BONDS from local government-owned investment companies in China fell in June, paring returns for 2011, after a state audit warned about repayment risks.

Among debt of 77 securities sold by the companies in 2011, 39 of the bonds declined in June, 24 gained and 14 were little changed, according to National Interbank Funding Center data. Fuzhou City Investment Development Co's 7.75 percent debt due February 2018 lost 0.7 percent as its yield rose 22 basis points to 6.67 percent, according to Shanghai Stock Exchange data. Linfen City Investment Construction Development's 7.23 percent note due February 2019 fell 0.8 percent.

Auditor-General Liu Jiayi said on Monday that China's first assessment of local government bonds found liabilities of 10.7 trillion yuan (US$1.7 trillion) as of December 31. Of that, 8 billion yuan is overdue, and companies are too often relying on government land sales to meet repayments, the report said. As much as 30 percent of loans to local government entities may go bad, accounting for the biggest source of banks' non-performing assets, Standard & Poor's said in April.

"Local-government vehicles have found it difficult to repay debt this year because the cash shortage forced banks to lend less money," said Hu Hangyu, a Beijing-based bond analyst at Citic Securities Co, China's biggest brokerage. "Investors should watch out for default risks."

Policy makers are seeking to limit the fallout from a US$2.7 trillion, two-year credit boom aimed at supporting growth during the global financial crisis. As the central bank tightened access to credit, local investment companies sold more notes. Almost 80 percent of regional authority debt was from loans and 7 percent was bonds, according to the audit.

Irregular financing

The investment companies - used to finance roads, bridges and sewage networks to skirt restrictions on direct debt offerings - sold at least 101 billion yuan of bonds since January 1, according to data compiled by Bloomberg News. China International Capital Corp, the nation's largest investment bank, estimated in April that it may reach 300 billion yuan in 2011, from 152 billion yuan in 2010.

"Some management of local government financing platforms is irregular, and their profitability and ability to pay their debt is quite weak," Liu, the auditor-general, said in a speech on Monday. He proposed that the government allow regional authorities to sell debt directly.

Yunnan Highway Development and Investment Co, a local government financing vehicle in southwest China's Yunnan Province that builds expressways, issued a notice to bankers in April saying that it couldn't repay the principal on some 90 billion yuan on loans, Caixin Century magazine reported in its June 27 issue. The company, which has 5 billion yuan in registered capital, couldn't be reached for comment when contacted by phone.

"It's very likely we will see defaults starting in the second half of this year, though the number won't be that big," said Guo Chenglai, an expert on local government financing vehicle bonds at China Chengxin International Credit Rating Co, one of China's main credit rating agencies.

The local government investment companies pay yields as high as 8 percent to sell bonds, compared with the 6.31 percent one-year bank lending rate.

Rugao Communications Construction Investment Development Co, a company based in Rugao City in east China's Jiangsu Province, sold 1.5 billion yuan of bonds due 2019 at 8.51 percent in January. The notes aren't backed by any collateral and the company had a debt-to-asset ratio of 47 percent in 2009, according to the prospectus. Rugao's assets rose by 86 percent between 2008 and 2009 and the company had a net loss from investments of 3 billion yuan in 2009, the prospectus said.

Public debt

The Agricultural Development Bank of China, a state-owned lender, sold bonds due 2018 at 4.59 percent on June 17, 392 basis points less than the coupon on Rugao's notes.

China's total public debt at the end of last year, including local government financing company and regional authority liabilities, was about 28 trillion yuan, or 71 percent of 2010 gross domestic product, Standard Chartered Plc said in a Wednesday note. The total doesn't include the debt of state-owned companies or central bank bills, the note said.

The one-week Shanghai interbank offered rate, or Shibor, jumped 27 basis points to 6.60 percent yesterday, after touching a three-year high of 9.07 percent on June 23. That compares with the 0.16 percent US dollar Libor rate.

The one-year interest rate swap, the fixed cost needed to receive the floating seven-day repurchase rate, rose 7 basis points to 3.83 percent in Shanghai on speculation policy makers will further restrict lending to cool inflation. It jumped 36 basis points this month, the most since January.

The average return on local government investment company debt this year was 1.23 percent, more than the 1.13 percent advance of China's local government debt tracked by HSBC Holdings Plc. The yield on Luzhou City Xinglu Investment Group Co's March 2021 notes is 6.26 percent, down from 6.47 percent when they last traded in April, interbank data show.

The majority of projects undertaken by these companies "are probably projects that have very high economic rate of return," said Nicholas Lardy, senior fellow in Washington at the Peterson Institute for International Economics. There's rising demand for water supply and urban transportation, so the government can boost their revenues with higher prices or subsidies, he said by phone.

Local governments and their investment companies may need to pay 880 billion yuan in interest on bank loan debt this year, 21 percent of local government tax revenues in 2010, Stephen Green, head of China research at Standard Chartered, wrote in the bank's report on regional investment company debt.

"At some point the central government will have to enter the field," he wrote. "It cannot have rumors circulating about hundreds of local government investment vehicle defaults undermining confidence in the banking system."

While the investment companies legally independent, the assessment indicated that the central government will take responsibility for the debt of its regional authorities' financing vehicles, Tao Dong, chief regional economist at Credit Suisse Group AG in Hong Kong, wrote in a Tuesday report. More than 85 percent of the debt was to be directly repaid or guaranteed by local governments, the audit report said.

The cost of five-year credit-default swaps protecting the Bank of China from default rose 53 basis points this month to a two-year high of 174.5 on Monday, according to data provider CMA, which is owned by CME Group Inc and compiles prices quoted by dealers in the privately negotiated market.

'Burden sharing'

The contracts retreated 5 basis points to 166 on Thursday, while default swaps on Chinese sovereign debt dropped 2 basis points to 87. The contracts protect investors from losses when a company or government fails to pay its debt.

The yield on China's 3.83 percent government bond due March 2021 was little changed at 3.83 percent yesterday, after touching a four-month high of 4 percent on June 15. The yuan was unchanged at 6.4636 per dollar yesterday, having gained 1.3 percent in the second quarter.

There will be more cases of requests by the local government investment companies to extend debt, said Wang Tao, a Beijing-based economist with UBS AG.

"I don't think the central government will blindly step in to bail out everyone," she said. "It's going to be a burden sharing between banks, local government and central government. It will get gradually resolved."