Should China build a muni market?

October 22, 2013

Reuters reported on the possibility that China’s government will take the next step in building a municipal bond market. It seems that local governments in China have accumulated a lot of debt and it needs to moved off their books. From Reuters:

China may decide next month to expand a trial program allowing local governments to sell bonds, in response to concerns that their huge borrowings are largely hidden from view and pose a risk to the stability of the nation’s financial system.

How big is this debt?

Local government debt totals up to $4 trillion or 42 percent of gross domestic product, according to some unofficial estimates, but much of it has been raised via financing vehicles that do not disclose details on the size and health of loans.

The U.S. market is about 23 percent of GDP, or $3.7 trillion. So the amount of local debt in China exceeds the U.S., and it’s not even fully disclosed, structured or regulated? Did the Chinese government really not know this massive borrowing was happening? The government wanted massive fiscal stimulus after the 2008 financial crisis.

Chinese law bans local governments from selling debt directly in a measure that was meant to restrain their borrowings, but local officials have skirted it by raising debt through financing vehicles to fund infrastructure projects.

Borrowing through so-called local government financing vehicles (LGFV) exploded in 2008-09, when China pumped 4 trillion yuan ($656 billion) in stimulus spending through the economy to cushion the impact of the global financial crisis.

Now China may have about $4 trillion of local market debt that it wants to securitize. Where to start? Here is my checklist for the Chinese State Council about how to create a strong and stable municipal bond market.

  1. Standardize the meaning of terms used in the bond market. Publish these terms online in a glossary or dictionary the way the MSRB has done for the U.S. market.
  2. Create a securities numbering system that is free to all market participants. One of the largest chokeholds on the development of the U.S. municipal bond market is the substantial fees required to license the CUSIP identification system.
  3. Create a standard form for bond market documents. Use a form that is mostly check off boxes and has the least amount of free text as possible. Require that all extant documents are converted to the new forms. Create a method for the judiciary to resolve differences between original and converted documents.
  4. Create a central repository for these documents and make it available to the general public, like the U.S. MSRB’s EMMA system.
  5. Mandate that local governments (or other quasi-public issuers) that have outstanding bonds disclose information about their financial condition on an ongoing basis. Information about events that are related to the issuer or their bonds like bond calls or defaults could be filed in online repository.
  6. Create a structure to report all bond trades in a central location. Use MSRB’s EMMA as a template to do this.

This is a massive undertaking and not one that should be done lightly. Securitizing $4 trillion of local government debt is not going to be easy. But like the U.S. market, China’s government could develop a place for the Chinese people to store their savings, create transparency about local government finances and create a foundation for an effectively regulated market. Good luck to the Chinese State Council.

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