China today ordered the biggest debt swap in the country’s financial history, to replace opaque, off-balance sheet local government debt with standardized provincial government bonds, hopefully alleviating the immediate risk from huge local governments’ debt burdens.
On top of that, however, the move is designed to expand what is a flailing bond market by 20-fold over the next five years and provide a rational way to finance local government development spending, which has in some regions imperiled the economy. Authorities have been wrestling with vast amounts of debt incurred by local governments in a mammoth development spree starting in 2008 as part of a national effort to roll back the global financial crisis.
At one point, the debt was thought to total as much as 19 trillion yuan, or US$3.1 trillion – a third of the country’s entire annual GDP. The local governments were prohibited from going into debt, so they created what were called local government funding vehicles (LGFVs) that were not included in the budgets. The Fitch rating service forecast that the first 1 trillion yuan would be directed to regions that overborrowed to the point where debt ratios are above the national average and pose risks to the broader economy. As property prices have fallen sharply in a deflating market, the problems for local governments to finance the debt have grown, since most local governments depend on land sales to finance government itself.
In order to deal with the problem, the Ministry of Finance’s much-discussed instruction to exchange 1 trillion yuan worth of high-interest local liabilities into low-risk, low-interest municipal bonds in 2015 begins a multi-year debt swap program that is designed to create one of the most important asset classes in China, one that is capable of supporting the complex work of urbanization at the local level while keeping their fiscal strength intact.
The immediate benefit of the swap will be realized by local governments, whose interest burden will decline. The knock-on effects on market efficiency in China, though, will be more important. China’s total municipal bonds outstanding could reasonably grow from last year’s 1.2 trillion yuan to well over 25 trillion by the end of this decade in the effort to provide a stable platform to finance the steadily rising provincial spending on infrastructure development and urbanization.
According to our forecast, the size of China’s municipal bond market will exceed America’s present US$3.7 trillion market by the end of this decade, with an important difference: China’s market will be concentrated in large, liquid issues backed by major political subdivisions rather than fragmented among tens of thousands of small jurisdictions.
The 25 trillion yuan municipal bond projection by 2019 assumes 1) a five-year progressive local government debt swap program of 17.8 trillion yuan as of mid-2013, 2) a moderate, steady increase in local government capital budgets; and a few trillion in one-off bond issuances.
This has nothing to do with quantitative easing, contrary to some initial reports. As Vice Minister Zhu Guangyao made clear March 11, the People’s Bank of China, the country’s central bank, will not buy any of the newly issued municipal bonds. China’s budget law specifically prohibits the monetization of fiscal deficits. It’s not quantitative easing: It’s a structural reform with far greater implications.