China Local Bond Sale

(In an interview with Financial Times on November 15, 2011, Professor Ning Zhu said that the fundamental problem of China local bond is local governments do not have the resources to pay the principal and the interest.)

Strong Demand for China Local Bond Sale

Shanghai became the first local government in China to issue bonds directly in nearly two decades, a reform that lies at the heart of attempts to clean up the troubled finances of its cities and provinces.

Local governments have amassed large debts through off-balance sheet borrowing and, at more than 25 per cent of gross domestic product; these debts are seen as one of the big risks looming over the Chinese economy.

By allowing bond sales, the hope is that the market will impose discipline and transparency on local governments, ensuring that their borrowing remains under control.

The first local bond auction drew strong demand that would be the envy of many European governments.

Shanghai on Tuesday sold Rmb3.6bn ($560bn) of three-year bonds at a yield of 3.1 per cent and Rmb3.5bn of five-year bonds at 3.3 per cent. They were both more than three times subscribed, according to the official Xinhua news agency.

Analysts cautioned that the sale amounted to a tiny step in the right direction and that far more was needed to reform the structure of government financing in China.

“I don’t think they’ve solved the fundamental problem, and the fundamental problem is a lack of local revenue generation capacity,” said Stephen Green, head of China research with Standard Chartered.

Cities and provinces remained excessively reliant on land sales and fiscal transfers from Beijing and there was a lack of supervision over their spending, he said.

Largely prohibited from borrowing from banks and selling bonds, local governments in China have created thousands of financing companies in recent years to get around these restrictions.

Beijing has struggled to get a clear picture of how much these semi-official companies owe and where they have spent their funds. National auditors estimated this year that they had racked up more than Rmb10,000bn in debt.

Recognizing that bond sales would be a much more direct way for local governments to finance themselves, Beijing has tentatively moved to open that door.

Over the past three years, the finance ministry has issued Rmb200bn each year in bonds whose proceeds were earmarked for local spending.

Then, too much fanfare last month, Beijing said it would permit Shanghai, Shenzhen, Guangdong and Zhejiang – four of the wealthiest, best-run jurisdictions – to go a step further by directly selling bonds.

Local governments had not issued bonds since 1994 when Beijing banned them from doing so because of concerns that they were accumulating unplayable debts. Guangdong province is next, with its auction scheduled for Friday, and will be followed on Monday by Zhejiang.

But there is less than meets the eye to these bond sales.

The central government dictated how much the local governments could issue, placing a low cap on them. Shanghai’s bonds equate to just about 2 per cent of its planned expenditures this year.

China’s national finance ministry will in fact pay both the interest and the principal on the bonds. Local authorities will be responsible for transferring corresponding funds to Beijing but analysts say the arrangement amounts to an explicit central government guarantee for the bonds.

“It is just the beginning of the beginning,” said Zhu Ning, deputy director of the Shanghai Advanced Institute of Finance, a business school.

“The current situation is such that local governments do not have the resources to pay the principal and the interest.”