in their credit profile. No single province is ranked within the top 10, implying less risk across each of our four assigned “pillars” (macroeconomic, fiscal, financial and policymaking). Investors should be aware that public finances are under strain to varying extents across all localities in China.
  • On a geographical basis, the wealthy eastern coastal provinces generally exhibit the least credit risk under the framework. They have diversified economies, sounder fiscal positions and superior policymaking structures. South-eastern Guangdong tops the overall rankings.
  • Credit risks are concentrated in western and north-eastern regions, parts of which have struggled amid the national economic slowdown. The central province of Shanxi is at the foot of our rankings, implying the highest level of credit risk.

"Given significant differentiation in credit profiles, the prices and yields on provincial government bonds have been poorly matched to date. Left unresolved, these distortions could act to dissuade investors and have a negative impact on the development of China’s fixed-income market. Our analysis will help investors gain a clearer picture in terms of risk distribution among provincial government bonds and allow them to allocate assets more efficiently," said Chen Chen, Tianjun Wu and Tom Rafferty, the China-based analysts for The EIU and co-authors of the paper.

The disparities highlighted in the EIU’s paper are inconsistent with the view that China’s provincial governments universally warrant an AAA credit rating (as they currently enjoy from local rating agencies). Investors that rely on such ratings or simply on the assumption of central government support for any local administration struggling with debt repayment, risk being exposed. Regulations that came into force at the beginning of 2015 introduced a “zero bail-out” policy with regards to local government administrations.

“Foreign investors will find attractive opportunities in the Chinese market. Currently, local government paper is absorbed by domestic state-owned banks and this has given rise to distortions in the pricing of credit. However, we expect the relationship between risk and returns will become better aligned in the coming years, as the government looks to reduce moral hazard and entice more foreign capital. Already, foreign investors are no longer subject to quotas in the interbank bond market, where most Chinese bonds are traded.

Nevertheless, overseas investors that venture into the local government bond market will need to tread carefully. The lack of independent credit ratings, absence of English-language material, unreliable economic data and non-transparent fiscal accounting points to potential hazards. While return-seekers will be presented with opportunities, particularly in a low-yield global environment, they will also therefore need to be armed with appropriate knowledge and information,” concluded The EIU analysts.


Download the full report at: http://www.eiu.com/ChinaCreditRisk




About The Economist Intelligence Unit

The Economist Intelligence Unit (The EIU) is the world's leading resource for economic and business research, forecasting and analysis. It provides accurate and impartial intelligence for companies, government agencies, financial institutions and academic organisations around the globe, inspiring business leaders to act with confidence since 1946. The EIU products include its flagship Country Reports service, providing political and economic analysis for 195 countries, and a portfolio of subscription-based data and forecasting services. The company also undertakes bespoke research and analysis projects on individual markets and business sectors. More information is available at www.eiu.com

The EIU is headquartered in London, UK, with offices in more than 40 cities and a network of some 650 country experts and analysts worldwide. It operates independently as the business-to-business arm of The Economist Group, the leading source of analysis on international business and world affairs.

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