On Thursday, Beijing became the eighth local government in China to issue its own municipal bonds. According to Xinhua, Beijing issued 10.5 billion RMB ($1.7 billion) worth of bonds, with five, seven, and ten year terms.
Beijing’s move is part of a larger program rolled out in May that allowed 10 local governments (Zhejiang, Jiangsu, Jiangxi, Ningxia, Shandong, and Guangdong provinces as well as the cities of Qingdao, Beijing, Shanghai and Shenzhen) to issue municipal bonds. Before then, local governments were not legally allowed to borrow money or seek outside financing for their debt. However, the lack of direct, legal options for financing local government spending didn’t prevent borrowing but simply moved it underground to China’s shadow banking sector. The shift to allow local governments to directly issue bonds is a move to eliminate the riskier shadow banking practices while providing a better-regulated alternative.
The program so far has been a success, with bonds being bought up in large numbers despite puzzlingly low return rates. Xinhua noted that the return rates for Beijing’s bonds (between 4.00 and 4.24 percent), were “below market expectations.” When Guangdong opened its own bond market in June, the Wall Street Journal noted that yields for those local bonds, set at 3.84 percent for five year bonds, “were lower than that [of bonds] sold recently by the central government.”
Xinhua used the Beijing bond sale as a springboard for a closer analysis of the local bond program. It noted that this program was a shift in approach from the central government. In the past, China has simply tried to ban shadow borrowing, but states have responded by shifting to ever-riskier and less-regulated approaches. Rather than tamping down on local government borrowing, the blanket ban merely pushed it toward unregulated sectors.
By 2013, Chinese local governments had racked up a combined 10.88 trillion RMB ($1.7 trillion) in debt. Roughly 40 percent (4 trillion RMB) was financed by local government finance vehicles (LGFVs), an unofficial banking technique wherein a shell company is set up to take out loans for the local government. By contrast, in 2010 official bank lending accounted for almost 80 percent of local government liabilities. And some estimates put the 2013 debt figure even higher — Reuters cited estimates that local governments might owe up to $4 trillion, with much of this money raised through LGFVs.
By allowing for the legal and direct sale of local government bonds, the central government hopes to be able to wean municipalities off of their addiction to LGFVs. The Xinhua article acknowledged that trying to shut down borrowing by local governments “only encouraged many of them to turn to the high-interest, short-maturity shadow banking sector to remain solvent.” To truly combat the shadow banking sector, the central government has to provide legal (and regulated) alternatives, with the new municipal bond program being the first step. The Diplomat’s Pacific Money blogger Sara Hsu argues that opening up the sale of local government bonds has helped prevent default on trust loans, which is turn helped prevent a potential crisis in China’s financial system
Eventually, the hope is to expand this pilot program beyond the ten approved municipalities. However, challenges remain, with one problem being the low return rates mentioned earlier. Xinhua notes that all ten of the pilot areas have been given an AAA credit rating — leaving some analysts at a loss as to how the relatively impoverished provinces of Ningxia and Jiangxi could possibly be rated the same credit risk as booming cities like Shanghai and Beijing. This suggests that local governments’ financial transparency still has a long way to go.
Selling bonds, as Beijing did Thursday, is the easy part. The test for the pilot system of local government bonds will come in five years, when the first sets start maturing and the local governments have to pay up. Under the new system, local governments are entirely responsible for covering the debt taken on through the sale of municipal bonds. Whether the local governments can do so will be the real test of China’s new bond market — especially as many of these bond sales are expected to be used to cover existing debts.