Local gov't financing vehicle default looms

China is likely to see the first case of a default by a local government financing vehicle this year, said Zhang Zhiwei, chief China economist with Deutsche Bank AG.

"The sooner the default happens, the better it is for investors ... as it could improve the pricing of risky assets and help policymakers solve the high financing costs in the market," Zhang said during a news conference in Beijing on Monday.

Shandong province recently issued a regulation which stated that the provincial government will not bail out governments at county level in case of debt default, making it the first province in China to step up curbs on local government financing vehicles.

Chinese LGFVs have issued debts to purchase land from local governments and for massive property development, which has created an oversupply in many second-and third-tier cites. Default risks for LGFVs started increasing after the nation's property market started cooling.

Zhang said the government had sent an important signal of regulating LGFVs, which have led to high financing costs and low efficiency in capital allocation.

"If money is used and invested more efficiently by private enterprises, China will have greater room to maintain 7 or 8 percent of GDP growth and avoid bad debts," he said.

Deutsche Bank has forecast that fiscal revenue of local governments in China may decline by 2 percent this year, the first contraction since the country's tax system reform in 1994.

The drop in land sales due to the cooling property market is the main reason for the decline. At the same time, the country will also see a sharp disparity in the fiscal revenue of local governments, the bank said in a report.

Top-tier cities and those that have diversified their revenue sources away from land sales will continue to see double-digit fiscal expansion, while governments of some second-and third-tier cities with property oversupply will face serious fiscal challenges.

The national fiscal revenue will grow at an average pace of 5 to 8 percent in the next five years, the bank said.

China's GDP growth is likely to hit 6.8 percent in the first two quarters of this year and rebound back to 7 percent in the second half of the year. "We expect policymakers to cut both interest rate and banks' reserve requirement ratio twice in 2015," Deutsche Bank said.

The low inflation level will offer the government greater room to stimulate the economy through monetary easing. The broad money supply will grow at 14 percent this year while the government's fiscal deficit will reach 3 percent of the GDP, both of which will probably exceed the government's target.

Economists said the chances of a financial crisis in China are still very small, though several areas need to be closely monitored. For example, a substantial reform of China's local government debt is crucial to reducing the economy's systemic risks.

A stronger central government in China will shift its focus to economic growth this year, after two years of intensive anti-corruption campaign, said Lu Ting, head of Greater China Economics, Global Research, Bank of America Merrill Lynch, on Monday.

Policymaking would be less constrained by political concerns this year, Lu said, with two years' preparation in the political sphere, Lu said in Hong Kong.

Monetary easing is expected to continue this year. With the end of the one-way appreciation of the yuan to the US dollar, the private sector tends to keep an increasingly larger share of their foreign exchange proceeds, depriving the central bank of the traditional source of base money supply and likely forcing the People's Bank of China to cut the reserve requirement ratio several times this year, he said.

With lower inflation, meanwhile, the central bank still has the room to cut benchmark deposit rate by 25 basis points and lending rates by 40 basis points this year.

Lu said reforms in other areas like clearing the local government finance vehicles are more important to reduce the funding costs for the real economy.

Bank of America Merrill Lynch predicts new bank loans could rise from 10 trillion yuan ($1.6 trillion) in 2014 to around 10.7 trillion yuan this year, with year-on-year loan growth slowing to 13 percent at end-2015 from 13.9 percent at end-2014.

The bull market propelled by liquidity will come to an end temporarily. But continued growth supported by companies' increased earnings is expected to form another wave of bullish performance, according to Swiss financial services firm UBS.

Chen Li, chief China strategist of UBS Securities, said: "In the short term, investment in infrastructure is likely to pick up in March and April this year, which is a result of expanded credit started in the fourth quarter of 2014. In the long run, the declining commodity prices will help with the increased profit margin of public companies, especially those in the manufacturing industry.

"As the central bank is expected to cut interest rate and required reserve ratio this year, companies' capital expenditure will go up again and lead to higher earnings. All these will help sustain the current bull market of A shares," he said.

Chen said that the lower interest rates and required reserve ratio will give momentum to the growth of banks and property companies.

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