Follow the money. The mounting debt of local governments and their related entities has cast a long shadow over China’s onshore bond market for many years. In this report, we provide an update on the fiscal health of the country’s 31 provincial governments as well as 89 local governments whose state-owned enterprises (SOEs) or local government financing vehicles 

(LGFVs) have a presence in both the Asian dollar bond market and the onshore RMB bond market. Our major finding is that most local governments no longer have the fiscal resources to support every LGFV and SOE. This has major implications for how these bonds are priced, with greater differentiation between the good, the bad and the ugly.  

From blind faith to fundamentals. These fiscal health updates – we have been analyzing the data since 2015 – have helped us track the shift in how investors decide what is the appropriate yield for SOE and LGFV bonds. This is especially important now that it is clear Beijing is becoming more selective about when it will step in to provide support. We sense that the market has now digested this policy shift and is starting to embrace the new model, one that may lead to more defaults and higher spreads. 

Our new framework. On the basis of our health check on local government finances and the latest policy moves, we provide a framework for pricing these bonds. With Beijing reducing its support role even further, the market now needs to focus on the fiscal strength of local governments and the asset quality of individual issuers. Investors also need to consider the strategic importance of the SOE or LGFV, the strength of cash flows, the relationship with local governments, and their degree of leverage. In this brave new world of market forces, we believe the number of defaults will rise, but not enough to disrupt the market. We think this is part of a renewed drive to clean up state debt as the deleveraging campaign gets back on track after the pandemic.