CHINA'S local government financing units led losses in corporate bonds last month, as a cash crunch fanned concern regional authorities will struggle to pay the US$1.7 trillion they owe.

Debt issued by Shouguang Jincai State-Owned Assets Management, the company set up by Shouguang city, Shandong Province, had the worst performance among the country's company bonds with a drop of 8 percent, according to data compiled by Bloomberg News. Fuzhou City Investment Development Co's notes were the second biggest losers, declining 7.8 percent, the data show. United States municipal bonds handed investors a return of 0.989 percent in the same period, according to Bank of America Merrill Lynch indexes.

The two-year lending boom that drove China's economic-stimulus program by pumping money into roads, highways and railways may end in a wave of bad debts and prompt the nation's third banking bailout in less than two decades, according to a Standard Chartered Plc report published on July 18.

A large portion, if not the majority, of these loans will not be repaid by the projects currently using the funds, according to the report.

"This is the worst period for China's bond market since the financial crisis," according to Fan Wei, a Beijing-based fixed-income analyst at Hongyuan Securities Co, the second biggest underwriter of local government financing vehicle bonds this year, according to Bloomberg News data.

"Issuance will continue," because bank lending rates are even higher, Fan said in a telephone interview on July 28.

Growth may slow

Rising concerns about local authorities' ability to pay their debts have emerged. In Europe, Greece is set for its second bailout in less than two years, after the previous package valued at 110 billion euros (US$157 billion) failed to solve the euro area's debt crisis.

Local government debt in China totals 10.7 trillion yuan (US$1.7 trillion), with 80 percent coming from banks, according to an audit posted on the National Audit Office's website on June 27. Recapitalizing China's banks following a wave of defaults by local government companies may slow growth in the world's second-largest economy.

During the last round of restructuring of the Chinese banking system from 1998 to 2005, the total cost to the government was about 5 trillion yuan, or 20 percent of China's gross domestic product at the time, May Yan, a banking analyst at Barclays Capital in Hong Kong, wrote in a report on June 3.

As Chinese policymakers push up borrowing costs and drain funds from the financial system to help damp inflation, which hit a three-year high of 6.4 percent last month, the companies are paying yields as high as 8.5 percent to access money.

Local Chinese governments, barred from directly taking loans or selling bonds, have created more than 10,000 companies to help finance infrastructure projects. They have even borrowed from banks and lent to property companies, Bank of America Merrill Lynch analyst Winnie Wu said in a phone interview on June 23.

The ChinaBond Corporate Bond Net Price Index fell 1.4 percent in July, hitting 89.267, the lowest since the data started in October 2008.

Investors lost 0.47 percent on Chinese government bonds in the past month, the worst performance among HSBC local-currency debt indexes covering Asia's 10 biggest economies excluding Japan. US government debt gained 1.8 percent, according to Bank of America Merrill Lynch's Treasury Master Index.

The yield on China's 10-year government bonds rose 16 basis points, or 0.16 percentage point, to 4.05 percent in July, the biggest monthly increase since November, according to ChinaBond, the nation's biggest debt clearing house.

The buyers of the bonds are mutual funds, trust companies and banks that sell wealth management products and city commercial banks as well as rural credit-cooperatives, according to a June 24 report from China International Capital Corp. Those funds and brokerages are now selling because of concerns about credit quality, according to George Weisi Tan, who oversees about 300 million yuan as head of bond investments at Fortune SGAM Fund Management Co in Shanghai.

"There's deleveraging but it's not easy to deleverage in China's bond market, liquidity is really poor," Tan said.

"The issuance in the primary market will cool down. There is no way they can pay 8 percent coupon rate to fund public projects where the return on capital is very low," he said.

Bond watch list

China Chengxin International Credit Rating Co, one of the nation's three biggest ratings agencies, put two bonds sold by companies backed by Yunnan Province on its watch list for the first time last week following the announcement of an asset transfer by the provincial government that would take away some of their valuable energy assets.

In the first five months of this year, 70 percent of corporate bonds were issued by the local government financing vehicles, according to CICC. They sold 96.1 billion yuan in bonds this year compared with 135.8 billion yuan in 2010, according to CICC data. In 2009 they sold 143 billion yuan.

"Everyone is worried about local government risk," Xide Ma, a Beijing-based fund manager of E Fund Monthly Income Fund. "But the default risk is not that high."

The cost of five-year credit-default swaps protecting Chinese government bonds from default rose one basis point last week to 87 basis points, according to data provider CMA, which is owned by CME Group Inc and compiles prices quoted by dealers in the privately negotiated market. That compares with 62 basis points for contracts on US debt.

The yuan gained 0.04 percent to 6.4340 yesterday, It touched 6.4336 earlier, the strongest level since the country unified official and market exchange rates at the end of 1993.

China's currency has risen 2.4 percent against the dollar this year. The advance compares with a 1.4 percent gain for India's rupee, a 7.2 percent gain in the Brazilian real, and a 10.6 percent gain in the Russian ruble.

Yuan forwards rose for the first time in three days after data indicated manufacturing expanded more than economists forecast in July and Congressional leaders approved a plan to raise the US debt ceiling.

US debt deal

The Purchasing Managers' Index was at 50.7 for July compared with 50.9 in June, the China Federation of Logistics and Purchasing said in a statement yesterday. That exceeded all 13 estimates in a Bloomberg News survey of economists.

President Barack Obama said leaders of both parties in the US House and Senate had reached an agreement to raise the US$14.3 trillion debt limit and cut the federal deficit before today's deadline.

Wei Jian, a researcher in the fixed income department at Bosera Asset Management Co, which oversees more than US$17 billion, said there are still good value bonds from local government companies that don't face the risk of default in the next one or two years.

"Right now because everyone believes the whole local government financing vehicle bond market is very risky, even if you choose some good bonds their price goes down," Wei wrote in an e-mailed response to questions.