Of Chinese bondage

“Future looks bright for China’s bond market,” crowed the headline of a November 4 article in People’s Daily, the Party’s official newspaper. The piece was just one of many in state-run media that have celebrated a new pilot program which allows local governments to issue bonds as a brave new mechanism to refurbish local government finances, clean up bank balance sheets and rejuvenate lagging investor appetite for Chinese debt.

Thus far, four provincial-level governments – Shanghai, Shenzhen, Zhejiang and Guangdong – have received approval from the Ministry of Finance to raise a total of RMB22.9 billion (US$3.57 billion) this year through sales of three- and five-year general obligation bonds. The first issue began on November 15, when Shanghai sold US$1.1 billion worth of bonds. Guangdong province quickly followed, selling US$1.09 billion of bonds several days later.

These governments will be joining a wave of Chinese corporations and institutions that are appealing to debt market to remain solvent. “Due to liquidity tightening on the mainland, Chinese companies are turning to bond markets,” said Joyce Huang, director for financial institutions at Fitch Ratings in Hong Kong. Among this rush are China’s largest insurers, which are seeking cash, in particular from renminbi-denominated “dim sum” bonds in Hong Kong, to help cover policy payments following a drop in the value of their stock portfolios this year.

Although expanding the bond market would help governments and companies cover short-term cash shortages, not everyone shares a rosy outlook on the initiative. Critics say the move is just another way for local governments and state-owned companies to delay badly needed reforms that would wean the country’s economy off investment-driven growth. If already-insolvent local governments continue spending and piling up bad debt, they say, that will only exacerbate the pain when the day of reckoning finally comes.

Overdue and too soon

Though Beijing has pondered the creation of a provincial bond market for a long time, its appearance in late 2011 came as somewhat of a surprise. Rumors about the initiative circulated for much of the year, but many (including this magazine) argued that Beijing would be unlikely to implement such an ambitious reform prior to the leadership transition in 2012. Moving local governments off their dependence on state-owned banks and putting them into the bond markets, however salutary in the long run, would require a revision to the law governing local government budgets; it would entail modifications, some profound, to the fiscal relationship between the center and localities. It would also necessitate the reform of a host of institutions, including banks, domestic ratings agencies and, most importantly, local governments themselves.

Beijing is aware of these challenges – the failure of a similar pilot program in the 1990s offered a comprehensive lesson in the risks. But an increasing sense of urgency has taken hold nonetheless. According to China’s National Auditing Office, nearly one-quarter of local government debt, or US$760 billion, will mature before the end of 2011.

Fiscal revenues alone may be insufficient to cover these debts. Beijing has cracked down on speculation in the property market – meaning local governments are earning less revenue from land sales by municipalities – and on liquidity – meaning everyone is getting less easy money from banks. Investors are increasingly skeptical as to the ability of local governments to meet their obligations.

It was this skepticism that caused the shares of Chinese banks to begin a precipitous slide in September. By early October, Bank of China’s H-shares had fallen 46% year-to-date – at which point domestic sovereign wealth fund Central Huijin Investment rode into the fray to buy up banking shares and signal support to the market.

The intervention did spur a recovery – Agricultural Bank of China gained nearly 15% in one day – but it was largely technical, said Fraser Howie, analyst at CLSA and co-author of “Red Capitalism: The Fragile Financial Foundations of China’s Extraordinary Rise.” Investors bought the shares aggressively to cover losses they had recorded on their short positions. “The government is managing the problem, not solving it,” Howie said.

Proponents argue that expanding the bond markets will solve both short-term liquidity problems and moderate the long-term structural cycle of booms and busts provoked by excess lending. Bonds are certainly an easy fix in the short term: They not only help local governments roll over their debt but also improve bank balance sheets. If local governments can restructure their debt by selling 10-year bonds and paying off current loans with the proceeds, they buy a lot of breathing room.

Municipal bonds also represent an important step towards increasing political transparency, said Liu Li-Gang, head of Greater China Economics for ANZ Research. While a municipal government can borrow money from a bank without notifying the public, bonds are issued on an open market and can therefore be more easily audited by local legislatures.

“This is a landmark event,” Liu said. “Before [the local people’s congresses] were basically a rubber stamp. Now they can ask questions. That will be an important institutional development, a move toward a more rule-based society and democracy.”

Too easy money?

These are certainly advantages, but the development of municipal bond markets still presents big challenges. For one, at present there is no legal mechanism that allows governments to tax specifically to support bond payments – making the term “general obligation bond” quite general indeed. But a bigger problem is that the new policy may not provide a more accurate way to measure and decrease risk, as bond markets are meant to.

To function, bond markets rely on a plurality of buyers who can make informed decisions about the value and risk of purchasing another party’s debt. But purchases of regional bonds are off-limits to private investors.

“The problem is the [domestic] bond market does not attract a very diverse group of investors,” said Howie of CLSA. “It’s dominated by the banks, there’s not a lot of volume, and there’s no sort of dependence on the market. So much of the bond risk comes back to the banks in the end.”

But others, like Liu of ANZ, argue that municipal bonds will have much broader appeal. Municipal bonds will offer a higher yield than the deposit rates at banks but less volatility than stocks and real estate, Liu said, and as such should appeal to a variety of buyers, from retail investors to pension funds. “I think this definitely will create a lot of excitement in the domestic market.”

Moral hazard

But the perception that municipal bonds carry little risk is in itself a problem, especially if it is accurate. At present, most observers assume that local government bonds are tacitly guaranteed by the center. Gang Meng, director of the rating committee of Dagong Global Credit Rating, suggested as much when he commented, “If a rating is required [for municipal bonds], it should be triple-A.”

That may sound like an attractive investment opportunity, but this absence of risk could turn out to be the system’s greatest shortcoming. It was a similar combination of easy money and weak discipline that pushed local governments deep into debt in the first place.

So long as investors believe that buying Chinese bonds is a one-way bet, it will be easy for local governments to continue raising money and spending freely. And so long as Beijing continues to bail local governments out, the money may be spent carelessly.

If debt markets simply become a new channel through which local governments raise, then misallocate, capital, China will come to regret this experiment.