China may witness its first local government bond defaults, although the timing was uncertain, Fitch Ratings said in a press release issued on Sunday, amid persistent concerns over high debt levels in the world second largest economy.

These bonds were issued by Chinese local government financing vehicles (LGFVs), which were created by local authorities to bypass restrictions on borrowing.

There are concerns about the potential for a wave of defaults in China due to high local government debt, which could impact the financial markets and potentially spread a wave of contagion across the global economy.

The LGFVs have also borrowed from the Chinese shadow banking sector as official channels dried up due to the government’s crackdown on leverage.

Shadow banking is a broad category of banking-like services from non-traditional players; it can include loans from non-financial companies as well as investment products. It is outside the bounds of normal banking regulation, so it largely goes unregulated.

No Chinese LGFV has defaulted to date on its publicly traded debt so far, but the first defaults “are becoming more likely and will probably trigger a repricing of the market,” Fitch said.

Fitch’s warning comes after S&P Global Ratings downgraded China’s long-term sovereign credit rating by one notch last week to A+ from AA-, citing increasing risks from the country’s rapid build-up of credit. Moody’s Investors Service downgraded China’s sovereign credit rating in May.

Despite the risk of LGFV bond defaults, Fitch said the overall risks are likely limited due to the government’s “pervasive ownership and influence” across the financial system.

But the ratings agency said widespread defaults remained a tail risk, or a potential scenario with only a small probability of occurring.

“The authorities continue to rely on local government investment—supported by LGFVs—to hit economic growth targets, and have a broad spectrum of policy tools to limit default contagion,” Fitch added.

“The authorities are in a position to prevent systemic defaults,” said Fitch, including using the last resort of bailing out the LGFVs using fiscal resources.

The central government has been trying to “disentangle” LGFVs from public-sector balance sheets to contain financial risks through means such as instituting debt ceilings and providing swaps to convert LGFV debt into explicit government debt, Fitch noted.

LGFV debt, however, has continued to rise with 4 trillion yuan ($605 billion) worth of LGFV bonds issued since 2015 still outstanding, equivalent to 5.4 percent of China’s gross domestic product.

Chinese authorities will likely to allow the lower quality LGFV bonds to fail, Fitch said.

“These would be LGFVs deemed most financially stretched by the authorities, and consist mostly of lower-tier (non-provincial) LGFVs, particularly those that mix commercial with policy activities, such as property with urban development,” said Fitch.

China has already allowed some state-owned enterprises to default in the last few years, as the central government seeks to instill greater budget and market discipline.

Source: cnbc china
Fitch: Some of China's first local government bonds are likely to default