China Moves to De-Risk Local Government Debt

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.

The debt swap also comes at a time when China is nearing the end of its two-decade long effort to liberalize domestic interest rates. Establishing a tradable yield curve in liquid municipal bonds will help establish risk-free benchmarks for the pricing of fixed-income instruments world’s largest economy.

At 1.2 trillion yuan at the end of 2014, 97 local government bonds outstanding accounted for only 3.2 percent of China’s 36 trillion yuan bond market. Policy bank bonds, primarily issued by China Development Bank, form the largest bond class at 9.7 trillion yuan, a 27.1 percent share, followed by China government bonds of 9.6 trillion yuan, or 26.7 percent.

The growth of these two top classes of bonds is limited in nature, and too small to meet investor demand. The growth of the CGBs is capped by the (modest) annual central fiscal deficit. The China Development Bank, meanwhile, lacks both a deposit base and steady cash flow streams. It is an inappropriate vehicle for a risk-free curve.

On the other hand, local governments have both appreciated land assets and a growing, potentially huge tax base. Municipal bonds backed by a rationalized tax system will bear much lower yields than local government financing vehicles, and will help to meet market demand for a tradable risk-free curve.

The growth of a municipal bond market depends in turn on the tax reforms proposed at last year’s Communist Party Plenum, which are designed to allow local governments to share in value-added tax revenues. Local governments now finance large part of their infrastructure spending through both LGFVs and land sales. In terms of underlying economics, this is the close equivalent of taxation.

In the US, local governments obtain a large portion of their revenue through taxes levied on privately-owned land. In China, where the government owns most of the land, local governments sell or pledge land as a collateral to obtain loans. A recent International Monetary Fund study claiming that land sales were the equivalent of deficit financing is mistaken.

But there is an enormous difference in market efficiency between the present system, where local governments borrow through a large number of special-purpose vehicles, and the emerging municipal bond market. That is the diversification of revenue sources. For the same reason that full-faith-and-credit bonds of large US states offer much lower yields than one-off industrial development bonds, most of China’s provinces have populations the size of European countries. Issuance of debt backed by provincial revenue streams, moreover, affords far less room for abuse than LGFV’s.

Removing some of the risk from what might become China’s largest fixed income market should have a salutary effect on investors’ portfolios. Chinese institutional investors as well as households will have access to a liquid market in low-risk bonds across the maturity spectrum. That will allow them to shift other parts of their portfolios toward risk, and support the growth of the corporate bond market.

In context of the overall reform program, the municipal debt swap is a small but significant step towards market efficiency, along with liberalization of interest rates, easier access for SMEs and start-ups to debt and credit market, and opening of the capital account.

With reporting from the Hong Kong-based REORIENT Securities Ltd. research team