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Can Municipal Bonds Shed Some Light on China’s Public Finances?

Guangdong province’s novel bond issue injects some transparency into local government finance, and may herald a big new investment opportunity.

It’s no secret that China’s provincial and municipal governments are saddled with a total of about 10.89 trillion yuan ($1.8 trillion) in debt. The nation’s auditor in Beijing confirmed that figure late last year, and a few local governments broke it down further by releasing their own red ink data. But most details of this indebtedness are still hidden from the public eye. Beijing won’t say how much each government entity owes, discuss repayment schedules or name creditors. Only since 2010 has the debt load been publicly acknowledged.

Against this backdrop of opaque public financing, China has opened a new municipal bond program. Launched in June as a pilot project, it has given a handful of local governments direct access to the interbank bond market for the first time. A full-fledged, nationwide market for muni bonds could open next year.

The program reflects Beijing’s willingness to at least experiment with the kind of budget transparency that municipal bond investors deserve and expect. If the program succeeds, the long veil that has traditionally concealed government debt obligations in China may be lifted once and for all.

Six provinces and four cities were invited for the experiment to issue muni bonds through the interbank market, which is supervised by the Shanghai and Shenzhen stock exchanges. First out of the gate was Guangdong province, which raised 14.8 billion yuan by auctioning five-, seven- and ten-year notes in late June.

The next round of auctions has not been announced, but it could be sponsored by any of the participating local governments. They range from wealthy Shanghai and its neighbor to the south, Zhejiang province, to the poor region of Ningxia in the country’s northwest.

Overseas investors can buy these bonds through the Qualified Foreign Institutional Investor scheme run by the Chinese government. As of June 30, 252 licensed institutions had been granted 565 billion yuan worth of QFII quotas for targeting a variety of mainland investments.

State media said the pilot bond auctions could raise up to 109 billion yuan over the next few months. Some analysts are even more optimistic. Hu Yifan, chief economist and head of research at Haitong International Securities Group in Hong Kong, says municipal bond issuance could hit as much as 400 billion yuan by the end of 2014 if the authorities expand the program nationwide. “This kind of experiment will significantly push the bond market in China and make budgeting more transparent,” Hu says.

Until now, Beijing’s financial controls on provincial and city spending included a ban on direct bond issues. The rule forced locals to raise money for infrastructure and general needs through bonds issued on their behalf by the Ministry of Finance and through local government financing vehicles. These quasi-public vehicles tap state banks for loans and issue yuan-denominated “dim sum” bonds through the mainland’s bank branches in Hong Kong.

Fears that local governments were also borrowing through the unregulated shadow banking system emerged in late 2012. The following year, defaults were averted after local governments cut rollover deals with banks for loans they could not repay. The central government as well as market players demanded to know what was going on, prompting a National Audit Office investigation that pegged the debt at 10.89 trillion yuan in late 2013, up from 9.63 trillion yuan a year earlier but little changed from 10.7 trillion yuan in 2010.

The pilot municipal bond program can’t possibly support all of the debt servicing local governments will need over the next two years. The auditor said loans worth about 2.4 trillion yuan, or 22 percent of the total debt, will mature this year, with an additional 17 percent coming due in 2015.

Wang Baoan, vice minister of Finance, recently told the First Financial Daily newspaper, “Short-term solvency and repayment issues have put a great deal of pressure on local governments ... at a time when fiscal revenue growth has slowed and spending is getting tighter. Furthermore, the pressure on local governments will increase as they confront larger debt burdens.”

Municipal bonds can do no more than supplement the overall financing schemes, including possible rollovers, that local governments will have to work out in the coming months. But Beijing has acknowledged that bond auctions are more likely to succeed if investors feel comfortable with budget information from local governments.

In hopes of closing the transparency gap, and in the wake of last year’s audit, the Ministry of Finance has ordered all local governments to release to the public their annual revenue and spending plans starting in 2015. Furthermore, the ministry’s instructions for the pilot program stressed that “this financing sector should operate in accord with the principles of openness, fairness and justice.”

Guangdong, a prosperous manufacturing hub near Hong Kong, qualified for its bond auction by becoming one of the first local governments to publicize its debt load. The province said it owed 862 billion yuan at the end of 2013, up from 817 billion yuan the year before. About 66 percent of that amount was owed to banks.

Guangdong officials also bucked tradition by announcing targets for the funds raised via municipal bonds, saying they would go toward low-income housing and highway construction projects. The province’s finance department also said it would share money with several cities.

China’s biggest, state-owned banks were among the 16 underwriters for the bonds, which were rated AAA by the domestic firm Shanghai Brilliance Credit Rating & Investors Service Co. Bond buyers were not announced, but state media said the winning bidders would earn rates in line with central government Treasury bonds sold that day. Guangdong’s five-year bonds pay interest of 3.84 percent, whereas rates on the seven- and ten-year tranches were set at 3.97 percent and 4.5 percent, respectively.

International credit agencies were not invited to bid for the business of rating the latest municipal bonds. Haitong’s Hu said Beijing thinks only domestic firms know enough about Chinese government budgeting to rate muni bonds properly. International firms “are very good at rating corporate bonds,” she said, but Chinese muni bonds “are not something they can handle at the moment.”

Along with the need for budget transparency, Beijing has recognized that domestic credit rating agencies need clearer guidelines for assessing local government risk. To that end, the Finance Ministry is now writing standards that credit agencies would use to examine provincial and city debt obligations, and rate municipal bonds in ways that can win investor trust.

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