China muni bonds set for take-off

The buzz around China’s municipal bond market gathered momentum in October 2014, when the financial authorities decided to restrict issuance by local government funding vehicles (LGFVs). That move underscored the long-held mindfulness of the Chinese financial authorities to the potential perils of a rising debt burden at the municipal level; in 1997 Beijing introduced restrictions to limit the contingent liabilities of local governments.

The 2014 move, whereby LGFV funding avenues were restricted through the prevention of financing via local government guarantees or comfort letters in the bank lending market, was not surprising. China’s federal government and financial authorities have long fretted about what they perceive to be reckless lending at the regional and local government (RLG) level. Ironically, it is the Chinese central government which must take part of the blame for the debt pile that has built up at the RLGs.

Pump-priming measures to stimulate the Chinese economy undertaken in 2008–2009 during the global financial crisis were supposedly aimed at local government, although there was more encouragement to pursue costly local infrastructure projects than there was federal government cash to finance them.

Of the Rmb4trn (US$615bn) stimulus money pumped into China’s economy, a relatively small percentage is said to have found its way directly into local government coffers. Hence local party officials resorted to a variety of ways to shoulder the effort, including engaging in off-balance-sheet borrowing via LGFVs.

“You could well say that China’s urgency to boost demand in the grip of fear as the financial crisis unfolded and the shouldering of that public project burden by local government has created a legacy that is only just playing out. The credit growth was staggering and China’s officials realise they have to do something about it,” said a Hong Kong-based DCM head.

That was then

It is of little surprise that prior to the introduction of the 2014 restrictions LGFVs were the choice means of funding for local government infrastructure projects. Little due diligence was required and the off-balance-sheet booking of the debt encouraged a mindset that could best be described as reckless.

There are estimated to be around 10,000 LGFVs in China and they are estimated to be sitting on between US$3trn and US$4trn-equivalent of debt, in the form of “shadow banking” finance, including loans from trusts and from bank lending.

Given the mismatch between the long construction periods on the infrastructure projects, projected operational viability and the tenor of the funding vehicles, which is typically between three and five years, it is small wonder that many China market-watchers see the potential for crisis in the LGFV sector.

Although sitting in the obfuscated sphere of China’s vast shadow financing industry, LGFVs had proved to be a slick means of raising funds, without the required documentation necessary prior to issuing paper in the muni market. In addition, local investors in LGFVs purchased the paper on the assumption that it carried local government backing.

“Issuing debt via local government funding vehicles was child’s play for local government officials. Given the paucity of yield available via bank deposits in China, investors jumped at the chance to book the 10%–11% yields available on LGFVs. It was all off balance sheet and the party just went on and on. Now, the hangover is emerging and it’s not a pretty one,” said a Singapore-based fund manager.

But the high yields offered on LGFVs and the massive volume of paper outstanding added up to a mounting debt service cost to China’s local governments. And so what appears to be one of the most urgent disintermediation projects to transfer funding to the bond markets and away from banks, trusts and retail lenders came into being.

The urgency is entirely appropriate. Data from the National People’s Congress released last August revealed that between June 2013 and the end of 2014 RLG debt increased by more than 30% to Rmb24trn, or equivalent to 38% of China’s GDP in 2014.

This is now

In response to these inauspicious circumstances, China’s central government in September 2015 undertook three measures.

Policy and commercial banks were urged to refinance ongoing and existing infrastructure projects funded by LGFVs; RLG debt was capped at Rmb16trn; and a Rmb3.2trn debt-for-bond swap was put in place to relieve RLG liquidity constraints, a 300% increase on the initial Rmb1trn proposed in March of that year.

Market players assumed that the crimping of LGFVs and the direct debt swap into bonds would herald the transfer of future funding at local government level to China’s muni market. There was some truth to this assumption.

Last year saw a municipal bond issuance bonanza, with a chunky Rmb2.6trn of munis approved, or roughly six times what was raised in that market in 2014. The issuance was partially derived from the swapping of LGFVs into around Rmb2trn of new muni paper. There is still an estimated Rmb11trn of LGFV paper that is earmarked for swapping into municipal debt.

This urgency to push munis as a necessary funding vehicle is in contrast to the genesis of the Chinese municipal bond market, which kicked off as a seemingly relaxed trial programme in late 2013. A cabinet-level think-tank, the Development Research Center, had called for the growth of the local government bond market with the slogan “open the front door, block the back door”. At its inception in 2013, approval was given for the issuance of a modest US$57-equivalent of municipal bonds.

Many commentators regard the development of the country’s municipal bond market as axiomatic to the Chinese authorities’ long-term strategy for China’s debt and interest rate markets.

Despite the background carnage in China’s equity markets, talk of capital flight and declining foreign exchange reserves which have been deployed to stabilise the renminbi, the country is in the process of liberalising interest rates. The Chinese financial authorities seem determined to set a rates background where market forces rather than policy determine yield levels across the rates curve.

“Ushering in disintermediation will eventually reduce refinancing risk at the regional and municipal level, and the greater disclosure required as a prerequisite to issuing municipal bonds will bring in a financing disincline, as well as tempering profligacy at the local government level,” said a Hong Kong-based hedge fund manager.

Big numbers

Jan Dehn, head of research at Ashmore, envisages the China muni bond market as having the potential to exceed Rmb10trn in total outstanding issuance. This would equal the entire outstanding volume of the emerging market offshore corporate US dollar bond market.

“The municipal market in China will be supported from the buyside via the growth of mutual funds and the opening up of the domestic bond market to offshore investors via the QFII (Qualified Foreign Institutional Investors) programme. I expect that China will use the rapidly growing mutual fund industry to price the local government bonds,” said Dehn.

Although there are structural factors which auger well for the development of the municipal bond market in China, it seems that LGFVs have still been raising funds via bank financing despite the central government’s supposed restrictions. And the undersubscription of a muni bond auction in August caused a 20bp-odd spike in the yields of bonds issued by some of China’s lower rated municipalities.

“Of course there will be glitches along the way, but given the diversity of China’s regional and local government there will eventually be a well-populated yield curve according to credit rating and general market perception. But China’s muni market is going to evolve with government backing into a significant instrument of monetary policy transmission and from here on in there is no going back,” said the Hong Kong-Based hedge fund manager.

In January, the Chinese ministry of finance instituted a pilot scheme whereby China’s free trade zones have been granted approval to issue municipal bonds.

The first issuance is expected from Shanghai, with Guangdong and Fujian also touted to issue muni paper. In a measure of the push the Chinese financial authorities are giving to municipal paper, the ministry granted eligibility for any emerging free trade zone issuance as collateral in repo agreements, as well as permitting foreign investors to purchase the paper.