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China's plan to run its biggest fiscal deficit since the global financial crisis may help develop its bond market, but the extra competition for funding could sink some of the major providers of local government financing.
Local government financing vehicles (LGFVs), which were invented to skirt restrictions on local government fundraising, are already under pressure from Beijing's drive to reduce local debt and migrate provincial financing to a more transparent municipal bond model.
With over $3 trillion in outstanding debt that funded essential infrastructure, along with some vanity projects and speculative adventures, LGFVs are finding it hard to service their existing debts, let alone raise new money when loans fall due.
Some fear they could go under.
"There is no way we can survive, and the pressure on the company is huge," said an executive at an LGFV in Yanghou city in Jiangsu province, who spoke on condition of anonymity.
His company has several billion yuan in debt raised to build roads and lay pipes.
"Our loans are due, and we can't repay them. If financing remains this tight, some companies will die."
To service China's 1.12 trillion yuan ($180 billion) deficit for 2015, up 170 billion yuan from last year, state borrowers will also turn to the bond markets, competing for cash with LGFVs just as investors grow wary that the vehicles no longer enjoy the tacit government guarantees they enjoyed in the past.
Greater liquidity and transparency in the bond markets should improve a major structural weakness in China's economy, the inefficient allocation of capital, but LGFVs benefited from such inefficiencies.
"In the past LGFVs would issue bonds with ridiculously low yields, which would then be purchased by local banks," said Zhou Hao, economist at ANZ Bank in Shanghai.
"Now LGFVs will have to issue bonds according to market standards. It is going to be a big year for LGFV bonds maturing, and many of them will have to find ways of refinancing at higher rates."
If big state issuers squeeze LGFVs out of the primary bond market, it could also hit capital spending at a time when growth in China is already at quarter-century lows.
ANZ estimated that the total impact of proposed changes to the fiscal system would force local governments to deal with a funding gap worth 4.2 percent of China's $10 trillion economy.
Beijing says it has plans to deal with such problems.
"We have to steadily deleverage, but must also prevent the economy from falling off a cliff," Finance Minister Lou Jiwei told reporters on Friday, saying local governments had an estimated 100 billion yuan of maturing debt this year.
He said local government funding would move from the LGFVs toward a municipal bond market, as in the United States.
But that doesn't help with existing debts, particularly those linked to projects without a steady income stream, and the muni-bond market is currently limited to a few top-tier regions and a quota of only 500 billion yuan for all of 2015.
In the meantime, LGFVs like Anhui Bozhou Jianan Investment Holding, the financing vehicle for the Bozhou city government in Anhui province, one of China's poorest regions, will continue to struggle to service per capita debt that stood at about 3,100 yuan in 2013 from per capita revenue of just 1,635 yuan.
As a partial solution, the government is pushing a Public-Private Partnership (PPP) model for local governments that would convert existing debt into corporate bonds.
But local governments fear they will get stuck with the debt raised for projects that might have been necessary but are not financially attractive, while the private sector cherry-picks the best.
"The construction projects were meant for us, but now the central government says it is not giving them to us," said a sceptical official at an LGFV in Bozhou, who declined to be named.
"The projects have been given to (private investors), and you still want us to represent the government and manage the PPP?"