China needs municipal bond rethink

China needs municipal bond rethink
Zhao Yingjie

National People’s Congress discussed on April 21 amending Chinese law to allow local provincial governments to issue bonds, potentially marking the beginnings of a national municipal bond market.

At the moment local governments can’t issue bonds in any form. In order to finance city construction, China devised two kinds of quasi-municipal bonds – bonds issued by the Ministry of Finance on behalf of a local government and bonds sold by local government financing vehicles (LGFV).

Only six local governments – Shanghai, Zhejiang, Guangdong, Jiangsu, Shandong and Shenzhen – are allowed to issue the former type of bond, so outstanding volume of these bonds is very low.

LGFVs meanwhile are not like ordinary investment companies. Having originated in Shanghai in 1992, they have a long track record but often the issuers’ profitability is poor and their main source of income is financial subsidies. Other problems related to LGFV bonds include little transparency and high-financing costs. Also because the operation of LGFVs is controlled by local governments, most investors believe that bonds issued by LGFVs won’t default.

So in order for China’s nascent municipal bond market to flourish, authorities need to rethink their regulation philosophy.

During the recent Third Plenary Session of the Communist Party, Beijing promised to let market forces play a decisive role in capital markets. For the municipal bond market this means bond issuance should move towards a more disclosure-based system rather than the existing approval-based system.

In this way regulators would only check whether issuers have disclosed all the necessary information about their financing plans for investors to make an informed decision; an approach taken by the US Securities and Exchange Commission.

The approval system, on the contrary, allows issuers to tap capital markets only when they have secured regulators’ approval. The review process is normally lengthy, rigid and inefficient and sometimes prevents companies hitting the market at opportune times.

As the government gradually withdraws from the market a disclosure-based system would help investors assess the potential for default – a growing risk recently highlighted by the default of privately-owned Shanghai Chaori Solar Energy Science & Technology on its interest payments. I expect retail investors will increasingly invest in municipal bonds, based on the US experience.

As to who will review an issue/issuer when it tells regulators it plans to raise capital, the form of state structure could be key. In a federal state such as the US, the sale of municipal bonds does not need approval at federal level. Under the disclosure-based system, highly-centralized China would still need to ensure that the issuer’s application is within budget to avoid local government expenditure running out of control.

In terms of disclosure, the municipal issuer should disclose detailed information about its outstanding debt, including liens, security, collateral pledges, etc. If an issuer makes changes in its final statement, investors must be made aware of any new or additional information on the underlying credit or of any alterations to the security provisions.

Apart from central government, China’s stock exchanges and National Association of Financial Market Institutional Investors (NAFMII) should also play an important role. Since they are closer to the market, these self-regulating organizations understand it better. They act as a bridge between the market and the other regulators. The importance of SROs is seen not only in markets where they lead regulation, as in the UK, but also in markets where the government is the chief regulator, as in the US.

In addition, municipal bonds could trade on a stock exchange and in the interbank market at the same time. So to avoid any regulatory vacuum or overlap, the stock exchanges need to cooperate with NAFMII.

Finally, it must not be forgotten that issuers of municipal bonds are not the same as issuers of corporate bonds. They are local governments. So the potential for political corruption must be taken into account. In order to prevent corruption in the underwriting process for municipal bonds the selection of underwriter must be done through a formal bidding process. 

Zhao Yingjie, a Ph.D. in accounting graduated from the Renmin University of China, is now a senior manager working at the bond market department of the Shanghai Stock Exchange.

The views expressed in this article are the author's own and do not necessarily reflect those of the Shanghai Stock Exchange.

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