A clandestine practice, previously cracked down upon in mainland China, is resurfacing in Hong Kong’s bond market. Local government financing vehicles (LGFVs) are reportedly offering investors significantly higher returns than officially stated, effectively doubling yields on their debt. This maneuver aims to circumvent rising interest rate demands and the risk of making future borrowings more expensive.
The Return of a Banned Practice
China’s LGFVs, crucial for funding infrastructure projects, are facing a substantial debt rollover challenge. To attract investors without openly signaling distress or increasing borrowing costs, some LGFVs are engaging in a practice that involves making extra, undocumented payments to investors. This strategy, which regulators had previously targeted on the mainland, has now reappeared in Hong Kong. During the second quarter, numerous LGFVs issued bonds in Hong Kong, offering returns that could be twice the official interest rate, according to market participants. This suggests that Beijing’s 1.4 trillion USD debt relief program may not be sufficient to address the liquidity stress faced by these entities.
How the Tactic Works
One common method involves an underwriter, often an offshore entity, facilitating the transaction. An LGFV issues a bond with a face value, say 100 yuan, and an official coupon rate of 8%. However, an investor might purchase this bond through an underwriter for a discounted price, such as 93 yuan. This discount effectively increases the investor’s total return to approximately 16%. The LGFV then reimburses the underwriter for the discount, often disguised as a “consultation fee,” which may be paid months after the bond sale. This arrangement benefits the LGFV by raising funds, the investor by providing higher yields, and the underwriter through fees.
Regulatory Scrutiny and Market Impact
Hong Kong’s Securities and Futures Commission has stated it will take “regulatory actions against licensed corporations whose conduct does not meet the expected standards.” The practice, if confirmed, would breach the city’s rules governing debt pricing and sales incentives. On the mainland, similar tactics have led to sanctions and fines. The hidden returns have contributed to volatile trading in some of these bonds in Hong Kong, as investors who received the extra payouts sell them shortly after purchase, driving yields closer to the unofficial rates.
Underlying Financial Pressures
The resurgence of this tactic highlights the financial strain on many LGFVs, particularly those from economically struggling regions like Henan and Shandong. These entities were established to finance infrastructure but have accumulated significant off-balance sheet debt. With Beijing limiting new mainland borrowings, LGFVs are increasingly seeking funds in offshore markets where they have more flexibility. The scale of LGFV bond sales in cities like Hong Kong and Macau has surged, indicating a growing reliance on these markets for financing.