Building Out China’s Bond Markets

The ambitious urbanization plans of new leader Xi Jinping will provide the next stimulus for developing China’s nascent bond market, we read in a Reuters report. Beijing has been taking ever larger steps in expanding its municipal and corporate bond markets as part of broader reforms of both the financial system and of local government finances.

The latter are teetering under the burden of more than 10 trillion yuan of debt, a large chunk of which already strained banks have recently had to roll over. Much of it is a consequence of the stimulus spending in the wake of the 2008 global financial crisis with a booster from last year’s spending to reverse the economic slowdown. Central government policy makers aren’t shy in laying down grand plans for local government to build out and pay for.

The finance ministry, which since the 1994 local government reforms has handled what bond issuance their has been on behalf of local governments, has been cautiously lifting the ceilings of permitted amounts and expanding the list of provinces that can do to the markets directly. As well as trying to let down China’s local-government debt bubble before it can go damagingly pop, an expanded muni-bond market also pushes provincial and municipal governments in three other desirable directions: less reliance of land sales to raise revenue; less need to repair to the shadow banking system to get round restrictions on official borrowings; and more transparency generally about their finances.

The scale of the proposed urbanization bond issuance is likely to be on scale unlike anything seem before, though. The current quota for local government bond issuance is 250 billion yuan ($40 billion). The domestic non-financial corporate bond market is larger; the Shanghai Securities News reported it had reached 3.45 trillion yuan for the year to date by November last year, three quarters as much again as a year earlier. The urbanization program is being pegged at upwards of 40 trillion yuan over 10 years.

Potentially doubling the size of the bond markets over that time will demand not just a fully-functioning muni-bond market, but also more robust corporate and high-yield bond issuance that can pull in foreign capital. It will also require the development of a secondary market in the issues. Otherwise, if held to maturity,  bonds become just a variant of bank lending, and will do little to divert risk from the state-owned banking system that now provides three quarters of China’s credit.

There is much other structural work to be done beyond that, including further consolidation of the three regulatory agencies that now have responsibility for various bond issuance, and a lifting of restrictions in the qualified foreign institutional investor rules that limit bond funds’ investment in bonds. Most of all it will need the government to let a few issues default so investors realize that the government won’t always bailout troubled issuers and that there is a risk to be priced in. That may be the most difficult change of all.

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