Foreign investors have increased their exposure to Chinese local government bonds over the past year. But recent cracks in China’s financial system and a shifting geopolitical environment have increased the financial and reputational risks for foreign investors holding these securities. This note analyzes these shifts and their implications. The findings are:
Foreign appetite for local government debt has soared: Global investors increased their holdings to over 11.5 billion yuan ($1.8 bn) by the end of 2021, from 2.5 billion yuan ($362.8 mn) at the end of 2018. Beijing’s liberalization steps have made these securities more accessible, and investors have been drawn by high yields and opportunities to diversify their fixed income portfolios. Yields and trends in foreign holdings of central government debt suggest further growth ahead.
COVID and property market turmoil have increased local financial risks: The property market slowdown and COVID-19 outbreaks are putting pressure on local government finances. The probability of local government bond defaults remains low, but valuation risk is prominent and could be amplified by possible local government financing vehicle (LGFV) bond defaults.
Reputational risks are growing and still underappreciated: Geopolitical tensions have led to a substantial increase in the reputational risks of owning Chinese securities, due to possible ties of companies to forced labor, military-civil fusion, audit non-compliance, and other problematic practices. Our proprietary dataset shows that local government issuers present similar risks, but foreign investors have been slow to recognize them. Links to forced labor and military modernization are the most salient risks for foreign investors.
Reputational risk is quantifiable and manageable: Reputational risk awareness is particularly important for global investors given the low liquidity in local government bond markets and thus limited options to close out problematic positions in the case of a crisis. The good news is that reputational risks remain heavily concentrated in a few areas. Active risk management can help weed out the bad apples, reducing the need for broad-based exclusion of local government bonds from portfolios.
