One of the ways to defuse China’s ticking local-government debt bomb would be to expand the muni-bond market. A pilot program that lets a limited number of local governments to issue directly a tiny slither of debt has been running since 2011. The Development Research Center, a State Council-related think tank, proposes expanding it beyond the two provinces and two municipalities that may issue up to 350 billion yuan ($60 billion) of bonds between them over three years. The timing of the Center’s recommendation suggests the issue is likely to be taken up at next month’s Party plenum at which economic reform will be prominent on the agenda.
“Open the front door, close the back door,” the Center says, in a reference to the way local governments got round the 1993 curtailment on their bond issuance by developing off-balance sheet special financing vehicles. The ban, imposed because borrowing had got out of hand, was only lifted in 2009. The finance ministry issued bonds on local governments’ behalf. Opening the front door to direct issuance by Guangdong, Zhejiang, Shanghai and Shenzhen followed two years later.
The purpose of expanding the muni-bond market now would be to bring greater transparency and market discipline to local government borrowing, and some order to local government financing that is mostly dependent on land sales, especially since the 2008 stimulus. So opaque is the process that central government has had to order a series of audits. The last one showed local governments holding 10.7 trillion yuan in debt as of the end of 2010. That was widely regarded as a light count. Some unofficial estimates now run to 25 trillion yuan. That would be equivalent to more than two-fifths of GDP. The latest audit is due to be completed in time for the plenum.
Such a level is of concern to policymakers on three scores. First, much of that debt funded unviable infrastructure projects unable to service the loans, let alone repay them. Second, much of the funding was mismatched; local governments were borrowing short-term to fund long-tern projects. Third, the big state owned banks will be left carrying the can if or when that debt defaults or can no longer be rolled over. The U.S. credit-rating agency Standard & Poor’s has estimated that as much as a third of local governments’ borrowing from the banks has turned sour.
Funding more of local government finance through capital markets would spread the risk among multiple investors. It is also assumed, they they would be more hard-nosed in the first place about deciding which borrowers and projects to back than bankers who often have a close relationship with local government officials.
While the central bank has been a proponent of an expanded muni-bond market for some years, the idea has been getting wider support in government circles because of the need to fund the continued rapid urbanization of the country. That is a high policy priority for President Xi Jinping, who sees at as critical to rebalancing the economy. But it also comes with a large price tag — an estimated 40 trillion yuan over ten years. Finance minister Lou Jiwei recently said that a muni-bond market should be the basis of local government financing, but that the transition should be “gradual”.
One reason for a cautious pace despite the urgent need is the fear among some policymakers that local officials may go on an issuance binge, taking advantage of their connections to local banks, which are the main investors in bonds, to get new issues taken up regardless. Another is that the secondary market for muni-debt remains underdeveloped, both the interbank market and that on the Shanghai and Shenzhen exchanges. The primary and secondary markets need grow in lockstep if either is to be successful. Developing the secondary market, however, quickly gets tied up with broader financial markets reform, particularly interest rate liberalization and the thorny question of to what extent the market would be opened up to foreigners both as underwriters and investors. That all suggests progress will be measured.
Then there is the question — never far away in China — of which agency would oversee an expanded bond market — and the plumbing that it would need such as credit rating, disclosure and underwriting standards, and bond holders legal rights. Three agencies now have jurisdiction over various aspects bond market, the People’s Bank of China, the National Development and Reform Commission, and the China Securities Regulatory Commission. The later, particularly under its politically adept former head Guo Shuqing, a long-time proponent of an expanded bond market for corporates as well as munis, has being most active in consolidating its power — it would say unifying supervision — over the bonds markets.
The politically most challenging aspect, however, will be to let even on muni-bond issue default so investors realize that the government won’t always bailout troubled issuers, and that there is a risk to be priced in. That was traumatic enough last year with the first corporate bond default. How much more so would it be to let a municipality or province default on its debt. That may be the biggest brake on progress of them all.