* Strong demand for first direct local debt sale
* Bodes well for coming Guangdong, Zhejiang, Shenzhen bonds
* Part of efforts to bring discipline to local borrowing
* China still testing waters for genuine municipal bonds
* Municipal bonds will come earliest in March next year
By Lu Jianxin and Jason Subler
SHANGHAI, Nov 15 (Reuters) - Shanghai became the first local government in China to sell bonds directly to investors on Tuesday, in a step aimed at preventing a repeat of the $1.5 trillion in municipal debt that now poses a threat to the economy.
The city issued 7.1 billion yuan ($1.1 billion) in bonds under a pilot programme Beijing hopes will lead to a municipal government debt market and prevent the frenzied borrowing in recent years that set off alarm bells at ratings agencies.
Municipal authorities are barred under law from borrowing directly from markets but amassed a mountain of debt via financing vehicles to fund infrastructure projects in response to Beijing’s stimulus package during the global financial crisis.
“This is an important step towards more market-oriented fund-raising by local governments,” said Li Jieming, a bond analyst at Sealand Securities in Shenzhen.
Local governments accumulated 10.7 trillion yuan in debt as of the end of 2010. The government expects as much as 3.5 trillion yuan to turn sour, while Standard & Poor’s reckons it could be as much as 9 trillion yuan, raising concerns about defaults and their potential impact on the banking system.
Chinese authorities have repeatedly tried to assure investors that the debt is manageable.
Analysts said a municipal bond market will force more discipline on borrowers and so help prevent the risky buildup of debt weighing on the economy now.
By having to go to the market directly and disclose their own budgets, local governments’ borrowing and investments in infrastructure will become more transparent and regulated by market forces, they said.
Foreign banks that are allowed to participate in the Chinese interbank bond market are allowed to buy the local debt, bankers said. But their are participation in China’s bond markets is modest, so purchases of municipal debt is expected to remain minimal for now.
The Shanghai auctions will be followed by similar sales by the southern province of Guangdong on Friday, the eastern province of Zhejiang on Monday and the boomtown of Shenzhen sometime soon.
“As is characteristic of Chinese reforms, the government may want a few more tests for local governments from less prosperous regions to issue bonds by themselves before the launch of real municipal bonds. It will take at least a few more months,” Li said.
Shanghai auctioned 3.6 billion yuan ($568 million) in three-year bonds at a yield of 3.10 percent and 3.5 billion yuan in five-year bonds at 3.30 percent, bond traders said.
Reflecting strong demand for the offer, the yields were significantly lower than 3.67 percent and 3.70 percent, respectively, for similar tenors of bonds that the Ministry of Finance auctioned on behalf of local governments in late October.
“The strong demand implies that coming issues by other local governments will also be well received,” said a trader at a Chinese commercial bank in Shenzhen.
“It is a strong indication that recent worries over possible default by LGFVs have eased greatly amid repeated central government pledges to ensure a proper solution.”
While Shanghai conducted the auction, the Ministry of Finance is a guarantor for the debt and will carry out the payment of interest and principal to ensure the sale was conducted within the law.
City and municipal governments have not been able to borrow directly from markets since the People’s Republic of China was formed in 1949.
The sale was also within the central government’s existing 200 billion yuan quota for local government bond issues this year, which to date have been conducted by the finance ministry on behalf of local governments.
Local government have borrowed via financing vehicles for years to avoid Beijing’s quota.
The pilot programme will give local governments experience to operate in a genuine municipal bond market, in which the local governments would obtain credit ratings in the absence of a guarantor.
That process, which Reuters reported in May was on the cards as part of plans to clean up the local government debt mess, could take some time.
The government would also need to ensure that it instituted other reforms along with the launch of a muni bond market, Hao Zhou, China economist with Australia and New Zealand Bank in Shanghai, said.
These should include ensuring that local governments did not use their influence to push local financial institutions to buy their debt, which could once again lead to a risky buildup in debt.
“It’s a positive move, but China still needs to carry out more structural reform to make sure that the local government bonds will be more like municipal bonds in the U.S. market. There’s still a long way to go,” said Hao.
