Article / 29 August 2014 at 13:41 GMT

China's bond market reforms may backfire

Managing Director / Asia-analytica Research
China
  • Local trial bond issues had benefited from market perceptions of sovereign support 
  • Betting on the creditworthiness of the local issuer introduces new risks 
  • Beijing may still not be able to walk away from a provincial bond default 

By Pauline Loong

The move to allow local governments in China to raise money directly in the bond market began more than three years ago when it became clear that the mismatch between local revenues and spending burden was no longer sustainable (see charts below).

Internal disagreements had kept the proposal stuck at the trial stage. But formal blessing appears imminent in an amendment to the Budget Law tabled for the fourth reading earlier this week aimed at ending the 19-year ban on direct issuance by local governments.

Not that the formality will change markets right away. Provincial governments are already issuing bonds under the trial scheme. But legal underpinning is necessary for the programme to move beyond the pilot stage and to establish proper mechanisms for the full-fledged municipal bond issuance targeted by the government.  

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Source: Chinese Ministry of Finance, Asia-analytica Research

What's in a name? Not much

In China, there is often a big gap between appearance and substance. The pilot programme on local issuance had been notable for market perceptions of implicit central government support. Even though the issuer of record is the local entity, the bonds had been structured in such a way as to effectively nullify local government risk for the bondholder. Investor assumption is that the real risk exposure is to the People’s Republic.

This is now supposed to change. In the latest tweak to the programme announced formally last week by the Ministry of Finance, the local authorities are now to make payments directly to investors and not through the offices of the MoF.

How this will affect investor perception of risk remains to be seen. These bonds were always supposed to have been marketed solely on the credit standing of the local issuer. But the technicality of the MoF being the payment venue for interest and principal had arguably strengthened the widespread belief that the debt is implicitly backed by the sovereign.  

Last month, the northeastern province of Shandong was able to issue bonds cheaper than the MoF. The three tranches of its renminbi13.7 billion (US$2.2bn) bond issued on July 11 were priced 20 basis points lower than those of MoF bonds with the same tenor.

This is among the widest gap in yields seen in bonds issued under the trial exercise. Shandong even managed to outdo Guangdong, the dynamic southern province with the rhyming name that is the nation’s export and manufacturing powerhouse. Guangdong’s five-year bonds in June were priced only 15 basis points lower than a similar issue by the MoF. Shandong was most recently in the news for the 25.8% surge in bad bank loans in the first six months of the year with the NPL ratio of its banks hitting 1.57% at end-June compared with the national 1.08%.

Then last Thursday, as if to prove the cynics wrong, the Beijing city government issued three tranches of Rmb10.5bn (US$1.7bn) worth of bonds at yields all slightly higher than the average for MoF issues with the same tenor over the previous five days.

Industry chatter all over town is that the city government had told the underwriters to ensure that yields were higher than comparable MoF issues. This would not be surprising. Local officials would simply be displaying their usual high political intelligence quotient by helping the central government achieve its stated goal of a genuine municipal market where demand determines pricing.
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China has allowed 10 local governments to issue bonds, but reforms will fall short unless the central government can step away from the pricing process. Photo: Thinkstock.com 

Reforms would mean new risks

The irony is that success in convincing investors that they are betting on the creditworthiness of the local issuer could well backfire. Demand might evaporate.

Market perception of implicit sovereign backing for local bond issues is crucial to investment interest. Few local governments are seen as able to generate the revenues needed to service their debt. In October 2008 when the idea of local bond issuance was first floated, the state media commented wryly: “If they reveal their books, no one would agree to lend.” This was the perception even before local governments started racking up huge debts to prevent the economy from slipping into recession. This debt reached an estimated Rmb20.7trillion (US$3.4tr) as at mid-2013.

Of course, there is always national duty – the expectation that corporates do the right thing and support what is good for the country. Fitch Ratings explained in a note just how good this development would be for China: “The … decision to allow local and regional governments (LRGs) to issue bonds directly on their own credit profile is a significant step forward in reforming LRG budget management and ensuring greater fiscal transparency”.  

But national duty goes only so far. And at the end of the day, is it even possible for Beijing to walk away from a provincial government default? Is it politically viable?

The public will hold the central government accountable in the event of trouble whatever the technical caveats. The downside to having near-absolute power over the nation is the near-impossibility of avoiding blame by waving the bond prospectus and saying your name is not on the document.

Then again, markets can surprise

This picture painted by Fitch Ratings in May would be Beijing’s dream come true: “We expect this pilot scheme to allow for more accurate pricing of risk, in light of the differing credit profile of LRGs. Local bonds will more accurately reflect the individual inherent creditworthiness of the authority rather than the sovereign's potential support, as was the case with the other issuance programme. If this pilot scheme is expanded, it will also allow for a more transparent assessment of the Chinese LRG sector, and result in a more sophisticated and responsible debt management policy.” 

-- Edited by Oliver Morrison

Pauline Loong is managing director of Asia-analytica Research
5y
Juhani Huopainen Juhani Huopainen
I don't remember ever seeing a banking/financial market liberalisation anywhere that would not have backfired. Some sort of "college cost" will eventually be paid by investors. Either the financing to provinces comes at a too steep price (as there is no backstop), or the lack of backstop is seen to be illusory (as central government is believed to l step in if something bad happens). At some point investors will face losses. I think higher yields are preferential to low risk premiums. Low interest rate premiums invite moral hazard, while high premiums at least in theory could help investors to build buffers against single-name credit events.
5y
Pauline Loong Pauline Loong
And do not forget national duty. Never underestimate the impact of official expectation on a corporate to do the right thing. Also, losses on a bond investment can translate into goodwill in other areas of business. As I have been arguing since forever: numbers can only only tell half the story in China.
5y
Juhani Huopainen Juhani Huopainen
Kind of reminds me of the euro area: "buy these bonds, and we will take care of you".

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