As China launches its municipal bond market, the central government is warning local cadres this doesn't amount to a bailout. Local governments that struggle to pay debts will need to come up with local solutions, said Lou Jiwei, China’s minister of finance. They won’t be bailed out by the central government, and China has no legal framework to enable them to declare bankruptcy.
Speaking at the Boao Forum for Asia, Lou said provincial governments are responsible for problems at lower levels, such as municipalities. If a local debt liability can’t be met, the province would have to arrange asset sales.
Lou spoke on a panel titled “Defusing the simmering local debt crisis” but insisted there is no such crisis.
Over the past two weeks, his ministry has issued two regulations that formalise the muni bond market programme after five years of pilot tests. Muni bond financing is expected to commence in April. The muni bond market is partly a reaction to the proliferation of provincial, city and township financing vehicles, backed by real estate.
Lou said there are about 100,000 of these financing platforms across the country, of all shapes and sizes, even at the township level. The slowdown in real estate prices and the economy overall is now placing a burden on many local governments.
As of June 2013, the latest period for which figures are available, total government debt – both central and local – was still below 40% of China’s GDP. This is far lower than in developed countries. Local government debt accounts for about Rmb10.9 trillion ($1.75 trillion), and is now a little bigger than central government debt, which is Rmb10.0 trillion.
Lou said the true number for local governments may be higher, closer to Rmb12-13 trillion, if guarantees are taken into account.
According to a March 27 research report by Deutsche Bank, the local government budget defiict is estimated at Rmb500 billion, which will be financed via a government bond issuance.
Beijing responded by approving Rmb1.1 trillion worth of bonds that provincial governments can now issue. Muni bond issuance will only be permitted when proceeds go directly to infrastructure and urban construction spending, Lou said. Bonds can only be raised when a project has cashflow. Moreover, the new rules allow only the local province’s finance arm to issue bonds; the many existing platforms were created by all kinds of local government departments.
The finance ministry hopes to create a buffer for local governments’ existing stock of debt by helping them refinance via bond markets at lower interest rates and longer maturities; it can also engage in swaps with local entities, trading government bonds for their various project loans. But Lou denied this meant the central government was bailing out local ones. He expects up to Rmb1.8 trillion of local government debt to be serviced this year. Deutsche Bank's report expects Rmb1.6 trillion of muni bond gross supply to emerge throughout 2015.
Credit rating confusion
Local governments are scrambling to find private sources of investment into their projects – and ultimately into their bonds. Huang Qifan, mayor of Chongqing city, said it is hard to attract private investment into projects intended as public goods. Local governments have to balance their books but need to immediately finance projects intended for use over several decades, such as roads. This has forced them to collateralise land via trust products, which end up in the shadow-banking system, or through other structures.
Li Jiange, chairman at Shenyin & Wanguo Securities, said infrastructure needs remain huge and will continue to absorb investment. The only way to accommodate this is via the shadow-banking system. But he said the system is rational and public savings rates are high. Banks might be wary of lending to infrastructure projects but will be willing to buy bonds off of trusted provincial governments.
Lou added that shadow banking in the West usually refers to derivatives and interbank short-term lending; in China, it involves providing investors with a return in order to support the development of public goods; this justifies Beijing’s swapping out historical debts and replacing them with bonds that offer local governments more affordable borrowing rates.
However for a municipal bond market to take off among private investors, it will require a credit rating and more transparency.
Michael Taylor, managing director and Asia Pacific chief credit officer at Moody’s Investor Services, said Lou’s reform package made sense. But currently Moody’s would be unable to rate local government bonds because there remained insufficient information about their assets and liabilities, revenues, and ability to service debt.
Jonathan Woetzel, director at McKinsey & Co., said overseas investors would be very keen to look at China’s local government bond offerings, but were concerned about the risks. The worry is not total volumes of debt but the quality of the underlying real estate, which remains opaque, its pricing volatile.
He also said China needed to ensure an independent auditor would evaluate local government books. “We need more transparency, data and independence in order for municipal bonds to get a credit rating,” he said.
Woetzel cited the case of Detroit, which entered chapter 7 of the US bankruptcy code. It wasn’t a happy experience, but the law provided a reference point for everyone.
But Lou said China would not be drafting any such laws for local governments. Instead they must focus on the asset side of their balance sheet; in other words, sell assets if they couldn’t meet payments.