Huge debts and questionable investments have driven many Chinese local governments to the brink. Now regulators have stepped in with a package of reforms. Stefania Palma asks how effective the new measures will be after decades of poor supervision.

China tackles local government financial woes

Decades of poor supervision and a dysfunctional fiscal transfer system have turned China’s gargantuan local government debt into one of the biggest threats to the country’s economic growth, as well as foreign investor confidence in the mainland’s financial system.

But, spooked by ballooning debt, the risk of bond defaults and pressure on the local banking sector from non-performing loans, Chinese regulators have accelerated local government financing reforms in the past 24 months.

Accounting changes, new debt ceilings, repurposing local government financing vehicles (LGFVs) and a nascent municipal bond market are helping local governments clean up their books. But if Chinese regulators want to increase foreign investment in local government securities significantly, critics point out that more needs to be done to improve data reporting and transparency. Fundamentally, China will also need to clearly define the financing and investment responsibility split between the central and local government.

Dysfunctional fiscal system

At the crux of China’s local government woes is a dysfunctional division of public spending and financing responsibilities. Chinese government administrations are categorised in order of size, by province, prefecture, county, township and village. Somewhat counterintuitively, the lowest levels of government have the highest expenditure needs but receive the smallest amount of central government support through an inefficient tier-by-tier transfer of funds from the centre all the way down to townships and villages – a legacy of the 1994 fiscal reforms. In China, all constitutional power lies within the central government while administrative power is highly decentralised.

Local government revenue is 20% of gross domestic product (GDP), but these administrations spend 28% of GDP. “There was a mismatch of investment and fiscal resources,” says Ivan Chung, head of greater China credit research and analysis at Moody’s. 

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Not allowed to issue bonds directly until 2014 and in dire need of financing, local governments set up LGFVs – construction and investment companies responsible for carrying out government infrastructure projects – to issue bonds and take out bank loans on their behalf. This phenomenon accelerated after China announced an enormous $4000bn stimulus package, resulting in a huge public infrastructure push, as a shield against the 2008 financial crisis.

But the volume of LGFV borrowing was not capped until mid-2015 and the use of proceeds was poorly monitored. This meant LGFVs were free to start investing in unsanctioned activities with a higher yield than long-term public infrastructure projects that were prone to bureaucratic delays. “This is not government debt but it is still on the LGFV balance sheet. It is a side-business model and it is all under one balance sheet so it’s hard to tell what is and what isn’t an LGFV core activity. Local governments may end up being exposed to unnecessary risk,” says Mr Chung.

The softening of China’s real estate market in the past five years also means many of these unsanctioned investments, which are in property development, have performed badly. And with sales of state-owned land-use rights accounting for 85% of fund revenues, local governments could be about to witness a key source of revenue dry up, according to a Deutsche Bank report.

According to Moody’s, LGFV debt grew to between Rmb9000bn ($1370bn) and Rmb10,000bn at the end of 2014, double the figure for December 2010. Chinese local government debt, including both administrations’ direct debt and LGFV debt, jumped to Rmb24,000bn from Rmb17,900bn in the 18 months to the end of 2014, according to Fitch Ratings. Alarmingly, local government debt accounted for a chunky 38% of China’s 2014 GDP.

Reforming government finances

In line with a fiscal policy focused on improving local government finances, the Chinese government has announced a series of reforms to rein in local administrations’ ballooning debt, to establish a more efficient debt supervisory system and to improve the efficiency of local governments.

Local governments drive investment in China

On the debt side, the state introduced a cap on local government debt of Rmb16,000bn by the end of 2015 and limited debt to 100% of a local government's GDP.

The Chinese government also set up the municipal bond market with a pilot programme in 2014 to monitor financing more easily and to offer administrations more efficient funding solutions. Local governments can now print bonds directly and are involved first hand in the deployment of proceeds, bypassing the LGFV middleman, which had little to no accountability. The ministry of finance is the key market regulator. “The government realised it could not control local government spending without controlling LGFVs,” says Oliver Barron, head of research at analysis and advisory firm North Square Blue Oak (NSBO) in Beijing.

Regulators are also forcing local administrations to move from cash-based to more sophisticated accrual-based accounting, as is common practice in the US, New Zealand and Australia, to improve poor balance sheet transparency.  

“Local governments will issue municipal bonds to fund projects and will use direct tax income as revenue to service costs. The overall goal is to finally have expenditure, revenue and costs all on the balance sheet,” says Mr Barron.

Muni-bond launch

Only five cities – Dalian, Qingdao, Ningbo, Xiamen and Shenzhen – as well as all 31 Chinese provinces can access the municipality bond market at present. Allowing only the largest local government category – provinces – and some of the most economically sound Chinese cities into the market first is the best way to build investor confidence, say analysts. Pundits expect more local governments to be included in the future, although the Chinese state has made no announcement yet.

Municipal bond issuance in 2015 reached Rmb3800bn – accounting for more than one-third of China’s fixed-income bond market (worth Rmb9200bn as of November 2015). Of the Rmb3800bn, Rmb3200bn was generated by China’s local government debt-swap programme – a further effort to help ease the debt burden.

Launched in 2014, the programme involves local administrations swapping high-yielding LGFV debt for new, cheaper municipal bonds. The programme’s Rmb3200bn size is impressive considering it outpaced Chinese corporate issuance in 2015, which stood at Rmb3000bn. The state is looking to increase the programme to Rmb15,000bn in the next three years, say analysts. NSBO, however, calculated debt swaps need to reach Rmb25,000bn in the next five years to absorb all LGFV debt.

Only some of the least leveraged provinces – Zhejiang, Shandong, Anhui, Guangxi, Xinjiang and Ningxia – refinanced all their outstanding debt due in 2015 through bond issuance (as of October last year). 

