Debt investors should beware China’s big divide

Bond investors beware: the Middle Kingdom is splitting down the middle.

Increasingly, international investors are being drawn to China’s debt markets, the third biggest in the world behind the US and Japan, as issuance soars and as central-government bonds start to be included in global benchmarks. But any fund manager venturing beyond these safest assets should consult a map before taking a plunge into provincial government debt.

It is not unusual for local governments to run big deficits in China. The latest official figures show that only the wealthy urban municipalities of Beijing and Shanghai posted a funding surplus in 2017. Revenues collected by the other 29 provincial governments fell short of spending.

But Moody’s, the credit rating agency, has found that the regional differences between provincial funding gaps are widening. Where eastern provincial governments faced an average revenue shortfall of 27 per cent compared with spending, those in central and western China saw gaps averaging 50 and 77 per cent, respectively.

Much of the extra spending out west is by design: China’s central government in Beijing has sought to iron out regional inequalities by encouraging big infrastructure projects, for example. But Amanda Du, senior analyst for sub-sovereign debt at Moody’s Investors Service, said differences between regions had worsened since 2015 and were expected to widen further.

Since inland provincial governments already have higher debt burdens from previous rounds of spending, she said, their ability to issue further bonds was limited. Instead they would continue to use off-the-books funds raised largely through special financing vehicles. This has the effect of piling on more risk.

“As long as they have that gap they will have to rely on off-balance sheet funding channels,” said Ms Du.

The upshot is that international debt investors may need to learn the difference between the provinces of Shanxi and Shaanxi. The former has a funding gap equal to about 20 per cent of its total revenue. Neighbouring Shaanxi, to the west, has a gap equal to 130 per cent.

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