Banking & Finance

Collateral damage

Jiangsu completes landmark debt deal

A Chinese national flag flutters outside the headquarters of the People's Bank of China in Beijing

Local governments breathe again

In March 1927 Chiang Kai-shek’s northern expedition reached Nanjing. The military campaign to unify China was half-complete but the Generalissimo was in dire financial straits. He needed more money to resupply his troops, keep the defeated warlords loyal, and repay some of China’s debts to foreign countries. So he turned his attention to the most affluent region – Jiangsu province – and made the Chinese banks in Shanghai his prime targets.

Led by Jiangsu-born banker KP Chen, the lenders pulled off a deal with Chiang, although they were effectively held to ransom by the Generalissimo. In a major innovation, Chiang got his bank loans by collateralising the future customs tariffs set to be owed by Jiangsu to the Nationalist government (which was officially established in April 1927).

Today Jiangsu remains one of the biggest taxpayers (although Shanghai is no longer part of the province). And yet again, the Chinese government is leveraging on its wealth to pioneer another financial revolution. This time round, it is about clearing up trillions of yuan in local government debts that have been threatening to cripple the banking system.

The National Audit Office has estimated that local governments had amassed debts of up to Rmb20.7 trillion ($128 billion) as of June 2013. Not everyone is convinced by the figure’s accuracy, nor is there an official view on how the black hole has swelled since.

Nevertheless, according to the state audit, Rmb2.8 trillion worth of municipal debts mature this year. To deal with the repayment schedule, the central government repealed a law in March that prevents local governments from running budget deficits. The finance ministry also gave the green light to provincial governments to issue their own municipal bonds. And a debt swap scheme with banks was put in place to roll over up to Rmb1 trillion in maturing liabilities.

Jiangsu was the first to undertake the reforms and it tried to auction up to Rmb65 billion worth of bonds in April. But the sale was postponed after underwriters failed to drum up enough demand from state lenders for the new debt.

“The state banks are reluctant to take part in the debt swap scheme, which aims at recapitalising local governments at the expense of the banks’ own financial flexibility,” the Economic Information Daily said.

Sweeteners were clearly needed for the banks to sign up to the Rmb1 trillion debt swap. And they duly arrived this month. Municipal bonds acquired under the programme, the central bank said, could be used as collateral for making further loans.

These liquidity-providing measures – including so-called ‘pledged supplementary lending’ – are generally referred to by analysts as China’s equivalent to quantitative easing (see WiC279).

“Banks now have more incentives. The debt swap scheme could also be an entrance ticket to the central bank’s QE programme,” the Jiemian news website suggested.

This week Jiangsu completed a landmark bond sale, raising Rmb52.2 billion. Of this, Rmb30.8 billion was raised in bonds sold to state banks via the debt swap scheme.

The coupon rates, Caixin Weekly has reported, are only slightly higher than the sovereign treasury rates commanded by the central government.

Previously, local governments had little choice but to roll over their municipal debts via shadow banking borrowing (such as wealth management products) at much higher coupon rates.

In the longer run, China needs a genuine market mechanism for local governments to raise funds, Caixin Weekly has also noted. And it added a cautionary warning about the moral hazard that the extensive use of local government financing vehicles (LGFV) has introduced into the municipal market. The magazine says munis “ needs to be investments of low-risk and low-return. Not a freak asset of high returns but low or even zero risk because of the central government’s unspoken guarantee [referring to the high-yield products issued by the LGFVs in recent years].”

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