China looks to municipal bonds to clean up local-govt debt


* Explosion in local govt debt on agenda for reform meetingin Nov

* Govt think-tank favours expanding municipal bond market

* Current pilot project is tiny but shows promise

* But some worry that municipal bonds would only worsen debtproblem

By Gabriel Wildau

SHANGHAI, Oct 21 (Reuters) - China may decide next month toexpand a trial programme allowing local governments to sellbonds, in response to concerns that their huge borrowings arelargely hidden from view and pose a risk to the stability of thenation's financial system.

A government think-tank that advises China's cabinet, theDevelopment Research Center, has put forward a proposal callingfor greater use of municipal bonds ahead of a policy-makingmeeting next month to decide Beijing's long-term reform agenda.

Local government debt totals up to $4 trillion or 42 percentof gross domestic product, according to some unofficialestimates, but much of it has been raised via financing vehiclesthat do not disclose details on the size and health of loans.

That lack of transparency - akin to the kind of off-balancesheet lending that froze international debt markets and led tothe 2008-09 global financial crisis - could be addressed throughuse of bonds, which require disclosure and spread the risk ofdefault across a wide array of investors.

"'Open the front door, block the back door,' and expand thescope of local government independent bond issuance," theDevelopment Research Center said in its draft proposal submittedrecently to leaders of the ruling Communist Party and publishedlast week on the website of Beijing's Renmin University.

Chinese law bans local governments from selling debtdirectly in a measure that was meant to restrain theirborrowings, but local officials have skirted it by raising debtthrough financing vehicles to fund infrastructure projects.

Borrowing through so-called local government financingvehicles (LGFV) exploded in 2008-09, when China pumped 4trillion yuan ($656 billion) in stimulus spending through theeconomy to cushion the impact of the global financial crisis.

"The rise in local government debt is ... a concern, giventhe complexity and opacity of municipal finances," the WorldBank warned in a regional economic update this month.

"This lack of transparency has led to debt levels higherthan would otherwise be acceptable to lenders, investors andpolicy makers."

Many reform advocates hope new policies announced during theparty's Third Plenum in November will include aggressiveexpansion of a pilot municipal bond programme launched in 2011.

They argue that local governments' current reliance on bankdebt and loans from trust companies - another form of opaquelending - contributes to profligate local spending. The use ofLGFVs adds to the opacity.

Economists say a real municipal bond market would be key toaddressing the local debt issue, with disclosure requirementshelping to impose a hard budget discipline on local officials.

In another sign authorities are poised to expand municipalbond issuance, another influential think tank, the China Academyof Social Sciences, teamed up with a major credit ratings agencylast month to issue ratings of local governments.


The local bond pilot remains tiny compared to the scale oflocal financing needs. The finance ministry in March set a quotaof 350 billion yuan ($57 billion) under the programme for 2013.

Still, bonds have been well received by investors and yieldshave hovered around 3.8 percent to 4.5 percent, nearly as low asChinese treasury bonds of the same maturity.

By contrast, weaker localities forced to resort totrust-company loans and other sources of shadow-banking financeoften pay more than 10 percent annual rates.

That suggests expanded bond issuance could enable manylocalities to cut borrowing costs.

The use of longer-term municipal bonds could also relievethe worrying mismatch between infrastructure investments thatmay take decades to produce financial returns and the short-termloans that are often used to finance such projects.

"Take a highway project as an example. It may take 20 or 30years after it's built to repay principal and interest. But thebank loans are typically three to five years," Wu Xiaoling, aformer Chinese central banker, told Reuters last month.

But low yields on the small pool of existing municipal bondsmay simply reflect investors' assumption that the financeministry has chosen fiscally strong localities for the pilot.

"If you suddenly let everyone issue bonds, then the marketno longer sees it as a special privilege. So then the marketwill have to go back to looking at fundamentals," said a bondanalyst at a mid-sized fund management company in Shanghai.


Chinese media quoted Finance Minister Lou Jiwei last monthas calling for "gradually forming a standardised localgovernment debt financing mechanism based mainly on municipalbonds".

The question is what "gradually" means.

The results of an official audit of local government debt,due this month, could determine whether the bond pilot isexpanded or left to wither.

The last audit showed local debt at 10.7 trillion yuan($1.76 trillion) at end-2010, though it used a narrowerdefinition of local debt than that used by banks such asStandard Chartered which see it as high as $4 trillion.

A dramatic rise could make authorities balk at expanding thepilot.

Official media quoted an unnamed audit officer last month assaying the new audit may show local debt nearly doubling between2010 and 2012. The article was later deleted from the website ofEconomic Information, a newspaper run by the official Xinhuanews agency.

Indeed, some in the finance ministry worry that allowingmore municipal bonds would only fuel local officials' appetitefor borrowing, making the debt problem worse. Such caution hasled most analysts to predict that authorities will permit only amodest expansion of the bond pilot.

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