While they may not want to jump in yet with both feet, bond investors should be keeping an eye on China. Its amendment to its Budget Law at the end of August has put in place a legal framework that will govern the sale of bonds directly by municipalities—something that has been proscribed, except for certain test areas—to investors for the financing of infrastructure projects.
The move comes as the latest step in China’s migration toward greater openness of its financial markets and a changing approach to regulation and transparency. Municipalities, which have been borrowing money in ways that raised eyebrows and concerns, are responsible for approximately 80% of their spending, according to an estimate from the World Bank.
However, the way the country’s tax-sharing system is currently structured, those same municipalities are only able to draw on about 40% of tax revenue. As a result, they’ve turned to a wide variety of financing methods to bring in money for everything from infrastructure projects to day-to-day spending.
In fact, worries had run high around the beginning of the year that there was a possibility of China’s economy imploding around the high level of various unconventional means of debt financing. George Soros had expressed concern over the potential for fiscal disaster in China, but Beijing was already taking steps to prevent disaster and began to subject its shadow banking sector to tighter regulation.
And while its municipal bond issuance program had begun as a trial back in 2011 with the provinces of Zhejiang and Guangdong, as well as the cities of Shanghai and Shenzhen, being allowed to issue their own bonds, in 2013 it added Shandong and Jiangsu provinces. This year it has added the city of Beijing itself, along with Qingdao, Jiangxi province and the Ningxia region as it moved farther along the road of regulation.
And while it still forbids the issuance of bonds to cover day-to-day operating expenses, it’s making a great deal of changes regarding the issuance of the bonds it does allow.
“The municipal bonds that were issued were limited to seven-year terms, and the municipalities weren’t responsible for paying” bond proceeds to investors; instead, the Ministry of Finance was responsible and “withheld the municipality’s pocket money to pay” the proceeds, according to London-based Edmund Harriss, who manages the Guinness Atkinson Renminbi Yuan & Bond Fund, under the earlier trial.“
“But to move forward, issuers have to take responsibility and budget it themselves,” Harriss said. Under the current terms of the program, he said, the government has said that “the maturities issued will be five, seven, and 10 years, and the municipalities will be responsible for servicing and repayment.”
Rules were also refined, Harriss said, so that municipal bonds will fund public projects and go onto the municipality’s own balance sheets, whereas corporate or commercial projects will see municipalities entering into a public-private partnership to issue enterprise or corporate private bonds.
“You will be able to see what kind [of bonds] they are. [The new regulations] are supposed to increase transparency; they will have to publish prospectuses. In that respect, it represents an opening up of government bond markets to have a municipal bond sector and to know what kind [of bonds they are],” Harriss said.
“At the moment, it’s chaotic. Local governments are using vehicles and don’t issue prospectuses, so you don’t know about the cash flow coming from the project that the bonds are supposed to fund, and you don’t know the collateral. So this is to put things on sounder footing. It’s a step toward formalizing methods of local government financing,” he said.
One of the biggest potential benefits for investors is that emphasis on transparency. Harris said, “One of the things [investors should remember], setting aside the difficulties of investing into the actual bond market and just looking in terms of what the instrument is, there is lack of transparency. Unless you knew very precisely where the parcel of land that collateralized your bond actually was, it was a very high risk going in. This [change] should make it a little bit clearer, and should be an improvement for investors in the future. It’s a definite step forward.”
There have been concerns over the amount of local government debt and what failure to repay could do to the broader Chinese economy. Harriss said that while there are valid reasons to be wary, it must be put into perspective. The number most often mentioned, he said, is $2.9 trillion. “It’s worth pausing and saying that the amount of debt actually outstanding in local governments is $1.8 trillion. The rest is debt guarantees and contingent liabilities.”
With the actual debt level at $1.8 trillion, Harriss said that 28% of that is due this year—approximately $380,000,000. “What has been a concern is that local governments in many cases are not in strong condition, and if rumors are true, nine provinces have failed to make repayments of $130,000,000. There is a bad debt issue, clearly, but understanding the actual size of the debt and the repayment schedule is important. The fact that they are moving local governments onto more transparent and sounder footing is a hugely good step. The question is how transparent [the bonds will] actually be, and we won’t know that till we see the prospectuses [and other data] and make a judgment. It’s early days, but exactly what is called for.”
Harriss said that the newly regulated municipal bonds will “certainly add to the list of possibilities” for management groups and sovereign funds who have quotas of yuan that they can invest in the fixed income market. “For the most part, an overseas investor tends to go in just to the sovereign issues for interest. There’s been very little to choose from in municipal bonds, such as it has been, and it’s been far too opaque for many of them [overseas investors]. This certainly broadens the range of opportunity, and I would expect the sort of yields that are on offer should be more attractive than for sovereign bonds.”
While the muni bond sector will still be quite small—Harriss said the quota for this year is in the neighborhood of $17–18 billion, compared with the size of China’s overall onshore bond market at more than $5 trillion—“it is important for investors, because it is another step forward to bringing China’s capital markets into the modern era, and to approve this [change in municipal bond issuance] they had to amend their Budget Law. It’s the first time they’ve amended it in 20 years.”