Broker's View

Public-private partnership financing yet to take off in China

Financing risks, government reliance for guarantees keeping lenders at bay, says JPMorgan

PUBLISHED : Sunday, 18 December, 2016, 3:21pm
UPDATED : Sunday, 18 December, 2016, 8:25pm

Yield-seeking investors may turn to public-private partnerships (PPP) next year due to their low risks even as the financing environment for such projects remains hazy, says leading investment bank JPMorgan Chase.

PPPs are set to gain traction as regulatory tightening will crimp mortgage lending and the allure for private sector fades, it said in a research note.

PPP is a long-term contract between a private party and a government entity for providing a public asset or service, in which the private party bears significant risk and management responsibility, and remuneration is linked to performance.

Risks associated with PPP financing is one reason why Chinese lenders have not backed too many PPPs.

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PPP financing is neutral or negative to Chinese lenders due to the long duration of the projects and the over-reliance on government guarantees, JPMorgan analysts Karen Li and Katherine Lei said in a research note.

JPMorgan sees legal enforcement as a major challenge for lenders since the cooperation framework of such projects are opaque. It goes on to add that areas like financing the equity component of the special purpose vehicles (SPV) through wealth management products (WMPs) or investment portfolios has been an area of concern for many Chinese lenders.

Other risks associated with PPP financing include duration mismatch and liquidity risk. PPP financing is usually spread over a period of 10 to 30 years, while the liability period for banks is six months. This mismatch increases liquidity risks for small banks due to their smaller deposit bases, Li said. Information provider Wind said in a recent report that the liability period for banks that finance the equity portion of the PPPs using wealth management products is often between three to four months.

Unattractive returns a challenge for China PPPs

The heavy reliance on government credit for longer duration investments is also challenging for banks, it said. Private capital participation is immaterial in such projects and the equity portions are usually funded by state-owned enterprises, local governments and financial institutions including banks or insurance companies.

“Based on the projects disclosed, we estimate that only 55 per cent of the PPPs have adequate cash flows,” said Lei.

About 60 per cent of the PPPs in China are linked to government payments or viability gap funding, according to data from the ministry of finance.

“Under the current fiscal structure in China, most of the local governments have run up fiscal deficits. In such a scenario, repayment of 60 per cent of the cost falls on the central government,” added Lei. “Though the short-term risk of default is low in such instances, the risk of over-reliance on government or state-owned enterprises for credit remains high in the long run.”

“Companies we visited expressed the view that contractors expect to earn most of economic value during the first three to five years after construction of the project,” Lei said.

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“This structure may reduce incentives for operators and contractors to manage projects efficiently after the construction period. It would also lead to risks to cash flow generated by projects.”

Local government financing for PPPs cannot exceed 10 per cent of the fiscal expenditure in a single year. But there is no such requirement for long-term budget planning in China.

“Given that PPP financing duration is 15 to 30 years, the risks of local governments defaulting on commitments increase,” Lei added.

JPMorgan said it prefers the approach taken by Postal Saving Bank of China. The lender increased its infrastructure exposure by purchasing the special bonds issued by policy banks and reduced direct exposure.

That said PPP financing also has several positives for lenders, chief among which are lower near-term credit risks, it said.

“The longer duration of PPP financing reduces near-term default risks for banks and cuts liquidity risks for borrowers,” Lei said. “Interest rates on PPP financing are relatively low compared to normal loans,which is positive for borrowers’ debt servicing ability.”