Banking & Finance

Our word is our bond

IOUs, bonds and local government finance

“Will they ever repay?”

Two years ago, Liang Weishi became interested in family history. Rooting around in the ancestral home, he found the information he was a looking for, reports the Nanfang Daily. It took the form of IOUs given to his grandmother by a squadron of Chinese guerillas. Dating back to 1941, they mentioned the rice, silver and gold she had lent them on pre-agreed repayment rates.

Liang presented one of the documents to the Jiangmen local government and received a one-off payment of Rmb20,000 in recognition of his grandmother’s loan. But when he took a second, larger claim to the authorities, he was told that this debt would not be honoured. Officials questioned his right to inherit the commitment from his grandmother before insisting that troops at the time had been representing the national government and not the local authorities.

But there was another good reason for Jiangmen’s civil servants to reject the request for repayment. Private loans made before 1949 usually paid monthly interest. And on this basis, some netizens have calculated that Liang is owed Rmb3.4 trillion, which would take the city 342 years to pay out of it current fiscal revenue.

Institutional investors may want to take note of Liang’s experience, as it bodes ill for a new scheme that will soon allow local governments to issue bonds of their own.

The pilot phase will start in richer provinces such as Guangdong and Zhejiang. Each will be allocated an initial quota of Rmb10 billion for fundraising, which is expected to be released by the end of the year.

This could prove to be a radical shake-up of the current system. Local governments have been forbidden from issuing bonds since 1993, when the central government became concerned that they would not be able to pay back their loans. Furthermore, a national Budget Law introduced in 1995 decreed that local governments were unable to operate under a deficit.

But the hope is that relaxation in the rules may help create a more systematic framework for other local governments to follow when issuing debt in future. Local governments will also enjoy greater freedoms to manage their own finances.

Another anticipated benefit is that the new bonds could satisfy demand for more investment opportunities in fixed income products, with banks and insurers getting a steady return on local government bonds.

That is only if the issuer proves capable of paying the money back, of course. And fears about creditworthiness inform the opposing side of the debate: that it is a mistake to allow local governments to issue debt because so much of their tax revenue is unpredictable, with a heavy reliance on land sales.

Local governments are also already burdened with existing debt. National Audit Office figures put local debt at Rmb10.7 trillion at the end of 2010, representing 27% of national GDP.

How does that square up with the stipulations under the Budget Law that local governments have to balance the books? In fact, local treasurers have been borrowing money but only indirectly, with the central government issuing bonds on their behalf. Or funds have been raised via an intermediary, like the local government financing vehicles now undergoing so much scrutiny after the tidal wave of investment that has gone into infrastructure projects over the last three years.

Proponents of the pilot scheme argue that, if local governments do start tapping the bond market more directly for credit, it might help with lending transparency. Investors will also pick issuers with better credit records, rewarding those who run a tighter fiscal ship. The rule changes will “open the front door, close the back door and build fences,” Jia Kang, director of the Research Institute of Fiscal Science, told National Business Daily. WiC’s quick translation: open and transparent system (the front door); harder to squander (the back door); and clearer to police (the fences).

As things stand today, much of the lending is being forced through quasi-official channels, including the murkier world of the local government financing vehicles. Regulators are still struggling to work out exactly how much has been borrowed, with different agencies coming up with competing estimates. Nor is the legal status of all of the financing vehicles clear, leading to concerns about what will happen in event of defaults.

We may soon find out, as large chunks of the debt begins to mature this year. Cracks first began to appear in Yunnan, where a local highway project defaulted earlier this year (see WiC113). But rumours intensified this month, following an article in Xinhua suggesting that 85% of the funding platforms in Liaoning province have already missed payment deadlines. The report said 156 out of 184 financing platforms in Liaoning were unable to make repayments because of insufficient revenues.

State officials then tried to rebut the claims, as well as emphasise once again that the burden is manageable.

Debt levels were “controllable”, Xu Lin, head of fiscal and financial department of the NDRC, the state planning agency, told the China Daily. Regulators “at all levels” have been paying attention to risk controls, Xu assured the newspaper, and “active measures” had been taken in some regions.

The consensus view is that there is little likelihood of widespread default, especially since much of the repayment will likely be rolled over onto longer-term schedules.

The next big change will be to improve the revenue side of the local government balance sheet. For example, if property taxes are introduced, those buying the new municipal bonds will do so with more confidence.

Keeping Track: Last week we wrote about the plans for a pilot scheme allowing a small group of provincial governments to issue their own bonds. The plan will initially launch in Shanghai, Shandong, Zhejiang and Guangdong.

Moody’s has come out with new report that views the move as “credit-positive”, according to Shanghai Daily. Moody’s reckons allowing local governments to issue bonds will help them to be disciplined in dealing with their debts and provide them with an alternative to raise capital. Previously they have relied heavily on the less transparent route of using local government financing vehicles. Moody’s adds that if these vehicles default, Chinese banks will see non-performing loan ratios go as high as 12%. (Sep 23, 2011)

Last week we wrote about the plans for a pilot scheme allowing a small group of provincial governments to issue their own bonds. The plan will initially launch in Shanghai, Shandong, Zhejiang and Guangdong.
Moody’s has come out with new report that views the move as “credit-positive”, according to Shanghai Daily. Moody’s reckons allowing local governments to issue bonds will help them to be disciplined in dealing with their debts and provide them with an alternative to raise capital. Previously they have relied heavily on the less transparent route of using local government financing vehicles. Moody’s adds that if these vehicles default, Chinese banks will see non-performing loan ratios go as high as 12%.


© ChinTell Ltd. All rights reserved.

Exclusively sponsored by HSBC.

The Week in China website and the weekly magazine publications are owned and maintained by ChinTell Limited, Hong Kong. Neither HSBC nor any member of the HSBC group of companies ("HSBC") endorses the contents and/or is involved in selecting, creating or editing the contents of the Week in China website or the Week in China magazine. The views expressed in these publications are solely the views of ChinTell Limited and do not necessarily reflect the views or investment ideas of HSBC. No responsibility will therefore be assumed by HSBC for the contents of these publications or for the errors or omissions therein.