Pursuing Lasting Progress in Emerging Markets

Prevailing Winds Fixing China’s Municipal Bond Market

June 14, 2018

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market. Learn more about Prevailing Winds.

The rapid growth of local government debt in China is a potential threat to the country’s financial stability. At the root of the debt problem is a severe fiscal imbalance that is driven by domestic politics. Local governments are responsible for the majority of total government expenditures but receive less than half of revenues. While the central government transfers back some of the funds it collects to the local governments, it is not enough to cover the ever-growing fiscal demands placed on these governments. Rebalancing the distribution of revenues is deeply political as it means a loss of power and control for the central government relative to the local governments.1 Figure 1 shows the difference between local government expenditures and revenues as a percentage of total government revenues and expenditures, and highlights the persistently large fiscal gap facing local governments.

Figure 1. Chinese Local Governments’ Share of Revenues & Expenditures As a % of Total Government Revenues and Expenditures

Average Gap is based on the average of the annual difference between local expenditures and revenues as a percentage of total government revenues and expenditures, excluding central government transfers, from 2008 - 2016.
Sources: WIND, Seafarer.

Local governments have historically been prohibited from direct borrowing. To offset the financing gap, local governments have resorted to a variety of indirect methods for raising funds. The most notorious of these was the proliferation of Local Government Financing Vehicles (LGFVs) after the global financial crisis. LGFVs are special purpose vehicles that borrow funds on behalf of local governments to finance projects ranging from infrastructure to real estate development. Much of the borrowing took place through relatively short-term bank loans. LGFVs were able to rack up an enormous amount of debt in a short period of time due to the implicit guarantees they received from the local governments that sponsored them.

As LGFVs’ debts grew to unsustainable levels, the central government stepped in and took action. In 2013, a nationwide audit of local government debts was conducted. Many were shocked and concerned to learn that local governments had accumulated nearly 18 trillion renminbi (RMB) in debt, equivalent to around one-third of China’s gross domestic product (GDP).2 While Chinese central government debt has historically been quite low, adding in the newly disclosed local debt revealed a much higher level of indebtedness across the government as a whole.

New rules implemented by China’s central government after the audit restricted the amount of borrowing through LGFVs and prohibited local governments from providing bailouts to LGFVs in default. Since then, there has been a continuous stream of new regulations from the center designed to limit the level of local government indebtedness. Local governments, for their part, have found new and creative ways to borrow that skirt these regulations.

Given that China’s ongoing fiscal imbalance has not been resolved, local governments will continue to borrow to offset the financing gap. In order to reduce the risks from this borrowing, local governments need access to more sustainable financing channels. In 2014, the central government began a pilot program to allow local governments to directly issue debt. The following year, a swap program was created that allowed local governments to issue bonds and use the proceeds to retire bank debt. As of the end of 2017, almost 11 trillion RMB in bank loans had been swapped into bonds.3 The number of local governments allowed to participate in bond issuances has expanded in recent years, leading to the creation of a large municipal bond market in China, as shown in Figure 2.

Figure 2. Chinese Local Government Bonds Outstanding May 1, 2015 – April 30, 2018

Data is monthly for the date range specified. Note that calendar years are based on an 11-month year, with December data excluded and aggregated with data for January of the following year.
Sources: WIND, Seafarer.

The creation of a municipal bond market is a welcome development as it provides a mechanism for reducing interest costs and extending debt maturities. This is necessary because many of the projects financed by local governments, such as infrastructure investment, can take significant periods of time to produce returns. A typical example is a local government financing the construction of a subway system. The benefits from such a system can be enormous – increased productivity, higher economic growth, and property development near the subway stations. These benefits, however, will be hard to measure, especially in the short-term, and the government financing the project may only ever realize indirect financial returns (such as higher tax revenues in the future). Financing these types of infrastructure projects with relatively short-term bonds presents a significant maturity mismatch. Local governments using short-term financing for long-term projects face constant pressure to rollover their debts.

Unfortunately, China’s local government bond market still has a way to go in terms of serving as an efficient form of long-term financing. The tenor on bonds has been very short, with an average maturity of around 7 years and a maximum maturity of 10 years.4 Compare this to the U.S. municipal bond market, which has an average maturity of over 17 years.5 Figure 3 shows the distribution of Chinese local government bonds by maturity.

Figure 3. Maturity Distribution of Chinese Local Government Bonds

As of May 31, 2018.
Source: WIND.

The Ministry of Finance recently issued new rules permitting longer maturities for local government bonds. Local government bonds and special purpose infrastructure bonds can now be issued with maturities of between 15 and 20 years. These new measures should help ease some of the rollover risk faced by China’s local governments.

China’s local government debt problems are far from solved. There are still significant amounts of off-balance sheet debt, often hidden through the guise of public-private partnerships and LGFVs with implicit guarantees from local governments. However, it is important to recognize that real progress is being made in the development of a viable local government bond market. China’s local governments may still be borrowing too much, but the borrowing is increasingly in a more sustainable form.

Nicholas Borst Seafarer Capital Partners, LLC

    The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

    1. Much of the central government’s position is a reaction to a time in the 1980s and early 1990s when fiscal revenues were imbalanced in favor of local governments. The lack of revenues left the central government hamstrung to meet its priorities. A fiscal reorganization in 1994 shifted the balance back towards the central government.
    2. Aileen Wang, Koh Gui Qing, “China $3 Trillion Local Government Debt Stirs Alarm,” Reuters, 30 December 2013.
    3. Chen Jia, “Local Government Debt To Be Swapped,” China Daily, 01 January 2018.
    4. WIND. As of 30 May 2018.
    5. US Municipal Issuance,” SIFMA, 30 May 2018.