Municipal clean-up

China’s domestic capital market holds the key to the overhaul of the country’s sprawling web of local government finances, and efforts to introduce municipal bonds are beginning to bear fruit.

After a series of small steps last year, the overhaul of China’s local government finances is set to take off in 2015 with the introduction of a municipal bond market.

The programme, mooted as a way to wean local governments off shadow banking and curb investments in projects with dubious economic impact, could quickly turn China’s municipal bond market into one of the largest in the world.

Observers have almost universally backed the reforms, and foreign banks are queuing up to get a piece of the action. However, despite the enthusiasm, there is still a great deal of uncertainty over the response of the Chinese central government in case a municipal issuer gets into financial trouble. This is a very real risk, given the parlous state of many municipalities’ finances. Should an issuer miss a coupon payment or default, it is also unclear the impact this would have on the market’s development and the ability of other local governments to access funding.

The last Chinese national audit report put the combined debt of Chinese local governments at Rmb17.9trn (US$2.86trn) as of June 2013. An updated report is expected within the next two months, and an already-staggering figure is expected to be even higher. More recently, Yan Jiehe, China’s seventh richest man with a fortune estimated at US$14.2bn and founder of China Pacific Construction Group, sued six local governments for late payments on contracts.

The growth of this debt burden, and much of it coming from non-bank financing channels, has caused concern among many economists and analysts. Some see local government finances as the biggest risk to China’s already-slowing economy.

Under the reforms, local governments will be able to issue bonds directly, curbing the proliferation of contingent liabilities through off-balance-sheet local government funding vehicles. Issuers will need to apply to the Chinese regulator for permission through a more-stringent process, which will take a closer look at the municipality’s finances and the reason for raising the money. Last year, 11 municipalities piloted the programme and this will be expanded to 31 in 2015. The overarching idea is that this reform will make local governments more accountable and transparent.

The Chinese Government has taken a tough stance in explicitly telling municipalities that it will allow them to default. However, it is far from clear that investors will draw a line between local and central government responsibilities.

“The reputation for this bond market is key. So, the weaker provinces won’t be as involved.”

“It seems there is no major concern over investor demand,” said Liang Zhong, a director and sovereign ratings analyst at Standard & Poor’s. “The central government said it wouldn’t bail out these bonds, but I don’t think most investors have taken that seriously. They want to improve stability, but it is very likely that a default could have quite significant repercussions on financial markets.”

Bankers question how active a role the central government will take if there is the possibility of a default. The performance of these bonds to date suggests that the market thinks the Chinese Government is bluffing. Standard and Poor’s China provincial bond index has gained almost 10% in the last 12 months. In some cases, yields have been even lower than for central government bonds, which analysts say implies that investors believe a de facto central bailout is all, but guaranteed.

There appear to be two schools of thought on the issue. One side believes that defaults are unlikely in the first place because the provinces initially chosen for the programme are in the best financial shape. It is no accident that the first municipal auction is to be held in Shanghai, which is to offer Rmb40bn (US$6.4bn) of six-month bills in February.

Furthermore, a more rigorous regulatory scheme will ensure the viability of the bond issue. Also, perhaps most importantly, they believe the central government will ultimately come to the rescue because a default will hurt the credibility of a blossoming marketplace and the reforms China badly needs.

“For the outstanding bonds, I don’t see any defaults happening,” said a senior investment banker, based in China. “For new bonds, the question is if anyone managed to slip through the rules and defaulted, what would the PBOC do? I believe they will still bail out the local government, but the local party chief will kiss his job goodbye.

“The reputation for this bond market is key. So, the weaker provinces won’t be as involved. The buildout will be slow, but it will build credibility.”

However, other bankers are taking a more nuanced approach. While they recognise the importance of the reforms for the health of China’s economy and financial system, they believe it is wrong to assume the government will step in.

“I don’t think a bailout is something people should rely on,” said a Hong Kong-based senior investment banker. “If the entity has a certain nature, the government would have no issue with selective defaults. Look at the backdrop of the anti-corruption campaign. If there are issuers out there that can’t pay, the government might go for a big name to make a point.”

Despite these uncertainties, foreign banks are eager to get involved. They are presently banned from underwriting these bonds, and can act only as traders. They hope the Chinese Government will eventually allow foreign institutions to underwrite, and a few have suggested it can happen as early as this year.

Bankers do not know how much issuance will take place this year, but they believe the number will be gargantuan longer term. Last year, Rmb109bn was issued under the pilot municipal bond programme. When compared to the estimated Rmb17.9trn of debt on local governments’ books, it is clear there is plenty of scope for substantially more.