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The central government has not, however, provided any formalor informal guarantee for LGFV bonds. It is therefore important to examine whatkind of security, if any, stands behind these bonds.
ByJames R. Long
James R. Long: Today I would like to specifically discusswhat your finding mean for Shanghai and China at large. As a student andsomeone always looking for an interesting thesis topic, how did you come acrossthis topic and furthermore how are you conducting your research?
DonaldClarke: Well, conducting research can be verydifficult, especially in China. I came across this issue of Local GovernmentFinancial Vehicles in a Bloomberg article I read this past year. It soundedlike an interesting topic so my research assistant and I decided to researchthe topic from a legal perspective.
James R. Long: So in your lecture you spoke most about legalissues concerning repayment of the loans, why are these bonds so unreliable?
DonaldClarke: Whether LGFV bonds are a safe investmentis controversial. Many analysts predict default. Others predict that even ifthe investments funded by the bonds do not pay off, the central government willbail out any LGFV that is in trouble. The central government has not, however,provided any formal or informal guarantee for LGFV bonds. It is thereforeimportant to examine what kind of security, if any, stands behind these bonds.
James R. Long: Interesting, you mentioned in your speechthree forms of security or collateral as a guarantee to the creditor, what arethe current forms of collateral creditors are expected to trust?
DonaldClarke: In reviewing LGFV bond offer memoranda, we found three main types ofrepayment safeguards, the local government promises to pay back the debt incase of a default by the LGFV. Many bond issues providing this kind ofsafeguard expressly say that they have obtained such a guarantee from the localgovernment. Some local governments will set aside part of their revenue as aspecial fund to pay off LGFV debt; others will pledge a bank account that hascash receivables from an infrastructure project providing fee-based services accordingto a build-transfer agreement between the local government and the LGFV. Stillother LGFVs make statements that are more obscure, saying that they have alwaysreceived the utmost “support” from the local government for their activities.Regardless of the specific form it takes, however, a government guarantee isnot a legally valid security. As Second kind of “safeguard” mentioned is use ofland use rights as collateral. This type of security interest isstraightforward. The issuer receives granted or marketable long-term land userights from the local government and offers them as collateral under theGuarantee Law. The third kind of safeguard mentioned is when a third partyentity guarantees to be liable for the bond in case of default. Theguaranteeing entity could be either a holding company with steady cash flowgenerated from its subsidiaries’ operations or, more often, a professionalguarantee company whose business is to provide financing guarantees.
James R. Long: Youmention the Government as a safeguard, if they [the government] say they’rewilling to back up the bonds, why is there a problem?
DonaldClarke: Well, this particular safeguard is problematic for several reasons.First, government guarantees are not recognized by Chinese law. Second,government guarantees are unenforceable in practice. Chinese law does not fullyrecognize governmental entities as an adverse party in economic activities. Theselaws are referenced in my paper. Even if a party were to successfully sue aChinese governmental agency, the chances of collecting on the judgment arevirtually zero. It is unimaginable that a party could show up at localgovernment offices and begin carting away computers and office furniture insatisfaction of a judgment. In short, any government guarantee represents atbest a “soft obligation” of the current (but not any successor) governmentadministration. Nevertheless, half the bond issues we studied have this kind ofsafeguard and no other.
James R. Long: Whatabout land uses rights and third party guarantees, what problem do you see withthese kinds of collateral?
DonaldClarke: In terms of the quality of this land use rights as a form of security,several issues must be considered. First, the land tends to be overvalued orquestionably valued. Not all prospectuses disclose how the land use rights werevalued. Second, there may be other encumbrances on the land. The quality ofdisclosure here varies greatly. Third, it is not clear how robust the land userights are as a legal matter. The Urban Real Property Law contemplates (withoutactually stating so unequivocally) that local governments shall receive cashpayments when they grant land use rights, and that development shall take placesoon after the grant. In the case of LGFVs, the transfer must be taking placewithout any cash payment (the LGFV will not yet have issued the bonds at thetime of the transfer) and the cash payment cannot come later, since the cashraised from the bond issued is needed for infrastructure projects.
James R. Long: I expect that Third-Party Business entities do nothold much promise either.
DonaldClarke: Not really. The guarantor in this case can be either an investmentholding company or a professional guarantee company specializing in theguarantee business. The bonds are secured by the guaranteeing entity’soperating assets that can be legally transferred or disposed of in order to payoff the debt of LGFV. Accordingly, the disclosure made in such cases includesmaterial information about the guarantor company instead of the LGFV issuer,with the guarantor company’s income-generating operations and assetsconstituting the bulk of the disclosure. Obviously, bond holders need to dosignificant due diligence on these companies to ascertain their assets andliabilities. A guarantor company’s guarantee will be worth little if it has tomake good on many guarantees at the same time with limited assets. And it isreasonable to suppose that whatever financial conditions cause some LGFVs todefault will cause many others to default as well.
Donald Clarke Professorat George Washington University Law School
