Why has China only dipped a toe in a form of local-government financing that is common the world over — municipal bonds? A robust muni-bond market would help China on three fronts where there is a clear and pressing need:
- It would spread the risk of China’s local government debt, estimated now to be a nervous-making $25 trillion yuan ($4 trillion), as much as a third of it possibly impaired, from the banks where it is now concentrated to a wider range of investors.
- It would bring some transparency and market discipline to local-government financing and lessen provincial and municipal government’s dependency on politically controversial and corruption-plagued land sales.
- It would provide a mechanism for financing one of the key initiatives in President Xi Jinping’s plans to rebalance of the economy, namely the continued rapid urbanization of the country, which carries a 40-trillion yuan price tag over ten years.
It was only in 2009 that Beijing lifted a ban on local government bond issuance that had been imposed in 1993 to curtail wanton over-issuance. Even then, central government issued the bonds on local government’s behalf. In 2011, it allowed the first direct issuance in almost two decades, by the provinces of Guangdong and Zhejiang and the municipalities of Shanghai and Shenzhen, four of the most gilt-edged issuers it could muster. But it was still a cautious move. The quartet were allowed to issue no more than a collective 350 billion yuan-worth of bonds over three years.
Signs are that experiment is going to be expanded. The Development Research Center (DRC), a think tank that advises the State Council, China’s cabinet, has just published a recommendation to that effect. No coincidence that it comes just ahead of next month’s Party plenum, which is going to focus on economic reforms to switch China’s growth model from investment and exports to domestic consumption.
“Open the front door, close the back door,” the DRC advised the State Council. The back door in question is the murky off-balance-sheet loans from bank and trust companies to special investment and other financing vehicles that local governments devised to get around the ban on bond issuance. The extent of that and its lack of creditworthiness in many cases has got policymakers worried about the prospect of the big state-owned banks being left saddled with a large number of bad loans. Having already bailed out the banks in the 2000s to the tune of more than 2 trillion yuan, central government doesn’t want to have to do so again.
Last month finance minister Lou Jiwei gave another sign expanding the muni-bond market was under consideration, when he said it should be the basis for local government financing. He also said China would need to move gradually towards it. There is a great deal of plumbing that would have to come with it, such as credit-risk rating, underwriting standards and the protection under law of bond-holders’ rights. Those involve a lot of soft skills in short supply within both the financial system and local government.
There would also be a need to develop a secondary market, which would quickly get wrapped up with the questions of interest-rate liberalization and the development of new wealth management and retail consumer savings and investment products. Even more contentious would be the question of the extent to which foreigners would be allowed to underwrite, package and own China’s muni-bonds.
Once those thickets are cleared, there is the issue of supervision. Three agencies — the central bank, the central planning agency and the securities regulator — currently have responsibility for various aspects of China’s nascent bond markets. Supervision would need to be unified. The China Securities Regulatory Commission is taking the lead in this regard.
The National Audit office has since July been updating its last audit which put China’s local government debt at 10.7 trillion yuan as of the end of 2010. Press reports suggest that its new number, expected to be presented to the Party Plenum, will at least double that. That would be approaching the equivalent of two-fifths of the country’s GDP. If so, putting local government financing on a sounder footing is more urgent than the pace of the expansion of the muni-bond market to date would suggest.
Taken with the other pressing longer-term needs it could meet, more muni-bond issuance and a larger range of issuers are likely to be approved in November. The only question is how bold Beijing dares to be.