An SPV: “Special Purpose Vehicle” is a legal entity that isolates the parent firm from financial risk. As the name mentions, it’s designed to fulfil “certain” specific objectives and is considered “bankruptcy-remote”.
In China, the local governments financed gigantic trillions of dollars of infrastructure projects in the last two-three decades using SPVs known as “Local Government Financing Vehicles (LGFVs)”.
LGFVs are set up by local authorities to borrow money for funding infrastructure and public welfare spending.
The salient feature one needs to remember about LGFVs is that the LGFV bonds are “usually” not allowed to be repaid from government fiscal revenue.
This is a significant concern because if the project becomes/is unviable due to force majeure circumstances or exogenous factors, the LGFVs will default, and the bondholders will suffer losses.
Nevertheless, before we go to the nitty gritty of these SPVs, we need to understand a bit of history.
PART 1: 2008–2015
It all started with the breathtaking stimulus of 3 trillion Yuan that the Chinese Government launched post the 2008 GFC. This stimulus encouraged the local governments to borrow money via LGFVs and spend on public infrastructure projects.
As a result, by the end of 2009, LGFVs had already accumulated 5 trillion yuan in bank loans. In 2009 (a single year), the debt ballooned by 3 trillion Yuan!
By mid-2013, total indebtedness at LGFVs reached 6.97 trillion yuan, almost 40% of the total 17.9 trillion yuan borrowings.
But why LFGVs?
The local governments in China until 2014 had limited options to raise money except for the local taxes (that too the control is with the central government).
Direct borrowing was prohibited, and as a result, the local governments used LGFVs to borrow and lavishly spend for their notable infrastructure spends.
This was an innovative way to gear up leverage in the form of “off-balance sheet items”, which kept the true health of the state governments concealed from the public eye.
But something changed in 2013–14:
As the LGFV’s borrowings saw a colossal rise, an audit was conducted in 2011 audit. The result was legal amendments that prohibited local governments from borrowing via LGFVs and a plan to refinance NAO-identified public liabilities into sub-sovereign bonds issued directly by provincial governments.
Despite shifting some 14 trillion RMB in LGFV debt to the official public balance sheet as part of a debt-swap program, LGFV borrowing continued to grow, prompting renewed efforts to limit the use of LGFV borrowing.
PART 2: 2015–2020
In 2015, the ban was raised, and the local governments were permitted to raise money via bonds and bank borrowings.
And the local government’s borrowings saw a colossal increase. The borrowings reached a mind-blowing 28% of GDP within a few years!
Though some of the increase can be attributed to the LGFV debt swap mentioned earlier.
Furthermore, the massive increase post-2016 explains the rise in the credit impulse, which I mentioned in the beginning.
Nevertheless, the local governments also continued to raise money via LGFVs in another ingenious way.
The fastest growing portion of the LGFVs balance sheet was the “receivables” component. These were the arrears of local governments towards these opaque SPVs.
You will be stunned to know that the receivables from local governments were equivalent to 18% of GDP in 2020, as per the IMF.
On the liabilities side, we can see from the chart that the debt grew at an astonishing 15% CAGR. On the asset side, the growth driver was primarily financial assets comprising accounts receivable and investments in securities, cash, loans, company equity and other unspecified tangible assets.
One can ascertain the constant need for increasing debt/leverage by digging deeper.
The precarious position of LFGVs is clear, as more than 85% of the source of funds is external financing, which is clearly shocking.
“This means that these entities are deep in the red (negative operating cash flow) and needs to borrow massively every year just to meet their operating expenses.”
In fact, LGFVs accounted for a large part of the total social financing for non-financial firms.
Read More: Canary In The Coal Mine- 2!. The $10 Trillion Hidden Debt Problem! | by Sagar