The extension of credit for a local government-owned contractor in China’s southern Guizhou province that failed to pay some of its debt last year has led to concerns that the country’s smaller banks will become caught up in local governments’ debt crises and face increasing pressure to carry bad loans. Banks might bear the brunt because local governments will want to avert payment defaults on publicly traded bonds. Zunyi Road and Bridge Construction Group, a local government financing vehicle (LGFV) – or firms controlled by local governments that raise money to invest in infrastructure – said in a filing to the Shanghai Stock Exchange on December 30 last year that banks had agreed to give it an extra 20 years to repay loans worth 15.6 billion yuan (US$2.2 billion). Moreover, the LGFV will not pay any of its creditors principal in the first 10 years of the plan. And while one such firm might have a limited impact on banks’ balance sheets, if this becomes a trend, it could spell trouble for China’s lenders, particularly the smaller ones, analysts said. China’s financially weaker LGFVs face default risks: analysts “We may see other local governments follow Guizhou’s practice,” said Ben Yau, director at Lianhe Global, a major Chinese rating agency. “To support LGFVs with limited funding, other local governments might ask bank creditors to extend their loans.” There have been red flags about liquidity risks at LGFVs this year, after Zunyi Road and Bridge Construction Group’s credit extension by local banks. The onshore net financing of LGFVs stood at 48.9 billion yuan in January, down 82.6 per cent year on year, S&P Global Ratings data shows. “Local banks usually have no choice but to support LGFVs in their region, given their business scope and ownership structure, with either local governments or local governments’ related units as the main shareholders typically,” said Ming Tan, director of financial institution ratings at S&P. “It is not a surprise to see some small banks in trouble. In some extreme cases, such lenders in less developed areas can go broke.” Moreover, while nearly 100 LGFVs across China have defaulted on their non-public debt, such as bank loans and trust products since 2018, they have not missed payments on bonds, neither yuan-denominated nor US dollar-denominated, that are traded on capital markets. China opens property market to private-equity investors, foreign funds “Most bond investors regard LGFVs as local governments and still hold a belief that they will not default,” said Lianhe Global’s Yau. “Thus, local governments are fully stretched to avert traditional payment defaults on LGFV bonds, to prevent such faith from collapsing . Banks will get burned.” While S&P’s calculation of bank exposure to LGFVs is about 11 per cent, Scottish asset manager Abrdn estimates that the sector’s total debt stood at around 53 trillion yuan as of June 2022, of which just 13 trillion yuan was in bonds. The rest is bank loans, trust loans and asset management plans, and other debt. “We do forecast more pressure for smaller banks thanks to less diversified assets, bigger exposure to low-tier LGFVs with shrinking local government revenues, and poor ability to issue capital,” said Aaron Ni, investment director of China fixed income at Abrdn. China plans revamp of banks’ risk-exposure rules to strengthen financial system Three rural banks – Zunyi Xinpu Changzheng Rural Bank, Zunyi Huichuan Qianxing Village Bank and Zunyi Bozhou Huilong Town Bank – carry Zunyi Road and Bridge Construction Group’s smallest debt amounts as compared with big banks such as China Citic Bank and China Everbright Bank. But their exposure to the LGFV is relatively large when compared to their own assets. For example, Zunyi Road and Bridge Construction Group owed Zunyi Huichuan Qianxing Village Bank 24 million yuan, about 4 per cent of the lender’s total loans of 651 billion yuan as of 2021. In comparison, the 2 billion yuan it owes China Everbright Bank amounts to just 0.05 per cent of the larger lender’s total loans. “Smaller city and rural commercial banks are particularly vulnerable because of their deep relationships with local governments,” Allen Feng and Logan Wright, China analysts at Rhodium Group, wrote in a research report last week. Soft China property market to weigh on local governments, weaker banks: Moody’s Such small banks, especially in less developed regions like Guizhou province, Yunnan province and Inner Mongolia, are already “at the edge of failure”, analysts said. This is partly because of a serious funding shortage amid competition for deposits with larger banks, and large delinquencies at local borrowers due to China’s economic slowdown in recent years. “So, problems at LGFVs might be the last straw for some small banks,” said Kaichung Lee, associate director of financial institutions ratings at CSPI Ratings.