This is how we always imagined the party to end. Somewhere and somehow, an accounting footnote known as an off-balance sheet entity or item becomes a front and center issue.
Searching the internet for a definition of “off-balance-sheet entity” you will find a fairly credible source in Investopedia. Their first sentence on the topic says it all, “Off-balance-sheet entities are complex transactions where theory and reality collide.”
“Off-balance-sheet entities are complex transactions where theory and reality collide.”
Looking any further on this topic and you’ll find many of the most infamous financial collapses centered around off-balance sheet entities or items, and emanating from the darkest corners of the corporate world. So when a municipality announces their inability to pay for an off-balance sheet item, it should get you interested.
On May 17, 2018, according to Reuters:
The article goes on to say, “Xilinhot Geipaishui Co [锡林浩特给排水公司], a local government financing vehicle (LGFV) controlled by the city of Xilinhot, has failed to repay loans from more than 20 mostly state-run leasing firms, said the sources, who were from two of the leasing companies involved.”
How hard is to keep up with an off-balance sheet loan? After all, it’s already considered unofficial by being an off-balance sheet item so that it could be managed outside of the main line of business. Add to the fact that the loan was done in the “shadow banking system” and you’ve got the perfect recipe for transparency, no? The Reuters article indicates that:
“…Global credit rating agency Standard & Poor’s had predicted in January that China could see the first default on a bond issued by an LGFV this year.
“But Christopher Lee, an S&P credit analyst in Hong Kong, said on Friday it was too early to tell if this case was such a watershed moment until there is more information.”
The claim that it is too early to tell if this case was such a watershed moment by the S&P rating analyst and the assertion by the Fitch Ratings agency in September 25, 2017 that “…the overall risks [in LGFV] are likely limited due to the government's ‘pervasive ownership and influence’ across the financial system” reminds us of Federal Reserve Chairman Ben Bernanke’s May 16, 2007 claim that “…the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system…” or Treasury Secretary Hank Paulson’s August 8, 2007 claim that “…the fundamentals of the economy are very solid.”
Doesn’t that last paragraph sound like Fitch is saying, “they’re too big to fail”? Supposing that off-balance sheet items fail all the time to little or no effect, it may be too early to tell what the ramifications are. However, ratings agencies, like the Federal Reserve chairman or Treasury Secretary, should not be so dismissive nor given a free pass when they have been notoriously wrong at critical junctures in the economy.
Would it be any surprise that the dark corner of company be found in the shadow banking system in China? This is an instance where it will be worth following whether or not there is an increase in these incidents or a domino effect associated with this specific default.