Credit risks loom over areas along the coast

Coastal and some western provinces, along with the nation's third-and fourth-tier cities, have the highest credit risks in China, including those from excess land and housing supply, rampant borrowing, and poor fiscal conditions, a new report said on Tuesday.

The study, prepared by Japans's biggest brokerage Nomura Securities, sheds new light on the geographic locations of China's credit default risk and is based on assessments made on property market risk, fiscal risk, financial risk and economic fundamentals in 30 provinces and 265 cities in China.

The four dimensions are specifically gauged in 13 indicators, including property investment to GDP ratio, home price to household income ratio, local government financing vehicle debt to operating income ratio, land sale revenue to fiscal revenue ratio, outstanding loans to GDP ratio and so on.

The team found that compared to nine years ago, risks are concentrating toward the coastal provinces, while central China is in a relatively better shape. Drilling down, Nomura sees more risks in Qinghai, Zhejiang, Liaoning, Hainan, Jiangsu, Fujian, Guizhou, Gansu, Chongqing and Heilongjiang.

At the city level, the report found a subsection of third-and fourth-tier cities (60 of 237 cities) have the highest risks, followed by second-tier cities. Housing oversupply and a weak standalone fiscal balance are the main problems in third-and fourth-tier cities, while high land and property prices are the root problem in second-tier cities. First-tier cities are in the low-risk category.

A prominent finding of the report is that risk factors are correlated to each other, meaning one can easily prompt another.

For example where property risk is higher, fiscal risk tends to be higher. Decline in housing sales and prices will intensify land digestion pressure, cut the land value, undermine fiscal revenue and endanger LGFVs' debt to the banks, usually collaterized in land.

"We believe that monetary policy needs to be accommodative to keep each risk factor from breaking out and creating negative feedback loops, in order to limit systemic risk. On the other hand, reforms should continue to encourage deleveraging in the property sector along with local governments, and therefore, a major 2008-style fiscal stimulus is an unlikely policy option," the report said.

Zhao Yang, chief China economist of Nomura and an author of the report, told China Daily that the report does not imply that regional and local governments will default on debt they directly incurred. Unlike the federal system, central authorities in China will bail out lower authorities, so a region's repayment ability cannot be viewed individually.

However, the report could offer investors a cue when evaluating corporate bonds, especially those issued by local State-owned enterprises. When an SOE faces repayment problems, it is unlikely that the local governments which are in a weak fiscal position will come to its rescue. There has already been an instance of an SOE defaulting on its bond repayments, Zhao said.

Nomura's research found much larger credit risk variation than the current LGFV ratings. These ratings, given by domestic agencies, overwhelmingly concentrate in AA-to AA+ range (91.8 percent of LGFVs ratings), and offer little information to investors.

The report also said the local governments with higher risks could lose their bargaining power to the private sector as they try to attract private investors, who will likely demand a higher risk premium. Many of these regions will likely be forced to launch measures such as public-private-partnership, and privatization.