Debt sustainability

In addition to volume, the municipal bond market can offer a more sustainable means of funding to local governments. First, these securities are cheaper than LGFV debt. Based on 2015 deals, the spread of municipal bonds was 30 basis points at most over the corresponding Chinese sovereign bond. “It is quite tight,” says Nicholas Zhu, senior analyst at Moody’s in Beijing. By contrast, top-rated LGFV bonds offer between 4% and 4.5% coupons while the 10-year sovereign bond yields below 3%.

Pricing is still a work in progress, but municipal bonds are starting to mirror Chinese provinces’ vastly different economic strengths. As of now, the spread between bonds printed by the developed coastal areas and poorer landlocked, western or north-eastern provinces is 10 to 20 basis points. Analysts expect this divergence to grow as the market develops – to investors’ benefit.

Municipal bonds are also building up the market’s maturity curve. If LGFV notes mainly had three- or five-year tenors due to refinancing pressure, municipal bonds range across three, five, seven and 10 years. Longer maturities avoid an asset-liability mismatch since they cater to local governments’ long-term infrastructure investment.

After initial hiccups, Chinese banks are now happy to arrange and deal in municipal bonds since they offer low risk weighting of 20% (an LGFV bond carries 100% risk weighting) and they qualify for a repurchase agreement with the Chinese central bank. “A low risk weighting means banks can use more capital to invest in other assets to compensate for municipal bonds’ relatively low interest rates,” says Terry Gao, director of international public finance at Fitch Ratings.

Attracting foreign investors

Domestic institutional buyers are driving the municipal bond market, but Chinese regulators are keen to involve foreign investors. The 2015 policy move scrapping pre-approval for foreign central banks, sovereign wealth funds and global financial organisations to trade bonds, interest-rate swaps and conduct repurchase agreements in the mainland was a step in this direction. But if the onshore interbank market opened up more, there would be huge demand from foreign buyers wanting to take advantage of any mispricing, says Mr Barron.

“The scale of the debt swap is such that demand from onshore investors may not be sufficient to meet the substantial increase in government bond supply… a large proportion of local government bonds thus far are held by big commercial banks, and the take-up from other onshore investors has been relatively limited,” said Fitch Ratings in an update last July.

LGFV outstanding bonds

Some international investors will see municipal bonds as a proxy to sovereign mainland China exposure, say analysts. The expansion of China's renminbi-qualified foreign institutional investor scheme and the renminbi’s inclusion in the International Monetary Fund’s Special Drawing Rights currency basket – could increase international investor interest.

But chaos in China’s equity and foreign exchange markets in recent months has dampened investor sentiment. The equity markets floored in mid-2015 and January 2016. In a surprise move, the Chinese government also devalued the renminbi in August 2015 and announced that the currency’s fixing would be based on how the renminbi closes in the previous trading session rather than against the US dollar. 

Other analysts, however, argue the launch of the municipal bond sector will help in this tough moment for Chinese capital markets. “This new development cuts across capital markets development. Given the volatility of equity markets and the subsequent injection of liquidity in the market by the central bank, there is excess liquidity trying to be invested in fixed-income markets. Local government bonds have turned out to be one of the viable options for investors,” says Mr Zhu.

Reinventing LGFVs

So, as LGFV debt gets swapped for municipal bonds and local governments take on infrastructure investments first hand, what will become of LGFVs? Although healthy LGFVs could still contribute to financing public infrastructure, analysts expect them to start focusing on commercial activities instead. 

But not all LGFVs will be successful. There are thousands of them at county or city level but the strongest vehicles are mainly at provincial level. The weakest might be dissolved, while others will either reinvent themselves or be acquired. 

Changchun Urban Development & Investment Holdings is a success story. Formerly a LGFV, it now owns the water pipelines of and builds infrastructure in Changchun – the capital of Jilin province. Leasing the city’s water pipeline from the government and running water utilities generates regular revenue flows. In October 2015, Moody’s assigned a first-time Baa1 issuer rating to this ex-LGFV.

Still more to do 

Despite a growing policy reform kit, it would seem that more needs to be done to improve local government financing and help those administrations most in need. In terms of the debt swap programme, opaque information still puts off global investors, say analysts. How and where exactly the swaps have been done and which LGFVs are being prioritised and why are just some details unavailable to the public. “We do not see actual data breaking down provincial debt so we don’t know which legacy debts have been swapped by the bond proceeds,” says Mr Chung. So far, only the south-western province of Yunnan has disclosed full details of its debt swap programme.

What is more, municipal bonds are now only rated by local ratings agencies. Analysts argue that having an international rating, which implies a more standardised balance sheet disclosure, would attract more foreign investors.

On a more macroeconomic level, local government financing reforms have so far failed to address a core issue: those administrations with the highest expenditure and financing needs (lowest levels of government) still have no access to the municipal bond sector.

Worse yet, recent tax reforms will thin local government revenues further. Starting in 2016, the Chinese central government receives all revenue from stamp duty on stock trading, while local governments were previously assigned 3%. China’s value-added tax (VAT) policy could also be damaging. The ministry of finance plans to replace the existing business tax with VAT on property and construction companies (of 11%) and on financial and consumer-service industries (of 6%). But while business tax revenue was split between central (75%) and local (25%) governments, VAT revenue will be entirely scooped up by the central administration. This will be the case until the central government can effectively monitor local government finances, argue analysts.

Like many policy changes in China’s history, the local government financing reforms are full of contradictions. “The state council keeps talking about passing administrative power down to local governments but we see the central government cutting it. Meanwhile, political power is increasingly centralised in the figure of president Xi Jinping. Which way are we going?” asks Mr Barron. But as is the case with many policy changes in China’s history, awareness and public acceptance of the problem often precede significant change.

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