Published on June 10, 2014 by Jia Guo
For the first time in nearly two decades, China is likely to allow local governments to directly sell/issue bonds in a bid to stem the potential financial crisis that has increasingly become a concern. The Chinese central government prohibited such a move in 1995.
According to many analysts1, ‘the only viable, long-term solution for China with regard to a local government debt problem is to develop a thriving municipal bond market.’ Some analysts have also opined that ‘the availability of local government bond issuance will increase transparency of issuing bodies, and encourage public supervision, which can effectively reduce financial risks on local government’.
However, could this so called ‘evolutionary’ local government bond issuance really be a solution to the potential financial crisis that might break out due to the current high-risk scenario of trillion-dollar government debt?
Here is where local government debt in China currently stands:
1. As on 30 June 2013, the direct and indirect debt of local governments amounted to CNY17.9 trillion, or 32.1% of GDP, up from CNY10.7 trillion at the end of 2010.2
2. The current unfavorable situation in China’s real estate market has led to a decline in the local government’s ‘land finance’ income, a source of income generated from frequent property transactions. Some local governments, where more than half the annual income is sourced from land finance, are experiencing significant difficulties in repaying existing debt.
3. Around CNY10.1 trillion (USD1.6 trillion) in local government debt has been sourced from banks, on which the interest is mostly at standard market rates.
4. Local government bonds are very much like State-Owned Enterprise (SOE) bonds, which are fully backed by government hierarchies. Although the backing is not legally binding, no default has ever occurred on SOEs since bonds were first issued in China. As a result, the new local government bond could expect a credit rating close to treasury level from recognised local rating agencies, and hence, an interest rate much lower than standard market rates.
With a view to quickly improve the repayment capability of the local government, the majority of the newly issued bonds are likely be used to repay existing bank loans, so that financial costs can be lowered and interest coverage ratio can be improved.
It is quite possible that by replacing old bank borrowing with the new bond, the imminent threat of a financial crisis is temporarily suppressed. However, to truly resolve the problem, over-reliance on ‘land finance’ must be dealt with in order to improve the quality of local government income composition. Unfortunately, this cannot be achieved by merely allowing direct bond issuance by local governments.
2 MIS report: Acuity Knowledge Partners releases compendium on research on Chinese local government-related debt (21 Jan 2014)
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About the Author
Associate, Credit Research
Jia Guo focuses on credit research delivery that helps investors better understand, estimate and benchmark the fundamental credit risk of China-listed companies at the firm’s Beijing office. He has 7 years’ experience in credit and auditing. Prior to joining Acuity Knowledge Partners, Jia worked at China Business Credit & Guarantee Company and KPMG China.
Jia Guo holds a Bachelor of Accounting and Finance (Honours) from Napier University in the UK.
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