Why China’s regional and local government bond market needs protection

Chinese regional and local government (RLG) borrowers look set to issue significantly more bonds as a result of China’s ongoing public finance reforms. The credit strength of upper-tier RLGs, consisting of 31 provinces and five centrally planned cities, is supported by their close ties with the sovereign. While we do not currently rate China’s upper-tier RLGs, their ratings would likely be in a tight range, and no more than two notches below that of the sovereign, if we were to apply our global rating methodology to them.

The default of an upper-tier RLG could impair wider financial markets. The need to avoid reputational risk and to protect China's sovereign rating would therefore give the central government a strong incentive to preemptively resolve financial difficulties faced by RLGs.

The central government has made it clear that it would take steps to limit any systemic risk arising from a potential RLG default. During the press conference at the conclusion of the annual National People’s Congress on March 15, the Chinese premier reiterated the central government’s expectation that “there will not be a regional, systemic financial crisis.” His comment could be interpreted as a statement of the central government's intention to prevent RLG defaults.

How to protect the RLG bond market without bailing out RLGs

Protection of the nascent RLG bond market is a central government priority. We expect that the central government would preemptively resolve any default by an RLG to protect the RLG bond market, which is still in the early stages of development. All indications are that the central government would correct any RLG fiscal or liquidity problems before any default occurs, allowing the central government to accomplish its stated goal of avoiding RLG bailouts while still eliminating contagion risk.

The central government’s policy of avoiding bailouts is ostensibly to address the issue of moral hazard, but this factor does not weigh heavily in our credit view, because the government’s overriding priority is to protect the RLG finance market. Preemption of fiscal stress is analytically equivalent to bailout in our expected loss framework when assessing credit risk.

The central government has broad powers to intervene directly in RLG operations, enhancing its ability to avert a default. For instance, it can force RLGs to sell assets in the event of debt repayment difficulties.

The RLGs’ total net financial and non-financial assets exceed their total direct debt liabilities, and are also likely to exceed their total debt, which stood at 17.9 trillion yuan (US$2.9 trillion) as of June 2013, according to the most recently available statistics.

RLG assets include owners’ equity in state-owned enterprises; an amount which totaled 17.1 trillion yuan at the end of 2014. RLGs also hold equity stakes in local commercial banks and non-bank financial institutions — such as trust companies, mutual and private equity funds — as well as significant land and mineral resources.

The most recent examples of policy measures designed to shore up RLG credit strength include the October 2014 State Council guideline prohibiting RLGs from further borrowing through local government financing vehicles, and the newly approved budget.

The approved budget sets a 600-billion-yuan bond issuance limit for 2015, an increase of 50 percent from the limit in 2014. The 600 billion yuan is also split between 500 billion yuan for general-obligation bonds and 100 billion yuan for special-purpose bonds tied to specific projects.

In addition to raising the limit for RLG bond issuance, the 2015 budget envisages a debt-for-bond swap designed to reduce the RLGs’ interest burden and extend the maturity of their existing debt. The Ministry of Finance (MOF) will permit RLGs to swap 1 trillion yuan of high-interest and short-maturity debt raised through third parties into low-interest and longer-dated bonds.

Because benchmark loan rates exceed bond coupon rates by about 200 basis points, and the average funding cost for local government financing vehicles is 200-300 basis points above benchmark loan rates, the swap will significantly reduce the RLGs’ debt service burden, if these bonds find buyers. A potential buyer, for instance, is the National Social Security Fund, which was recently approved by the State Council to invest up to 20 percent of its 1.5 trillion yuan assets in RLG bonds.

The MOF estimates that the debt-for-bond swap will cut the RLGs’ annual interest bill by 40-50 billion yuan, implying a reduction in the average interest rate of 4-5 percentage points.

Another benefit of the debt-for-bond swap is the bonds’ longer maturities. The average maturity of RLG bonds issued in 2014 was 7.1 years, far exceeding the typical 1-3 years maturity of bank loans, and the 2-3 years duration of shadow banking products.

Based on the latest data as of June 2013, 17.1 percent of the RLGs’ direct debt, or 2.7 percent of projected GDP, is coming due this year. The 1 trillion yuan debt-for-bond swap is 53.8 percent of the amount due in 2015.

All 31 provinces and five centrally planned cities will be allowed to issue new bonds to swap up to 53.8 percent of their debt due in 2015.

To help deal with potential liquidity stresses of debt not swapped, the MOF allows the refinancing of projects under construction through bank loans, before the transition to a fully fledged RLG bond market is complete. Such a refinancing possibility was in doubt immediately after the State Council issued debt management guidelines in October 2014.

Outlook for the RLG Bond Market

As the latest policies take effect in the coming months, we expect a significant reduction in the RLGs’ debt service burden. A liquidity stress caused by hasty implementation of public finance and debt reforms is much less likely now.

In the years beyond 2015, as China's ongoing fiscal reforms phase in, a more market-based approach to credit discipline, and variations in the creditworthiness of the RLGs could become more evident for lower-tier entities in the country.

For instance, differences between the creditworthiness of upper and lower-tier RLGs will be much wider than the differences between upper-tier RLGs.

Jenny Shi is a Moody’s Investors Service Managing Director and Country Manager for China. Shi provides leadership and oversight for corporate finance and other fundamental ratings franchise in China, manages and oversees cross lines of business in the country.