Shifting liabilities
Nie Riming told Global Times," because the central government has vowed to guarantee all municipal bonds issued under the program, it serves as less to expand local funding sources and more to transfer financial liability from the local governments to the Chinese taxpayer."
In 1959, the Anhui provincial government started to issue local government bonds to spur local agricultural development. From 1959 to 1961, the provincial government floated 120.3 million yuan ($18.97 million) in bonds, which it primarily used to buy farmland and subsidize farmers.
Shortly thereafter, a drought hit the province. The financial losses - coupled with the social unrest of the time - caused revenue to plummet, and in 1962, the province defaulted on 33 million yuan of its bonds, according to an article in May 2010 issue of Financial Theory and Practice, a Chinese academic journal. The central government stepped in the following year to pay off the debt, but also prohibited local governments from issuing bonds on their own.
The phenomenon would repeat itself. After the central government lifted the restriction in 1981, it had to again bar local governments from issuing bonds in 1994 because they had ran up too much debt. Now, with the local governments again on the hook for trillions of yuan in debt that they have amassed through other means, the central government is taking another look at local government bonds, not as the problem, but as a solution.
Guangdong Province is scheduled today to auction 6.9 billion yuan in local government bonds, also known as municipal bonds, through a pilot program that the Ministry of Finance (MOF) launched last month to allow cities and provinces to again issue bonds. Shanghai Municipality became the first locality to participate in the program when it sold 7.1 billion yuan in bonds Tuesday.
The program aims to expand the sources of local government funding, which have lately been dominated by bank lending and land sales. In theory, this would shift some of the financial risk of local government debt to bond investors.
However, because the central government has vowed to guarantee all municipal bonds issued under the program, it serves as less to expand local funding sources and more to transfer financial liability from the local governments to the Chinese taxpayer, said Nie Riming, a research fellow at the Shanghai Institute of Finance and Law.
The debt dilemma
The pilot program will be limited to four localities: Guangdong Province, Zhejiang Province, Shanghai Municipality and the city of Shenzhen, according to the MOF announcement. Under the program, these local governments will be allowed to issue a total of 25 billion yuan in three-year or five-year bonds this year.
Issuing a bond is similar to taking out a loan, except the loan is sliced into pieces and sold off to investors, who then collect the interest and principal payments until the bond matures.
The central government also plans to cap the amount that local governments can issue each year and control the interest rate, or yield, that they pay on the debt, according to the announcement. The Global Times contacted the MOF with questions about the program, but did not receive a reply before publication.
Government controls were necessary to ensure investor confidence, said Liu Shengjun, deputy director of the Lujiazui International Finance Research Center at the China Europe International Business School.
"Without the central government's guarantee and other controls, investors wouldn't have much confidence in these bonds because the local governments already have huge debts and don't publish detailed budget information," Liu told the Global Times.
The problem is that it is difficult for regulators to control bond yields, especially if the program is expanded beyond the four localities.
For example, if regulators try to hold down yields, it allows local governments to borrow at lower rates, but investors won't be adequately compensated for the risk they are taking, Nie said. On the other hand, if regulators let yields rise too high, it makes it harder for local governments to repay bondholders, especially if they have a habit of borrowing irresponsibly.
The need for a guarantee
The idea of allowing local governments to again issue bonds started to gain attention after the National Audit Office disclosed on June 27 that local governments had run up an estimated 10.7 trillion yuan in debt - primarily in bank loans - by the end of 2010. The local governments amassed the debt through the use of local government financing vehicles (LGFV), which are corporations that the local governments set up for the purpose of financing infrastructure and other projects. Because local governments were barred from taking out bank loans and issuing bonds on their own, LGFVs gave them a way to borrow money without running afoul of Beijing regulations. It also allowed them to run up a huge debt that until recently remained off their books.
With such a large amount of hidden debt and a lack of overall budget transparency, local governments would be likely to abuse the power to sell bonds if there weren't any restrictions, said Zhang Taowei, an associate professor from the School of Economics and Management at Tsinghua University.
This is in part because of the transitory nature of high-level local official careers. In the past, local government officials have had more of an incentive to hit short-term goals, such as annual GDP targets, than to ensure their city or province will be able to meet its long-term financial obligations, Nie said.
"After all, local officials frequently change posts, so heavily indebted infrastructure projects usually just end up becoming the problem of their successors," Liu said.
Experts are concerned that these factors mean the local governments have little incentive to ensure they borrow at reasonable rates and ultimately lead to unaffordable borrowing. This not only exacerbates the local government debt problem, but also increases the chance of default.
Guaranteeing the bonds solves this problem, Liu said. By shielding investors from default, the central government guarantee buoys investor confidence, which pushes down bond yields. With less interest to pay, local governments are less likely to overextend themselves. But the catch remains - the central government is on the hook if the local governments can't pay.
A first, but small, step
If the pilot program is eventually expanded to the rest of the country, it would help increase the transparency of local government financing because every locality would have to issue its bonds on an open market. At the very least, it would become much easier to track the amount of local government debt in the financial system.
Local governments have actually been able to issue municipal bonds since 2009, but it had to be done through the central government. The pilot program functions more like an expansion of this system than the precursor to an unfettered municipal bond market. With its central government controls, the program shows that China's municipal bond market remains in a transition between a free market and one controlled by the central government, Liu said.
Liu believes that the central government ought to eventually drop its controls over the market. But it first needs to strengthen oversight of local expenditure and make local budgets more transparent, he said. Without that transparency, it will be difficult for investors to judge the value of municipal bonds.
"Since those measures will take time, the program still requires central government restrictions to protect the interests of both bond investors and the public," Liu said.
Global Times | By Wang Fei'er | 2011-11-17
