China Economics Update:Municipal bonds have arrived

China’s Ministry of Finance today announced that ten local governments will be permitted to issue municipal bonds in 2014. The ten municipalities in question are Beijing, Shanghai, Guangdong, Shenzhen, Zhejiang, Jiangsu, Shandong, Jiangxi, Ningxia and Qingdao. We take this as a positive step by the central government in its effort to improve the fiscal management of the banking system by streamlining local debt issues.

    Local government debt has been one of the main threats to China’s economic and financial stability. Based on the latest figures from the National Audit Office, total local government debt including contingencies was around RMB17.9t by June 2013, or 153% of total fiscal income in 2013. Debt raised by local government financing platforms amounted to RMB6t, or 39% of total local government debt by June 2013. This has brought into question the low transparency and repayment capability of local governments. Recent actions by the central government, notably establishing a more transparent local debt management system, are designed to put these concerns to rest. According to guidelines issued by the Ministry of Finance, municipal bond issues will need to obtain credit ratings from independent rating agencies and publish all necessary financial information including local fiscal income, expenditures and debt levels. This represents a big improvement in transparency as it gives investors a clearer view of the repayment capability of government issuers.

    Municipal bonds to replace LGFV debt in financing local infrastructure investments. Most LGFV debt has relatively short duration, which makes it difficult to match future cashflows with repayment schedules. This is not a problem in most developed countries where municipal bond issues with longer durations are the norm for funding transportation and utility projects. In addition, the pricing of the new bonds will benchmark against treasury bonds of the same duration, implying that coupon rates of municipal bonds will be much lower (300-400bp) than current LGFV bonds. This would reduce financial expenses associated with local government infrastructure projects.

    What amount of local municipal bonds will be issued? The guidelines did not disclose the total scale of municipal bonds to be issued in 2014. We estimate that total issues could amount to RMB150b in 2014F. Thus, the budgeted total fiscal deficit could expand to RMB1.45t in 2014F. This would generally favor local transportation and utility investment in the ten provinces and cities that are part of the trials.

    Local governments face de-leveraging in the medium term. Total fiscal income and fiscal expenditure slowed to 9.2% YTD (vs. 10.1% YoY in 2013) and 9.6% YTD by April 2014(vs. 10.9% YoY in 2013). We expect fiscal income to slow even further in 2H14F due to a decline in income from land sales and tax income. We look for local governments to reduce their holdings in local SOEs and privatize certain government-owned assets as part of an SOE reform package over the next two-to-three years.