China Faces Rising Default Risks In Local Government Debt

After years of talks about the potential risks within China’s local government debt universe, default may finally take place this year.

There are signs that the Chinese government has become serious about tackling this problem, and any local government debt default would add pressure to China’s economy and its financial system, according to a report released by BofA Merrill Lynch Global Research.

China Banking Regulatory Commission (CBRC) has ordered Chinese trust companies to cap their exposure to local government financing vehicles this year at the same level as 2013, according to Chinese media reports.

As of June 2013, China has a total of RMB17.9 trillion local government debt, according to the National Audit Office.

Bank loans accounted for 57% of that total, with total loans at around RMB10.1 trillion. Bonds took 10% of the total with RMB1.8 trillion, and trust companies accounted for 8%, with RMB1.4 trillion outstanding.

BofA Merrill Lynch says the Chinese government may allow some local government financing vehicles to default in the second half of this year.

This may be the next objective of the government, after it addressed moral hazard problems in speculative capital flows betting on the RMB’s rise and expected bail-out of Chinese trust products.

Moreover, many local government financing vehicles are in negative cash flow, because their projects are often not for profit.

Many of them need to roll their debt continuously. But with the tightened control measures the Chinese government seems to be launching, it will be more difficult for them to do so, posing higher risks for defaults.

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