The push this week by China’s government to develop its onshore bond market has huge implications.
On Monday, the local government of Guangdong Province sold Rmb14.8 billion ($2.4 billion) worth of bonds, the country’s first local government bond in the name of the local authority.
Previously, six local governments could issue bonds but conditionally and only in the name of the Ministry of Finance. The six are Shanghai, Zhejiang, Guangdong, Shenzhen, Jiangsu and Shandong.
However, on May 19 the MoF for the first time allowed the local governments to tap the bond market under their own steam and included four more cities and provinces: Beijing, Jiangxi, Ningxia and Qingdao.
The move will grant more debt-issuing responsibilities from the central government to the local and regional governments, which is symbolically important.
Previous issuance from the local governments - in name of the MoF - actually came with an implicit guarantee from the central government. So the changes mean the local governments can now assume default risks by themselves, while backing their debt with their own revenue.
The move will also help build a more advanced rating system and a more transparent borrowing model. The Guangdong government bond has a credit rating – the first for such debt - and the authority will disclose information such as its revenue, outstanding debt and debt ratio.
“Increased transparency of the fiscal and debt activities of the country’s local governments will lead to greater accountability on the part of local governments with respect to their investing and borrowing practices,” according to a May research report by Moody’s.
Allowing local government to issue bonds in their own names will decrease embedded risks in China’s banking system, credit analysts said.
China’s local governments (except the ten) can’t borrow money from capital markets directly, according to Chinese law.
They thus have typically set up a local government financing vehicle (LGFV) primarily for funding infrastructure and real estate development projects, which have long been flagged as key source of risky shadow banking.
The problem here is the local infrastructure projects, some of which are potentially loss-making, often take years to generate investment returns, raising the risk of default.
Local governments can now borrow more freely. “The shift in debtors from LGFVs to local governments can help standardise borrowing activities and reduce potential massive default risks in the banking system,” said Chen Long, a credit analyst with Bank of Dongguan.
Also on Monday, Ping An Bank issued Rmb2.63 billion in asset-backed securities (ABS) and listed them on the Shanghai Stock Exchange.
This represented the country’s first ABS listed on a stock exchange, instead of the interbank market, which will diversify the investor base for ABS products and further decrease the pressure on the interbank market of default risks.
More changes needed
However, analysts believe that more changes are needed for a healthier onshore debt market.
The selected 10 local governments still do not have full freedom in terms of borrowing. Chinese law is in the process of being amended so such borrowing will be legally authorized.
Currently the central government controls the local government bond issuance process in a few ways: the amount of bonds the local authorities are allowed to issue is subject to an annual quota assigned by the State Council and the governments are only allowed to issue fixed-rate bonds with limited maturities.
Although the local government bonds are rated, the rating methodologies need to improve. The Guangdong bond was rated AAA, the highest credit rating in the mainland market, due to the province’s rapid economic growth and high debt paying ability. However, analysts said that the other governments may be granted the same rating, which would not reflect the difference in pricing risks among the issuers.
The effort to develop the bond market can “only be considered a success if investors price debt of different local and regional governments according to their individual credit characteristics,” the Moody’s report said.
The pricing of the bond was not solely determined by market forces. The five-, seven- and ten-year tranches of the Guangdong bond were priced at 3.84%, 3.97% and 4.05% respectively, which are close to those of central government bonds with the same tenor. The five-year note’s yield is even lower than the central government’s five-year of 3.99%.
The yields of local government bonds are often lower than those of the central government, which is rare in a normal market. “Local banks and other investors must support local governments by buying into their bonds,” said a Beijing-based bond investor.
Crucially though, “the bond market will need time to change investors’ mindset of the implicit [central government] guarantee. Chinese bond investors will learn how to price the risk after a few defaults really happen,” said Bank of Dongguan’s Chen.
