* State Council issues regulations on municipal bonds
* Central govt will not bail out local debt
* Analysts see Rmb1trn of muni bond sales in 2015
By Lianting Tu
SINGAPORE, Oct 8 (IFR) - China has taken a big step towards the resolution of its mounting local government debt burden with the introduction of a legal framework allowing cities and provinces to issue debt directly.
Last week’s regulations make it clear that the central government will not bail out local obligations, a key step in creating a municipal bond market that analysts expect will reach Rmb1trn (US$164bn) of new issues in 2015.
“The amendment to the budget law provided the necessary legal foundation to develop the municipal bond market in China,” said Julia Wang, a Hong Kong-based economist at HSBC.
“The State Council directive is an important step toward clarifying where liabilities ultimately lie.”
China amended the budget law in August to allow local governments to issue debt, and a Rmb109bn pilot scheme involving 10 municipal and provincial issuers has been in place since May.
Last week’s regulations from the State Council provide further details on eligible borrowers, the use of proceeds and the fate of existing local government borrowings.
New debt must be raised directly by local governments - namely provinces and special administrative regions - and not through associated companies.
Proceeds can finance public projects that generate no income, such as parks and schools, and projects with defined income streams, such as toll roads. Municipalities cannot, however, use bonds to cover routine expenditures such as staff salaries.
Under previous rules, municipalities either needed the Ministry of Finance to issue debt on their behalf, or had to resort to indirect financing platforms, so-called local government funding vehicles (LGFVs), to circumvent restrictions on direct borrowings.
The arms-length arrangement means it is often unclear if the government is legally responsible for servicing the LGFV’s debt, even though investors assume their bonds are protected by an implicit government guarantee. No local government issuer has yet defaulted on a bond.
That approach, however, has led to an unregulated build-up in local government liabilities, particularly in recent years as municipalities borrowed heavily to maintain economic growth.
Investment accounts for about 40% of China’s GDP, and there are concerns that heavy spending on inefficient projects has left local governments burdened with unsustainable debts that ultimately will become central government liabilities.
As of June 30 2013, China’s local governments were directly responsible for Rmb10.9trn (US$1.8trn) of outstanding debt, raised off balance sheet through various platforms including LGFVs.
However, after factoring in contingent liabilities, such as the obligations of municipal-owned enterprises, total debt reached Rmb17.9trn, according to data from China’s National Audit Office. Financing raised through LGFVs accounted for almost 40% of total debt.
“Investments are very important for China’s economic growth. The new regulations are intended to discipline local governments into financing their investments in a more sustainable manner,” HBSC’s Wang said.
In a bid to deal with the existing debt, the central government is now going through a screening process to identify which LGFV debts have full local government support, which ones are contingent liabilities for local governments and which ones don’t carry any support.
The new framework paves the way for debt swaps and restructuring of existing local government debt, and should improve local governments’ financial sustainability and reduce overall systematic risk in China’s economy and financial system, economists at UBS wrote in an October 8 research note.
Terry Gao, Hong Kong-based director for international public finance at Fitch Ratings, also welcomed the measures.
“There are three points that are progressive in the latest reform. The first is the central government said for the first time that they will not bail out the local governments’s debts,” he said.
Second on Gao’s list is the central government’s roadmap to solve the existing local government debt problem, and third the accountability of local government officials for their debt and leverage management.
“Previously the key metrics to gauge the performance of local government officials was the local GDP growth. But now they will need to balance their investment and funding decisions,” Gao said.
The State Council’s pledge not to bail out local debts will mean that investors reward the healthier provincial and municipal governments with lower funding costs.
“The new regulations are also trying to reinforce the idea that the government will not assume all liabilities indiscriminately,” said Wang.
“Local governments should meet their share of the liabilities. Beyond that, the government’s role is in supervision and maintaining systematic stability.”
Analysts do not expect municipalities to turn to the bond market this year, as this year’s Rmb109.2bn quota for municipal bond issuance, set when the pilot scheme was announced in May, is unlikely to change.
UBS, however, expects as much as Rmb1trn (US$163bn) of new muni bonds may be issued to fill the financing gap in 2015.
“Separately, the swapping of old local government debt with new bonds will likely be gradual as it will take time to examine and regroup the old debt stock and for the new local bond market to develop,” UBS analysts said in the October 8 note. (Reporting by Lianting Tu; Editing by Daniel Stanton and Steve Garton.)