(Yicai Global) Jan. 6 -- China’s interbank bond market regulator has stipulated that the issuance of new bonds by local government financing vehicles now designated as high-risk must be used only to pay maturing debt, insiders told Yicai Global.

The proceeds of such bond sales by LGFVs being classified as ‘red’ and ‘orange’ must only go to pay back similar debt, sources at brokerages and trust firms said, confirming a rumor about a new policy from the National Association of Financial Market Institutional Investors. Those labeled as ‘yellow’ and ‘green’ are unaffected, they said.

“Deleveraging LGFVs may be more challenging than deleveraging property developers because it basically means deleveraging the local governments themselves,” a foreign fund manager said. Local governments cannot use the money raised to increase leverage as they usually do, which will make the LGFVs’ cash flow extremely unstable, the person added.

Urban construction investment bonds, also known as ‘quasi-municipal bonds,’ are medium-term corporate bonds issued by LGFVs, a type of local government financing tool that fund infrastructure projects, mainly in the property, transport, and utilities sectors. CNY3.6 trillion (USD565 billion) worth of these bonds is set to mature this year.

Local authorities are determined to resolve debt issues at local firms and LGFVs play a crucial role in funding local economic development, according to bond investment managers. The possibility of large-scale risk exposure is low in the short term, but there may be an uptick in market divergence, they added.

Refinancing costs and other related difficulties will increase in some areas with lower credit ratings and fewer financial resources. “There are challenges behind the issuance of bonds, especially those by LGFVs rated ‘AA,’” a bond underwriter said.

But the positive aspect of the NAFMII’s tiering system for LGFVs may be that it can avoid the indiscriminate selling of urban construction investment bonds by institutions and debunk the myth that urban construction investment bonds are 100 percent safe, the bond investment managers noted.

Sales of these bonds will increase further this year despite policy tightening, said Zhai Jin, an analyst at Moody’s Investors Service. But the increase will remain moderate and continue to help local governments bridge the funding gap, she added.

“Refinancing is this year’s priority for the LGFVs as CNY3.6 trillion (USD565 billion) worth of domestic urban construction investment debt will mature this year,” Zhai noted, adding that as LGFVs in relatively developed areas get more resource support, they will issue more bonds.

Editors: Tang Shihua, Futura Costaglione