China takes another step toward municipal borrowing

April 24, 2014

Last January, when I made my predictions for 2014, I wrote:

The biggest muniland story this year will be the development of the Chinese municipal bond market. It’s not often that you get to watch a government launch a bond market. And China’s will be massive. From the South China Morning Post:

The [Chinese] mainland’s quest to solve its $3 trillion-and-growing public debt problem by starting a domestic municipal bond market hinges on the one thing officials are most afraid of: transparency.

As markets absorb the results of the latest audit of state finances, Beijing’s long-standing vow to develop a municipal bond market to curtail rapid growth in other types of hidden public debt will take centre stage once more.

Now the Chinese State Council is poised to take the next step in approving guidelines that mean local governments will be allowed to issue debt. reports:

State Council would set quota system on debt, but only under strict conditions.

China may allow local governments to sell municipal bonds under narrow parameters in a move to regulate their borrowing and reduce systemic risk.

Qualified provincial-level governments that win approval from the State Council, the country’s cabinet, will be able to raise some of the funds needed for construction projects through bonds, if a draft amendment to the Budget Law is approved by the top legislature.

The draft amendment, which was submitted on Monday to the National People’s Congress Standing Committee, sets strict conditions for such debt issues.

The scale of any debt issue must be within the quotas approved by the NPC as well as local legislatures. Debt proposals will only be approved if there is a stable revenue stream to cover repayments, and proceeds of such issues can’t be used for current expenditures.

Except under these conditions, local governments may not issue bonds or provide a guaranty to any institution or individual.

The U.S. government, of course, does not set limits on the amount of debt that state and local governments can issue. And more importantly, the U.S. government does not verify that bond issuers have sufficient cash flow to repay debt, not does it bar issuers from borrowing to fund current expenses. If China adopts the legislation as described, it will have a more restrictive muniland framework than the U.S., which might be a good thing.

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It’s the first time for the nation to formulate explicit rules and supervisory principles for local government bond sales.

The current Budget Law, which is some two decades old, bars most debt issues by local governments.

But governments at all levels have managed to raise funds in recent years through bank loans or via local government financing vehicles [LGFVs] to pay for a plethora of infrastructure projects.

A survey by the National Audit Office found that as of June 30, 2013, local government debt and contingent liabilities surged to about 17.89 trillion yuan ($2.9 trillion), a 67 percent rise from the previous estimate of 10.7 trillion yuan at the end of 2010.

Much of this debt, especially that raised through LGFVs, poses a systemic risk because of its opacity, said Liu Jianwen, head of the Fiscal and Economic Law Research Center at Peking University.

Liu said Monday’s draft marks a breakthrough in that it establishes detailed procedures and criteria for local government bond sales.

‘Since local government bond sales have become a prominent issue, it is wiser to regulate them than to ignore them,’ he said.

I’m not in favor of the U.S. federal government regulating local government bond issuance, but states have an important role to play in monitoring local government liabilities. As bank loans to state and local governments increase in volume, America may be unknowingly creating the problem that China is trying fix. It’s critical that municipal issuers that take bank loans and other off-balance sheet financing disclose this to taxpayers, bondholders and rating agencies.

Let’s keep an eye on how China builds its local government financing channels. There may be lessons for us.

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