Saturday, July 5, 2014
Reuters reported a few days ago about the lawsuit brought by Qilu Bank against a local government financing vehicle (LGFV) in the same city (Jinan in Shandong Province) for unpaid debt. The lawsuit is unusual for two reasons: first, it is apparently the first openly disclosed default of a LGFV on a bank loan, although few doubt that there have been others that have been quietly dealt with, and second, not only is the debtor a shareholder in the creditor (albeit small: only 0.08%), but the debtor is controlled by the local government, which probably controls the creditor as well. In addition to the informal influence the Jinan city government undoubtedly enjoys, what appear to be entities directly under its control hold more than 20% of Qilu's equity. And of course the Jinan political authorities also have the power to ensure that no local court will issue a verdict displeasing to them.
LGFVs exist because in general, local governments in China don't have the power to borrow, but they still want to spend more than they have for things like infrastructure projects. They then set up wholly-owned corporations (LGFVs) to do the borrowing and undertake the construction. The problem is that local governments also lack the power to guarantee debt. Thus, LGFV debt as a legal matter is either unsecured or secured by something other than a government guarantee - for example, land-use rights that the local government has transferred to the LGFV.
As the Reuters article reports, many lenders consider (or at least at the time of lending considered) LGFV debt to be informally guaranteed by local governments. Now, apparently, they are having second thoughts. They should have more of these. I was struck by a paragraph in an earlier version of the Reuters report (apparently removed from the version now at the link):
A senior bond trader at a major Chinese state-owned bank in Shanghai noted that while investors still largely considered debt issued by provincial-level financing vehicles to be effectively guaranteed, that no longer held true for lower level entities.
Any non-central government guarantee of LGFV debt is invalid and legally worthless, full stop. And this is over and above the fact that even if the guarantees were legally valid, a creditor could not win a case and enforce a judgment against an unwilling guarantor government. What is remarkable is that creditors still continue to believe in these guarantees, and possibly quite improperly carry these loans on their books as if they were guaranteed. The worthlessness of the guarantee is evident in the sentence itself: it says that investors “no longer” consider lower-level LGFV debt to be effectively guaranteed. So they considered it guaranteed at time A, and at time B they do not consider it guaranteed, even though nothing of legal significance has happened. That’s not what “guarantee” means; it is a legal obligation that persists despite changing circumstances. If investors understand that a lower-level guarantee can evaporate, why do they think that a provincial-level guarantee can’t? It looks like the GITIC bankruptcy all over again.
- Reuters news story
- Qilu Bank 2013 annual report disclosing the existence of the bad debt and the lawsuit (excerpts) [English | Chinese]
- October 2013 IMF Working Paper explaining LGFVs
- Short article from Sept. 2013 International Business Times explaining LGFVs