Why are Chinese metro operators looking for new funding channels?
China's ambitious plans to develop metro systems in a large number of cities are a funding headache. Local governments, which own the railway assets through infrastructure investment companies, are currently shouldering most of the expansion and operating costs. But the burden is proving increasingly unsustainable, given the vast scale of projects and the governments' already-high debt. Many metro operators are therefore exploring new funding channels.
(BII) is a good case in point. In March this year, BII became the first Chinese metro company to tap the overseas bond market when it issued US$300 million in five-year senior unsecured notes. The operator is also the first to partner with private investors for an expansion project.
How has BII benefited from its overseas bond issuance?
The US dollar-denominated bond issue in March has helped BII expand its funding channels and reduce its funding costs. This is particularly meaningful because the credit environment in China is tight and interest rates tend to be high. The bond was oversubscribed five times and attracted diverse investors, including mutual funds, banks, insurance companies and pension funds.
To facilitate future overseas bond issues, BII established a US$2 billion medium-term note program in June 2014, the first ever for a local government-related entity in China. The company issued a RMB1.2 billion (US$193 million equivalent) three-year bond under the program. The interest rate for the renminbi bond is more than 2% lower than for the company's domestic bond with the same tenor.
Will Chinese infrastructure investment vehicles follow BII's lead?
It's likely. Overseas bond markets can help diversify funding sources, broaden investor bases and reduce funding costs for Chinese companies, including firms investing in metros. So far, the central government has given approval to 38 cities to have at least one metro line by 2020, and each operator will be looking at viable funding routes. We estimate that new investments associated with the expansion of the metro network could reach RMB2.5 trillion (US$400 billion) by 2020. Nevertheless, we still believe that local governments will continue to primarily finance most of the metro projects--directly or indirectly--given that the operators are still likely to generate weak operating cash flow.
Are all local governments with metro development plans as creditworthy as Beijing?
The creditworthiness of local governments varies and their ability to support metro projects differs. Some of the municipalities that have the go-ahead to develop metros are in "third-tier" cities in the west of China, where the economy is weaker and population levels are lower than in other cities such as Beijing -- a first-tier city. Nevertheless, local governments have more flexibility to proceed with metro projects to support local economic growth targets after the National Development and Reform Commission delegated the approval process to provincial commissions in May 2013. In recent years, the fiscal income of local governments has largely depended on rapid growth in revenue from land sales and auctions via land grant fees. However, the significant contribution from these fees may not be sustainable over the long term, and can fluctuate with volatility in the property market and any changes to central government policies.
In reviewing creditworthiness, we assess the linkage and the importance of metro investment companies to their affiliated local governments. This assessment helps determine the likely extent of government support if the companies were in financial distress. Such likelihood is "almost certain" in the case of BII, indicating the strongest support. Until 2035, BII has access to annual project funds of RMB15.5 billion from the Beijing government. The company uses the funds as equity capital for new projects, and to pay the debt principal and interest related to rail construction.
How likely are metro companies to attract private capital?
We believe the central government's encouragement of more private capital for infrastructure projects is positive for the development of stable, long-term financing in the sector. Two metro lines in Beijing and Shenzhen were among 80 projects that the central government included in its model for "public-private partnerships". But attracting the capital won't be straightforward. We see a potential conflict between companies that are focused on profiting from their investments and the public-service nature of metro operators. Metros fulfill a key public benefit, in transporting local populations for low fares, supporting economic growth and reducing traffic pollution. Currently, most if not all metro operators in China are running operating losses because of the low fares and face a rigid fare-adjustment mechanism. They need significant government subsidies and exemption from depreciation and amortization charges to break even.
Will fares rise?
Fares are highly likely to rise over the next few years. Fares should at least cover operating costs and expenses. The extremely low fare in Beijing (at a flat rate of just RMB2) is unsustainable, given the high operating costs, and will make it difficult to attract more private capital. Local governments have two choices: (1) to keep fares low and give financial subsidies to private investors; or (2) raise fares and formulate a more transparent and predictable pricing mechanism. Fare revenue is a sustainable operating cash flow and can increase with the growth in ridership.
To supplement fare revenue, operators could also make better use of their railway assets and expertise by expanding into other business segments, with the support of local governments. Examples include rental of retail spaces in stations, advertising in trains and stations, income from the provision of telecommunication and bandwidth services in metro premises, and property development along the metro lines. These rail-related or derivative businesses would help generate good cash flow and should yield reasonable investment returns over the long term.
Will property development become a key funding source?
The "rail plus property" model in Hong Kong is appealing to many Chinese metro companies and their local governments. MTR Corp (MTRC) owns the largest land bank in Hong Kong, and property development income is an important cash flow for the metro company. However, not all rail financing in Hong Kong is based on the "rail plus property" model. The Hong Kong government fully funds the construction of certain lines when property development is not an option, such as when resettlement proves too costly. For example, the Hong Kong government fully funds the West Island Line. In addition, MTRC doesn't develop properties on its own or bear the development costs. The company chooses developers by tender and enters into profit-sharing agreements with the partners.
China's land auction system could limit the scope of metro operators to develop property. All the land for property development must be bought through public auction; the government cannot directly allocate the land to the metro companies to develop. In practice, land auctions can be tailored so that only the metro companies or their consortium can fulfill certain eligibility criteria. Metro companies would be exposed to all risks associated with property development. In our view, property development income could be a good source of supplementary cash flow to Chinese metro companies, but it's less likely to become the main financing channel for metro development.
The author of this article is Gloria Lu, Standard & Poor’s director of corporate and infrastructure ratings.
