Understanding China: infrastructure financing and bond issuance
- Over the last 20 years China has spent around 10% of GDP a year on infrastructure spending (versus an average of 3-4% in other developing countries and 2% in developed countries).¹
- Urbanisation in China required the housing of 500 million new residents in China’s cities between 1980 and 2010. Not only have these people been accomodated but significant improvements have been made to basic infrastructure. Access to piped water has doubled in three decades, waste water treatment rose from almost none in 1981 to 84% by 2011.¹ During the same period road service per capita was multiplied by seven.
- Local governments in China take almost exclusive responsibility for urban infrastructure investments and financing. In 2011 China invested the equivalent of 12.5% of GDP in fixed assets for public utilities, infrastructure and facilities. More than 80% of this was sponsored by local governments and their entities.¹
- In this article we explain how local governments in China finance their infrastructure spending as well as the measures being implemented to improve credit differentiation among local government bond issuers.
How do local governments in China access funding ?
China’s Budget Law² imposes strict restrictions on the borrowing powers of local governments. To circumvent this law, local governments have set up around 10,000 Local Government Financing Vehicles (LGFVs) to issue debt and finance infrastructure investment. Local government borrowing rose sharply to finance stimulus packages in the wake of the 2008 financial crisis. By the end of June 2013 the explicit debt load of local governments amounted to RMB 10.9 trillion; local government guaranteed debts, RMB 2.67 trillion; and other contingent debts, RMB 4.3 trillion, with the total around 33% of GDP.
The first LGFV bond was issued in 1992 to raise funds for the development of the Shanghai Pudong district, as supported by the Shanghai government. For a long time, LGFV bonds have been regarded as risk-free instruments with quasi-sovereign status within China’s economic and political system. However, many LGFVs are making losses and might take years to generate investment returns. With limited profitability, many of them have relied heavily on local government support such as subsidy policies. Although LGFV bonds have been supported by the government, this does not necessarily equate to cast iron government guarantees. The poor financial metrics of LGFVs necessarily raise the risk of default risk.
In many ways the development of LGFVs and accumulation of local debts can be seen as part of a “transitional period” from the traditional planned economy to market economy. As reforms to modernize China have led to a decentralising of power from the central government to local governments the later have slowly became administrative and economic units.
Local governments have however tended to opt for a role of “unlimited government” rather than supplementing the market. This is the root cause of the boom in LGFVs and accumulation of debts. Local governments will have to evolve toward the provision of social and public services and abandon their ambitions of an unlimited role for local government in regional development projects.
What is the central government doing to improve management of local government debt burdens?
In October 2014, China’s State Council issued Guofa  No.43, aimed at establishing a standard for the management of local government debt. The document outlines the procedures governing borrowing by local government entities and the solutions for repaying maturing debt. Subsequently, the Ministry of Finance issued a document specifying both the debt repayment process and the principles for local government to apply when screening repayable debt. The yield of LGFV bonds fell to “historic lows” in the secondary market after the issuance of No.43.
In December, 2014, China’s Securities Depository and Clearing Co., Ltd. (CSDC) released a “Circular” document stating that new applications for the use of corporate bonds in bond repo business would not be accepted. Henceforth, said the CSDC, only corporate bonds rated ‘AAA’ or issued by firms with a rating of at least ‘AA’ above could be used for bond repo business.
The release of the document by CSDC triggered a stark differentiation in the yields of different types of LGFV bonds. The credit spread of interbank ‘AA’ rated LGFV bonds rose above those of industrial bonds with the same maturity for the first time since August 2014. Through this yield adjustment, the yields of some LGFV bonds have started to reflect more adequately the liquidity risk that results from their disqualification from the bond repo market. By excluding lower grade bonds from use in repo (bond repurchase contracts) they are potentially less attractive to buyers reducing their liquidity and increasing the risk of holding such bonds. This inevitably reduces demand for these bonds and puts upward pressure on their yields.
Since 2014, industrial bonds, particularly private bonds have started to exhibit credit differentiation following a series of credit risk events. In comparison, LGFV bonds remained unaffected. The No.43 document urged local government bodies to screen and clear debts, and the “Circular” tightened up conditions for financing corporate bond repurchase pledges. Both measures led to a greater credit differentiation within LGFV bonds. With the first peak payments due in 2015 and reinforcement of government screening, the question of whether LGFV bonds should be considered general government debt will be critical. Under the new regulations, the bond market would be closer aligned to a market-based pricing system with better credit differentiation and classification by yield.
What are the latest developments? How is the situation likely to evolve?
In early March 2015, an officer of the Ministry of Finance stated that, “Subject to approval by the State Council, the Ministry of Finance has recently issued 1 trillion yuan³ in local government bonds to replace part of the existing debt, allowing local governments to convert maturing high-cost debt into lower-yielding municipal notes to be repaid at a future date.” The replacement bonds are issued by local government to fund repayments of the debt maturing in 2015. The total amount of bonds to be issued accounts for 53.8% of the maturing government debts.³
The impact of this solution on the bond market can be viewed in two ways. On one hand, the replacement of debt could reduce the systematic risk associated with repayments of the LGFV bonds, thereby increasing the market’s appetite for and tolerance of risk. On the other hand, issuing bonds with benchmark interest rates as a replacement for the high yield bonds and extending maturity dates, puts stress on the supply side of bond markets. In addition, some regulatory agencies have recently started to relax approval conditions for newly-issued LGFV bonds, without violating No.43.
Finally, it’s likely that the supply of LGFV bonds will recover from the decline that’s occurred since application of the strict new policy on bond issuance. Nonetheless, worries about the status of LGFV bonds remain apparent among investors, despite the bond replacement solution. This is due to the fact that the process for screening local government debt still has to be determined and the process by which some bonds will obtain quasi-government status is unclear.
1. ‘Urban China: Toward Efficient, Inclusive, and Sustainable Urbanization’, 2014 by the The World Bank and Development Research Center (DRC) of the State Council of China
2. In the early 1990s local governments engaged in a period of excessive spending on infrastructure investments financed by banking lending and bond issuance. This triggered a bout of nationwide inflation. In response China’s central government passed a draconian budget law in 1994, prohibiting local governments from running deficits or issuing bonds.
3. Source: Wind, HFT, April 2015
4. Source: HFT, April 2015