HONG KONG: China's push for a municipal bond market could increase the pressure on those provinces already struggling to fund massive debt piles, effectively creating a two-tier market dominated by its major cities and financially strong regions.
The challenge for investors will be how to assess risks of different provinces in the world's third-largest bond market as the central government tries to withdraw its implicit guarantee on their debts and introduces market discipline to fundraising.
Beijing has permitted 10 cities and provinces to sell municipal bonds, an expansion of an existing pilot programme with one significant change - the local governments will be responsible for repayments. "Those guys who have been given permission don't need to raise money. The idea is for them to get their own rating, unlike loans where it is the sovereign's backing," said Daiwa Capital Markets economist Kevin Lai. "The guys who really need to raise money are the guys in the red and in fiscally bad shape." The bonds would have to be rated and benchmarked against central government bonds.
That is something the local ratings industry has not previously had to do, so could provide its own challenges in developing the market.
"In the US, leading up to the sub-prime (crisis) there was rating inflation even though there were just 3 agencies. Imagine if all 6 local agencies in China were to compete for market share," said David Cui, an analyst with Merrill Lynch in Hong Kong. Currently, the Ministry of Finance sells bonds on behalf of local governments, an arrangement that left it responsible for repayments and gives even the weakest provinces an effective sovereign guarantee on their borrowing.
"In China, not only do you need to see reform allowing bonds as well as loans, you will also need to find investors other than banks to provide that funding. Those are the true reforms," said Viktor Hjort, the Hong Kong-based head of Asia Fixed Income Research at Morgan Stanley.
"The funds available in China's bond market are finite; first movers have an advantage."
FIRST STEP
Official estimates put local government debt at about $3 trillion, equivalent to one-third of China's annual output, and private sector estimates are even higher.
Analysts welcome the move to develop a domestic government bond market as the start of a long-term reform that will improve financing through the economy.
"Such a market is vital to reducing the risks to China's sovereign creditworthiness stemming from local governments' use of off-balance-sheet debt," Standard & Poor's analysts said in a report. Guangdong, Qingdao and Shandong are taking part in the pilot programme and, with debt-to-GDP ratios in the teens, are unlikely to be worried about the need for disclosures.
The test of the market will come when those with weaker balance sheets have to tap the market on their own.
"The problem is whether the local governments will fully disclose their financial positions, particularly those with weak metrics. The higher the debt/GDP ratio, the greater the urgency for them to raise money," said Merrill Lynch's Cui. Much of that existing debt has been raised through local government financing vehicles (LGFV), opaque entities that help regional authorities skirt the ban on municipal bonds. Beijing has tried to curtail the LGFVs, but the debt still needs to be serviced.
"As the central government has sought to limit bank loans to LGFVs, local governments have turned to issuing riskier, more expensive forms of debt," Debra Roane, a senior credit officer at Moody's Investors Service, said in a report "For example, about 8 percent of local related government debt is in trust products that are very short term and typically at interest rates higher than 9 percent."
Many local governments take out bank loans with terms shorter than the projects they are financing, resulting in a mismatch of maturities and income.
The pilot tries to address that by requiring 10-year bonds to account for 30 percent of bond issues. "Some LGFVs's information disclosure are a bit opaque and their cash flows are not very strong because the infrastructure projects they are involved in have relatively long ramp-up periods," said Fitch Ratings analyst Terry Gao. As part of Beijing's broader reform plans, it will take over some spending obligations from provincial governments on condition that they have more sustainable tax revenues and constraints on spending.
"They need to solve the basic underlying problem - it has to do with how can they find enough revenue to pay the debt without relying on land sales," said Daiwa's Lai.
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