Will Chinese Local Governments Now Turn to Bonds?

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This week China revised its budget law for the first time since its inception 20 years ago. One of the more important changes is to formalize ongoing experiments in local government bond issuance. The change is certainly a breakthrough but the significance will ultimately depend on how much the central government allows local governments to borrow.

China has experimented with local government bond issuance for almost five years. In 2009, the Ministry of Finance first began issuing collective local government bonds. Collective bonds are bonds issued by the Ministry of Finance on behalf of several local governments in which the Ministry of Finance is responsible for repaying principle and interest. Three years later China began allowing certain local governments to issue their own bonds. In contrast to the collective bonds, in this pilot selected localities are responsible for issuing and paying the principal and interest on their own bonds. This self-pay pilot was expanded this year and now includes 10 provinces and cities.

However, these experiments have not yet had a meaningful impact on the structure of local government debt. The last national audit revealed the share of official local government debt derived from bond financing has barely changed in the three years. In the first half of 2013, official local government bonds were only 3.7 percent of total local government debt down from 3.9 percent in 2010. To put this in perspective in the first half of 2013 local debt financed from explicit bond issuance was only one-third the size of funds raised by trust companies, leasing, or non-bank financial institutions.

Local Debt Structure

The reason for the slow growth in bond financing is that the central government controls the amount through quotas. For example, the total quota for local government bond issuance this year was only Rmb400 billion not nearly enough to cover the Rmb3.5 trillion in local debt set to mature in 2014.

As a result of the limited quota, local governments still rely heavily on local government financing vehicles to issue bonds. Local government financing vehicle (LGFV) bonds outstanding are more than double size of official local government bond issuance.

However, greater reliance on local government financing vehicles is not a good option for increasing local government reliance on bonds. Only a small number of local government financing vehicles have the financial solvency to issue bonds on the interbank bond market. For example, most LGFV bonds are enterprise bonds regulated by the NDRC. The NDRC does not allow firms with an liabilities-to-assets ratio exceeding 80% to issue bonds and strictly monitors issuance if liabilities-to-assets exceed 60 percent. In addition, due to the opaque nature of the relationship between local governments and their financing vehicles, a disorderly resolution could spillover to the entire market. For example, if a locality decides not to bailout a defaulting local financing vehicle this could drive investors away from these products entirely, creating a short-term funding gap for local governments.

It is unclear how these conditions will change now that the budget law has been revised. The new budget law says that local government bond issuance will be capped by a quota set by the State Council. In theory, the Ministry of Finance could use this to open up the existing self-pay pilot to all provinces, and increase the existing annual quota. However, for this to have a meaningful impact on the structure of local debt, the quota must increase significantly from current levels. For example, if the quota were quadrupled to Rmb 1.7 trillion, this would cover only half of debt due to mature this year. And even this would only make official bonds account for 12 percent of local debt outstanding.

Local Quota Estimate

Viewed more broadly, the reform to allow local government bond issuance appears to be a mixed blessing. By maintaining the existing central government quota system for local debt issuance, the central government is effectively limiting the role of the market in determining how much localities should borrow. If the quota is insufficient, this ultimately could still drive local governments to pursue less explicit channels for financing their obligations.

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