Are you an optimist or a pessimist? These days, news about China seems to be mainly good or mainly bad. The market and media response to China’s local-government debt swap programme shows why maintaining a balanced view is essential.
The programme allows cash-strapped local governments to begin refinancing debt—which is currently held mainly in the form of bank loans—with bonds. There are a number of advantages to municipalities in refinancing: extending maturities of their debt, lowering overall borrowing costs and diversifying funding sources. From bank lenders’ perspectives, it will reduce repayment risks, free up room on balance sheets and allow more liquidity into the system.
Many commentators initially greeted the programme as a form of quantitative easing (QE), because they assumed that the new bonds would be bought by the central government or its agencies. Optimists saw QE as potentially supportive to the Chinese economy; pessimists took it as confirmation that local governments’ finances were indeed in bad shape.
But we disagree with the QE hypothesis altogether. We think that China’s fiscal problems are overstated. And we think that too little attention is being paid to the positive market implications of the programme itself.
Putting the Squeeze on Municipalities
One problem with analyzing China’s fiscal position is that the country’s budget figures can be misleading. It’s safe to say, however, that local governments overall have been in much worse shape financially than the central government.
One reason is the share of revenues raised by local governments that is taken by the central government—75% of value-added tax and 60% of corporate income tax, for example. Another reason is the sheer volume of infrastructure projects initiated by the central government since 2007 but financed at the local level, mainly through local government finance vehicles (LGFVs) and land sales.
In other words, local governments have fallen between a rock and a hard place.
But the central government has recently introduced reforms to address the issue. Last year, it passed a law to allow local governments to retain more of their tax revenues, and it put an end to their use of off-balance-sheet LGFVs in favor of using the bond market.
China’s Municipal Market to Double Swiftly
The debt swap programme will facilitate this process by swapping RMB1 trillion (US$161 billion) of maturing LGFV debt of mostly three to four years’ maturity into longer-term municipal bonds (10 years and longer).
And this is where things get interesting. While the swap programme is clearly beneficial to local governments, if banks were expected to simply exchange loans for bonds on their balance sheets and then hold onto the bonds, there would be no effect on the overall financial system.
For this reason—and as part of its broader policy objective of developing the domestic capital markets and making its economy more market-oriented—China’s central government is working towards broadening and deepening the investorbase of the municipal bond market. In time, the investor base will include national social security funds, pension funds, mutual funds and foreign investors, as well as banks.
Just as importantly, the market will grow. As with the introduction of the offshore renminbi and the Shanghai Hong Kong Stock Connect project, China tends to introduce a reform, implement it in a provisional format, and then roll it out further once big-picture ramifications have been considered. We think the Chinese municipal bond market will follow a similar pattern, with the potential for rapid growth. We expect issuance to double to around US$300 billion by the end of 2016.
From our perspective, China’s local government debt swap programme looks less like an enforced fiscal Band-Aid and more like an important milestone in long-term structural reform, and nothing less than a new asset category for global capital markets.