How Can Local Government Bonds Change China
Notes of the speech by Prof. Wang Yongqin in the seminar of “China’s Urbanization and Local Government Debt Risk” hosted by SIFL on January 19th, 2013
Just like a painting, China’s economy is so attractive when viewed at a distance but vaguely when looking closer: after 30 years’ development, China becomes the second largest economy in the world in terms of the economic aggregate index GDP. However, the China story is not so powerful to overcome increasing doubts--there are many problems in its banking system, financial system, government system, etc. Among them, government debt problem is causing more and more concerns.
In fact, China’s economic problem is actually debt problem, either the enterprise debts or the government debts. If we take a closer look at this problem, there’re “rob-Peter-to-pay-Paul” operations during the government and enterprise debts repaying.
If we regard the government as an enterprise, it also needs financing. For a developing country, it desperately needs money to finance its urbanization, so it is a financial problem. There are two industrialized financing models. The first one is the earliest model executed in the developed countries like England and the USA as they enjoyed the comparatively excellent financial order and had the financial market prior to the Industrialization. The British government had to issue bonds to raise enough capital to repair roads and bridges, but other countries lacked the same conditions. The second model is the one adopted by developing countries and underdeveloped countries. During the industrialization period, a country with the support of the financial market, generally speaking, has to rely on the government-leading and bank-operating financing system; China is a special case, where the local governments play the leading role in the financing system by putting the land as mortgage to raise funds, thus highlighting the government intervention.
The largest problem confronting China in its economic development is the financing problem. After the tax-sharing reform in 1994, the tax incomes retained by the local governments dropped drastically while the majority of the tax income was under the control of the central government. At the same time, the local governments are not obviously relieved of the corresponding expenditures, so in view of the further economic development, the local governments are confronted with the tremendous financing restraint.
However, in view of the tremendous development of China’s urbanization since 1994, we think that the local governments are the main bodies with two financial innovation highlights: one is Pooling: pooling many projects together under a unified bond by changing the information - sensitive assets into information - insensitive assets to reduce the total risk, thus stimulating the transaction. The second is Pyramiding, meaning that the local government issues the bonds by using the land to initiate the construction project and then puts the bonds under pledge for financing, which can mitigate the credit restraint and maximize the bank leverage.
If a country does not have the satisfactory financial market, the harder it tries to heighten its information transparency, the fewer transactions it will have. India has the comparatively rotten system, yet it enjoys the higher information transparency, including its legal system and the media. Even so, India has the poorer market liquidity or its entire economic system has fewer transactions. So everything is quite clear and sure we just think that India is far from satisfactory in this respect. China has the lower transparency, showcasing the better performances but not the worse performances. China, at present, has the comparatively poor system, so if investors have the confidence in its future development, the local government adopts the Pooling Model for fund raising, which will increase the transactions and maximize the liquidity. On the contrary, if the local government’s debts are unpacked for case-by-case calculation, there will be the adverse selection, possibly triggering off the financial crisis.
However, transparency is a double-edged sword. Though low transparency promotes transactions under poor-developed financial market, systematic risks are also been accumulated at the same time. For example, at the initial stage of economic development, the information transparency of Southwest Asian nations including the East Asian tigers is low, but they enjoyed fast economic growth. Later on, they increased the transparency with no big institutional improvement, and then came the Asian financial crisis. So it’s very important to manage the transparency. If China fails to have its transparency problem effectively solved, it is likely that some problems will unexpectedly crop up, resulting in the hard landing.
For sustainable financing, now China begins to issue the municipal bonds, which can maximize the transactions as it can retain the advantages of the lower transparency and mitigate the government intergenerational conflicts, thus enjoying the more connotation-oriented development.
More specifically, municipal bonds can used to be mortgage or investment products, thus diffusing the liquidity in the real properties and promoting the development of the bond market. In bond market, it values the average quality of bonds instead of the specific enterprise, thus, such market is insensitive to information.
In addition, the municipal bond is a financial instrument and the market pricing provides the extra information to evaluate the local government. In the past, when the central government evaluated the performances of local governments, it cared about nothing but the relevant GDP ranking. The municipal bonds can change the competition model and behaviors of the local governments, thus positively affecting the local governments to transform their governance with more restraints.
