The reform of China’s local government finances is creating an opportunity out of a crisis. After years of debt-fuelled expansion, the country’s provinces and municipalities are now turning to the capital markets to consolidate their borrowings and finance future spending, presenting investors with an opportunity to diversify and underwriters with a growing revenue stream.
This is a big step in the right direction, but it is no free ride. Market participants will need to tread carefully if they are to avoid the many potential pitfalls ahead.
China’s local government borrowing has been a source of much concern in recent years, amid fears that a slowing economy may challenge Beijing’s ability to support its free-spending provinces.
Measured at Rmb10.7trn (US$1.7trn) in the first national audit at the end of 2010, local government obligations had ballooned to Rmb24trn by the end of 2014, comprising Rmb15.4trn of direct debt and Rmb8.6trn of contingent liabilities.
Such huge numbers alone make the debt cleanup a near impossible task, but on top of that is China’s need for continued capital investment to prevent an economic slowdown.
The global capital markets can play a role in supporting that investment cycle, but international investors will need to be sure they are not being suckered in as a last resort, taking up the slack as onshore appetite cools.
Investors can no longer assume Chinese credit is risk-free, with the roster of corporate defaults growing steadily both onshore and offshore. Even state-owned enterprises have fallen behind on domestic debt payments, raising questions over the central government’s willingness to stand behind a failing provincial bond.
The central authorities have had to sweeten the deal to persuade domestic investors to take part in a giant debt swap, allowing banks to use the securities as repo collateral. Some smaller provinces struggled to meet their funding targets in the first round of direct municipal issues.
Strong onshore liquidity has helped the local governments, and offshore investors have so far been happy to follow suit. Those that take part, however, need to be comfortable assessing risks across very different provinces, and with credit ratings that can vary markedly between different providers.
IFR’s China Municipal Funding Roundtable brought together a panel of market participants in October to debate these and other themes affecting overseas issuance from the country’s provinces and municipalities. The panel left in no doubt that the revamp of China’s public sector finances is creating opportunities for the capital markets, but perhaps with a heightened sense of the challenges involved.
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