One is famous for its rum, the other for moutai, China’s favourite liquor. But Puerto Rico and Guizhou have something else in common. They hold the unwelcome distinction of being the most heavily indebted territories in their respective countries, with debt-to- local-GDP ratios of roughly 70% (Puerto Rico) and 85% (Guizhou).
Chinese regulators might do well to learn the lessons from America’s $3.7 trillion municipal bond market. And they should especially look at the way it has been roiled by a year-long debt crisis in Puerto Rico. About 70% of US municipal bond funds are thought to hold Puerto Rican sovereign and quasi-sovereign debt, which has the same tax-exempt status as US states and was once a magnet for investors in search of yield in a low interest rate environment.
However, the beginning of US tapering combined with Puerto Rico’s underlying economic problems triggered a sell-off last summer. And that became a headlong downward spiral earlier this year when all three global rating agencies downgraded the territory to junk bond status.
If the world’s most sophisticated bond market can buckle under pressure, what does that say about the prospects for China, which is taking its first steps towards establishing a municipal bond market and in doing so untangling the Gordian knot of Rmb17.9 trillion ($2.89 trillion) in local government debt, much of it held by banks? In May, the government expanded a pilot project allowing 10 local governments to issue debt in their own name (previously the Ministry of Finance was ultimately responsible for coupon and principal repayments).
First off was Guangdong, which raised Rmb14.8 billion in late June. The deal was a landmark for the bond markets given Guangdong has the biggest local economy in China. If Guangdong were a country in its own right, its GDP would rank 16th in the world behind South Korea and Mexico.
That was followed last week by new issuance from Shandong province, the country’s third largest economy behind Guangdong and Jiangsu. However, the deal raised eyebrows after the five, seven and 10-year tranches were priced at fixed rates about 20 basis points below the sovereign curve. By contrast, Guangdong’s seven and 10-year notes were priced flat to central government rates (although the five year came about 5bp below).
One participant joked with newspaper CBN that the Shandong government “should be requested to issue bonds on behalf of the central government, or other provinces given it seems to have found an effective way to reduce its financing costs.”
Guotai Junan bond analyst Xu Hanfei then suggested that non-market factors were at play as “credit risks are not reflected in the pricing”. Some analysts believe this is because local banks, which hold the provincial government’s tax receipts on deposit, were keen to curry favour by bidding for the bonds at low levels.
At least the media’s attempts to analyse Shandong’s fundamentals point to a strengthening understanding of the credit differentials between different provinces. While Shandong’s economy is smaller than Guangdong’s, its credit profile is ostensibly stronger. Debt to GDP stood at about 15.9% at the end of 2013, the lowest of any province.
Since Guo Shuqing, former head of the China Securities Regulatory Commission, became Shandong’s governor last year, he has also made the province a pioneer in promoting greater fiscal transparency. Shandong will publish all of its budget plans down to town level by 2015. At the moment, bond investors and issuers don’t have access to this kind of detail elsewere.
Both Guangdong and Shandong have been awarded triple-A ratings by local agency Shanghai Brilliance. One key test will be local raters’ willingness or ability to rate a local government below the sovereign ceiling.
As Moody’s reiterated in a recent report, China’s municipal bond market can “only be considered a success if investors price the debt of different local and regional governments according to their individual credit characteristics.”
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