A third of China’s $2.5 trillion corporate bond market is going to be hung out to dry

It’s becoming clear that China’s local governments — for years accustomed to easy and no-risk financing — are about to be left to fend for themselves.

That means one third of China’s  $2.5 trillion corporate bond market may not have the backstop of the government, which means it’s under threat of collapse.

To understand how this works, you’ve got to understand how local governments get financed in China: Bonds are issued by corporations set up by local governments called local government financing vehicles (LGFV). They allow local governments to raise money without having to go through banks, and these bonds have become an $820 billion market.

Up until now, the LGFVs have been a pretty safe investment with an unspoken government guarantee.
China tightened the screws.

Enter Directive 43 — a vague government order made back in October that bars local governments from paying down debt issued by companies (like LGFVs). They’re also not allowed to raise debt through LGFVs, and must restructure existing debt.

Additionally, in a separate directive, Beijing said that these bonds can no longer be used as collateral in China’s two stock markets.

So LGFVs aren’t illegal, they’re just incredibly risky now. As a result, only 11 LGFVs have sold bonds this year. Usually 45 LGFVs sell bonds per month.

So this is basically game over for this bottom-less well of no-risk debt.
And Beijing is serious this time.

After a meeting of the Communist Party’s Politburo this week, the government issued a statement reiterating its commitment to economic reform — “we need to give higher priority to improving the structure of the economy,” it said.

In the past that has meant that the free-wheeling debt issuance of old is about to disappear some more, and in a somewhat dramatic fashion.

“While this policy is positive for the long run, we see rising risks of a mini-hardlanding in 2015,” wrote Deutsche Bank in a recent note. “We define a mini-hardlanding as GDP growth dropping below 6% in one or two quarters… The press release suggests the government will push for reforms on financing for investment, price liberalization, fiscal and financial sectors.”
But local governments think they still hear music.

One problem with all of this in terms of the LGFVs (aside from a massive hole in the market) is that the Chinese media doesn’t seem to have gotten the memo. According to Wei Yao, an analyst at Societe Generale, news reports are still touting a bunch of ambitious local government infrastructure projects. They’re being approved by the planning agency, but she’s “skeptical” that Beijing will allow them to come to fruition.

“More importantly, if the central government is still serious about its fiscal reform, funding will get in the way of local infrastructure spending, be it modest or ambitious,” Wei wrote in a recent note. “To achieve the same 20% growth in infrastructure investment as in 2014, at least CNY12tn will be needed in 2015. Even maintaining the same amount of investment (CNY10tn) will be a battle, with 40% of the funding (previously sourced from local governments’ off-budget borrowing) potentially affected by the reform.

“The planning agency’s approvals are carrying less weight, as infrastructure funding is expected to rely more on private investors. Policymakers are clearly working towards a smaller role of the government in the business world. In our view, the acceleration of approvals is merely part of this general trend.”

So it sounds like the party is over, even if local governments still think they hear music.