China's 'rude' attitude to municipal bonds

IFR 2133 14 May to 20 May 2016
6 min read
Jonathan Rogers

THERE WAS A deliciously candid revelation last week into the workings of Britain’s establishment when Queen Elizabeth was caught off-guard complaining that Chinese officials accompanying Xi Jinping and his wife had been “rude” to the British ambassador during their state visit last year. I’m not a monarchist but I have no reason to doubt the veracity of the Queen’s complaint, captured by a television crew’s super-powerful microphone.

Call it rudeness or hauteur – apparently it involved the first couple turning their backs and walking away from the senior diplomat – it’s an attitude that characterises the current Chinese administration.

Xi’s whole state visit was rather like an absolute monarch visiting a constitutional monarch and revelling in the power imbalance. The problem is that this attitude is being made manifest in the Chinese authorities’ handling of the financial markets.

We’ve had the various measures put in place to stem meltdowns in Chinese equities, which have resembled unreconstructed central planning. Alongside this, China’s authorities have paid lip service over the past few years to the concept of market forces playing an increasing role in setting interest rates across the yield curve as well as in the foreign exchange markets.

But it seems the old-style command economy never really went away – and nowhere is this more apparent than in the authorities’ approach to the nascent municipal bond market.

THE HYPE AROUND munis is that the Chinese authorities are targeting a market size of Rmb15trn (US$2.3trn). That would easily outstrip the entire amount of emerging market dollar bonds currently outstanding globally. China’s municipal bond market is set for one hell of an issuance bonanza.

And the reason is that China’s local government funding vehicles (LGFVs) are sitting on a vast pile of debt which the central planners want to be swapped into municipal bonds. The thinking is that this will reduce the threat of systemic risk by disintermediating the debt away from banks, trusts and retail lenders.

The project is urgent. Last August China’s National People’s Congress released data showing that between June 2013 and the end of 2014, local government debt shot up by more than 30% to Rmb24trn, equal to 38% of GDP in 2014.

So, late last year the authorities sanctioned a Rmb3.2trn debt-for-bond swap to take the liquidity pressure off LGFVs. At the same time Rmb2.6trn of muni bonds were approved, a 600% increase in what was raised in China’s municipal market in the previous year.

Much of this was swapped from LGFV loans, with a whopping Rmb11trn still to go, hence the prospect of a gargantuan bond market coming into being pretty much from scratch and moreover in record time. That certainly wasn’t the thinking when China’s muni market was established in 2013 with a puny US$57m-equivalent of issuance.

The massive irony is that far from being a colossal exercise in disintermediation, in fact, the biggest buyers of the newly minted municipal paper have been the big Chinese banks. In what looks like a carefully constructed exercise, the banks have booked muni paper, which by most reckoning is firmly in junk territory but which has somehow managed to get awarded Triple A status by the local ratings agencies.

And the bonds carry a 20% risk weighting rather than the 100% rating assigned to the LGFV loans so – hey presto – the banks’ returns on equity get a handy kicker from booking the new munis.

That return would have been substantially higher had the newly issued municipal bonds been issued with coupons appropriate for low-grade credit. But no, the Triple A rating means these newly transmogrified local government loans have been able to price through the sovereign’s implied curve. Just like magic.

EXCEPT IT’S NOT magic, since this sleight-of-hand from the conjuring book of the central planners has left the banks sitting on capital losses, given that most of the newly issued paper traded below par on the break. The banks are buying this debt at an immediate loss in what begins to look like an act of supreme civic duty.

Or maybe not. Although some of the municipalities issuing are staring at compromised debt service ability given their long-standing reliance on land sales and sunset industries such as coal mining and steel production, the consensus is that, should default loom, the national government will step in with cash injections to head it off at the pass.

There are other developments which might support what looks like an artificially priced market. China’s mutual fund industry is growing at breakneck speed, and if funds accept the credit ratings and implied sovereign support at face value as well as the ultra-low spreads, a somewhat quirky market can grow rapidly. The opening up of the market to qualified offshore institutional investors might add critical mass on the same criteria.

It’s not quite following the script, but then again institutional investors have lived with the sky-high price/earnings ratios of Japanese equities for years thanks to similar structural oddities.

The question really is how much rope the central authorities are willing to extend to local government in this central planning pop-up. The smoke-and-mirrors described above will allow China’s muni market to grow in the short to medium term. But longer term, a systemic crisis that would make America’s mortgage bond meltdown appear small beer may be beckoning.

Jonathan Rogers_ifraweb