China’s biggest banks are loading up on trillions of renminbi of municipal bonds at artificially high prices, in a move that could leave the sector with large underwater exposures to indebted local governments that cannot be offloaded without taking substantial losses.
Amid lacklustre demand from private investors, many of whom have balked at what they see as artificial pricing, support from the banks has enabled municipalities to meet central government targets to switch expensive loans into low-interest bonds.
Beijing has indicated that it wants the municipal bond market to triple to Rmb15trn (US$2.3trn) by the end of 2017, in part to improve the transparency of municipal debt, but also to ensure cheap, long-term financing for local governments. Most of that growth will come from municipalities swapping old loans into new bonds, but a sizeable chunk of issuance will also be fresh debt.
Municipalities did Rmb3.2trn of swaps last year and printed Rmb600bn of new debt. Banks bought the vast majority of that and are expected to support the market further as more debt is issued. Issuance could be Rmb10trn over the next 18 months.
“Banks are going to have to do a lot of heavy lifting given the amount of debt issuance planned,” said Matthew Phan, an analyst at CreditSights. “Commercial banks do without doubt feel an obligation to support government policy, and their participation in the debt swaps and in buying up new issuance is confirmation that they are doing exactly that.”
Inflated prices
But the terms of some of the deals have raised concerns that banks may be buying the bonds at inflated prices. Shanxi, recently ranked as the province with the most risky credit profile by the Economist Intelligence Unit, sold Rmb8.1bn of five-year bonds last month with a coupon of just 2.65% – inside China’s own sovereign bond curve.
Guizhou – the province with the highest public debt-to-GDP ratio, according to China’s National Audit Office – also issued several bond tranches last month within a few basis points of the sovereign yield. The Guizhou and Shanxi deals, like many other municipal bonds, are now trading below par in secondary markets.
Analysts say the bonds are being issued as quasi-sovereign debt, pricing in the assumption that municipalities will be bailed out if they fall into trouble. That is despite Beijing bringing in rules more than a year ago against such bailouts. Standard & Poor’s has said half of the country’s provinces merited junk status; domestic credit ratings agencies have rated all the bonds issued so far as Triple A.
“This is going to put enormous strain on the financial system”
“Severely indebted provinces that are hugely reliant on declining industries, such as coal and steel, have been able to sell bonds at incredibly low rates,” said Christopher Balding, professor of economics at Peking University HSBC Business School. “Some of these bonds are yielding less than Chinese sovereign debt … it doesn’t make sense.”
The low coupons are possible because the banks are under pressure from central government to perform “national service”, but also because the swaps are negotiated privately between local governments and banks keen for ancillary business. Beijing has also placed a cap on coupons, meaning that even debt issued supposedly into the “market” has to price tightly to the sovereign curve – even if fundamentals indicate otherwise.
“This is quasi debt-monetisation,” said Balding. “Getting local government debt under control is the primary thing here; what problems it creates for the banks has always been secondary. This is going to put enormous strain on the financial system.”
Price strains
There have been instances where those price strains have shown: a 10-year bond auction from Liaoning last August went undersubscribed, for example.
But banks have generally kept on buying. Bank of China, the country’s largest, increased its government bond holdings – sovereign and municipal – by Rmb477bn last year to Rmb1.32trn. Industrial and Commercial Bank of China increased its holdings by Rmb421bn to Rmb1.88trn, while Agricultural Bank of China doubled its holdings to Rmb1.42trn.
There is some financial rationale for buying the bonds, apart from keeping a lucrative client happy. Risk weightings on municipal bonds are just 20% (compared with 100% for loans to local governments), so even a much smaller coupon can result in a substantially higher return on equity for a bank because less equity is required.
But falling secondary prices mean that many of these bonds are now bid below par, meaning banks will book a loss if they offload their exposure. Given the size of their holdings, even a small drop in prices could result in huge losses.
A lack of liquidity would also be likely to complicate any attempts to offload exposures. And for Beijing, there is a disincentive to improve the situation: analysts say tempting more investors in would require higher yields, which would bump up refinancing costs for municipalities and trigger a collapse in prices for bonds issued so far.
“There is one big constraint for banks buying these bonds: there is very limited ability to trade them on secondary markets,” said Nicholas Zhu, an analyst at Moody’s. “There is a risk the banking system could get clogged up. Discussions have taken place to improve liquidity but as yet there have been no concrete measures.”
Another risk is that, with a possible Rmb10trn of issuance over the next 18 months, the municipal bond market could sap liquidity from a banking system that is increasingly reliant on borrowings from the People’s Bank of China.
Although many of the swaps involve banks simply rolling old loans into new bonds for the same amount, there could be hundreds of billions of renminbi of fresh issuance too, which would quickly deplete liquidity and could hit other bank lending.
“It is clearly an ambitious project, and one that is important in making local government debt more sustainable,” said Jean-Charles Sambor, Asia-Pacific director at the Institute of International Finance. “But it is hugely reliant on banks being able to buy at levels that support low coupons, and the PBoC continuing to inject liquidity into the banking system to ensure that banks have the funds to buy.”
Sambor warns that the strategy could backfire.
“Banks’ holdings of illiquid municipal bonds purchased at relatively high prices could be detrimental for the health of the banking system over the longer term, especially if reforms to the banking sector are slower than expected and if there is a sharp deterioration in the economy,” he said.
“They could be a significant risk.”
