SHANGHAI/HONG KONG China's cash-strapped local governments have suddenly rushed to an unusual corner of the debt market in Shanghai where ambiguous rules offer ways to skirt restrictions on onshore borrowing.

Some analysts have described local government financing vehicles (LGFVs) as the "black hole" of China's financial system, with debts of more than $9 trillion and rising. But Beijing is counting on their continued spending to help lift a patchy economic recovery.

Sales by LGFVs of so-called "pearl bonds", which are issued as foreign debt in Shanghai's free trade zone, have soared to a record 72 billion yuan ($10 billion) so far this year, official data shows - nearly double last year's total.

Analysts say the fundraising spree is due to the market's offshore designation, which makes it an elegant alternative for local vehicles frozen out of onshore borrowing by tighter rules on their finances since 2021.

LGFVs accounted for about two-thirds of the issuers and 60% of the debt sold this year nation-wide, according to Reuters' calculations.

Among all the newly-issued FTZ bonds this year, 55, or two-thirds of all 82 issuers, were LGFVs, according to Reuters' calculations.

The market has also offered favourable pricing relative to rising global rates due to surging dollar financing costs in the wake of the U.S. Federal Reserve's aggressive rate hikes. That has benefited both local issuers and Chinese banks which are the dominant buyers of such debt -- underscoring the broader systemic risks of such concentrated exposure to LGFVs' burgeoning debts.

"Domestic financing policies for district and county-level LGFVs are still strict, and financing channels are limited," said Shi Xiaoshan, senior analyst at CSCI Pengyuan Credit Rating Co Ltd.

"For LGFVs with relatively low credit ratings, overseas financing is still an important financing channel."

The "pearl" or free trade zone (FTZ) bonds have been around since 2016 but are only now becoming popular as tighter central government supervision on LGFV debts starts to bite. About 5.5 trillion yuan worth of onshore LGFV bonds are due to mature this year, according to ratings agency Fitch, the highest since 2021.

Although bonds issued in FTZs can be in any currency, all new issuances this year were denominated in yuan.

"LGFV issuers are active in the FTZ bond market because they require funding," said Royston Quek, managing director of debt capital markets at Haitong International Securities in Hong Kong. "The onshore market is closed to some of them."

AMBIGUOUS POSITIONING

"Pearl bonds" differ from other offshore bonds as trades are cleared by the state-owned China Central Depository & Clearing Co, rather than a global clearing house.

To participate, investors must register at the CCDC. In practice, almost all the 30 active accounts are Chinese banks, whose buying power has put the market into a sweet spot.

Despite concerns about LGFVs fiscal health and the country's sputtering economic rebound, coupons of around 4-5% for three-year terms are much lower than semi-government borrowers can get abroad as well as being a fair bit higher than the 3-4% return that banks could expect from loans to a state-owned enterprise.

One recent deal, for example, was Quzhou Industrial Development Group Co, of China's eastern province of Zhejiang, which issued 500 million yuan of 3-year FTZ bonds with a coupon of 4.2%. China's 10-year sovereign bonds are trading at just under 3%.

"How big the FTZ market could grow depends on how much Chinese banks could allocate their risk limits to FTZ bond issuers and if other investor segments decide to get involved," said Tim Fang, head of Greater China debt capital markets at Credit Agricole CIB.

STRING OF PEARLS

To be sure, the market also seems to have at least the implicit backing of authorities, as its sudden popularity coincides with a push to broaden yuan financing.

Financial regulators and lenders, including Shanghai Pudong Development Bank and Bank of Communications, held events in May to promote the bonds.

"Pearl bonds" expand the scale of offshore yuan transaction and promote yuan internationalisation, Zhang Hong, director of the Pudong New Area Financial Regulatory Bureau said at a forum in Shanghai.

Still, some bankers say the sudden promotion and influx of funds has raised eyebrows and questions over how investments and currency flows into such bonds ought to be categorised.

"Due to the ambiguous positioning of the free trade zone, in the actual practices, FX regulators are vague and inconsistent about whether foreign debt in the free trade zone needs to be registered and managed," China Chengxin International Credit Rating said in a note.

China's National Development and Reform Commission, which is in charge of granting foreign debt quotas in China, did not immediately respond when contacted by Reuters. The State Administration of Foreign Exchange, the country's FX regulator, did not immediately comment.

($1 = 7.1 Chinese yuan renminbi)

(Reporting by Georgina Lee in Hong Kong and Shanghai Newsroom; Additional reporting by Tom Westbrook in SINGAPORE, Editing by Kim Coghill)