China hopes to finance infrastructure development with a fresh wave of local government debt to bolster the country's slowing economy, but it also wants potential investors to pay closer attention to the underlying risks.
The People’s Bank of China outlined what some of these risks are in its China Financial Stability Report last week, shortly after the State Council announced a directive aimed at boosting the delivery of new infrastructure with a series of policy recommendations.
Among the recommendations is that local governments should strengthen the management of special purpose bonds to ensure that funds raised are actually spent on projects under construction.
Using local government bonds to fund Chinese infrastructure investment is hardly new – that is how it has always tended to be done. The context is different though.
New bond issuance by local governments has been squeezed this year by the central government's deleveraging campaign, Xia Le, Hong Kong-based chief economist for Asia at BBVA, told AsianInvestor. But now, with exports beginning to suffer due to the intensifying US trade war, Beijing is keen to reverse tack to reduce the chances of any infrastructure drag on GDP growth, he said.
China's economy grew by 6.5% in the third quarter, the weakest year-on-year pace since the first quarter of 2009. Still worse, infrastructure investment grew by 3.3% in the first nine months in 2018 compared with the same period last year.
The government has been releasing liquidity into the market by easing monetary policy, including cuts in banks' reserve requirements, and by encouraging investors to buy infrastructure bonds. So demand should pick up and, overall, there should be more issuance in the coming months, Xia said.
In fact, local governments were ordered in August to issue more than Rmb1 trillion ($144 billion) in special purpose bonds to meet a Rmb1.35 trillion quota by end of October. Such bonds are tailor-made local government debt for funding infrastructure projects.
Investors comprise mainly Chinese commercial banks, although Chinese insurance companies are increasingly participating as well. PICC Group, for example, said in August that it was eyeing local government debt to lengthen asset duration.
Outstanding Chinese local government bonds totalled Rmb16.47 trillion at the end of 2017, of which Rmb6.14 trillion was made up of special purpose bonds, according to the central bank’s report.
Investors have become more interested in local government bonds after a new rule introduced this year ensured they would be adequately compensated for the market risks involved, Terry Gao, senior director for international public finance at Fitch Ratings, told AsianInvestor.
Previously, local government bonds were often sold at very low yields, even lower than central government bonds, partly because the investors who did participate – Chinese commercial banks in the main – wanted to build a good relationship with local governments.
With the yields so low, fewer investors were willing to invest in them, he said.
The Ministry of Finance stipulated in late August that the yield of local government bonds has to be at least 40 basis points higher than the average yield on Chinese government bonds in the five days before the bonds go on sale.
While Beijing is keen to encourage infrastructure investments, the Chinese central bank has also gone to some lengths to emphasise the potential credit and duration mismatch risks that go with asset class.
In 2015, local governments were ordered to report bond issuance in their budgets and keep issuance within a quota. As such, some local governments were incentivised to conduct illegal financing and some financial institutions were willing to take the initiative to make loans and provide finance through shadow banking, the Chinese central bank said in its report on Friday.
Some governments raised funds through indirect means such as third-party financing vehicles, public-private partnerships or development funds. These off-balance sheet items, or hidden debts, have unclear and potentially higher risks but are growing rapidly, according to the report.
That is partly because most financial institutions in China suffer from what the report, using quotation marks, called the “government credit illusion” – the idea that the local government must be able to repay the debt since it is supported by fiscal revenues.
There are higher duration mismatch risks too. Local government bonds mainly invest in medium-to-long-term infrastructure projects, which have long cycles with returns that may not be guaranteed and are only paid after a long time. But the bonds themselves are usually more short-term in nature, which means the debt needs to be rolled over to keep projects going, according to the report.
As result, it said the government planned to closely monitor and control the issuance of hidden debt, rein in shadow banking, and strengthen the auditing and accounting of local governments.