Sovereign support backs creditworthiness of RLGs

By Jenny Shi Source:Global Times Published: 2015-4-1 18:08:02

Central supervision essential for bond program


Illustration: Chen Xia/GT



China's regional and local governments (RLGs) are becoming significant bond issuers, against the backdrop of ongoing financial reform. Support from the central government is currently the key factor determining their high levels of creditworthiness, even though the government has announced that it would not guarantee RLG bonds.

China's Finance Minister Lou Jiwei said at the Boao Forum for Asia Friday that outstanding RLG debt currently totals 12 trillion ($1.93 trillion) to 13 trillion yuan, exceeding the total for national debt.

Lou also said that the ministry has not yet decided whether it plans a second 1 trillion yuan debt-for-bond swap program in the coming months, but did hint of a possibility, assuming the current program proceeds well.

China announced the initial program on March 8 and said that it was allocating 1 trillion yuan that RLGs could use to convert part of their maturing debt into bonds.

RLGs are now emerging as significant bond issuers during this period of sweeping reform of public finances, and are being encouraged by the central government to borrow directly by issuing bonds to reduce interest burdens, and to extend the maturity of existing debt.

Before January 1, 2015, China had barred its RLGs from deficit spending, which resulted in little RLG bond issuance, except for a small pilot program.

The National People's Congress' newly approved reforms set a 600 billion yuan issuance limit for 2015, up 50 percent from 2014, and marking a significant step in China's efforts to expand RLG bond issuance, which began in 2001 with a limit of just 40 billion yuan.

The 600 billion yuan is split between 500 billion yuan for general-obligation bonds and 100 billion yuan for special-purpose bonds tied to specific projects. China is encouraging its RLGs to borrow directly from the capital markets to reduce their reliance on opaque borrowings through third parties, such as local government financing vehicles (LGFVs), which mainly raise money by taking bank loans.

Because average funding costs for LGFVs are 200 to 300 basis points above benchmark loan rates, which still exceed bond coupon rates by about 200 basis points, the reform will significantly reduce the RLGs' debt-service burdens.

In view of the deepening reform of public finance in China, a new market-driven RLG bond market - with a rapidly expanding scale - will be established, and huge investment opportunities for both commercial banks and other enterprises will emerge.

During the process, challenges will persist, requiring the authorities to increase the sector's transparency and enhance the regulatory framework. We noted that Finance Minister Lou also said last Friday that the central government will not bail out RLGs that cannot repay their debt.

Following Lou's words, the central government is, however, expected to protect the RLG bond market by correcting RLG liquidity problems before a default occurs, thereby accomplishing the central government's stated goal of not bailing out RLGs, while eliminating contagion risk.

The central government's ability to avert an RLG default is enhanced by its power to directly intervene in RLG operations. For instance, it has the power to force RLGs to sell assets belonging to State-owned enterprises, in the event of debt repayment difficulties.

In the longer run, China could follow a managed pathway similar to Japan, with the central government extending support in some form to RLGs. Alternatively, it could follow a more free-market approach similar to the US, where insolvent local governments generally declare bankruptcy, and either liquidate or reorganize with debt-repayment plans. A third way or a Chinese model could also emerge, assuming some characteristics of both approaches.

Currently, in terms of creditworthiness, our credit analysis indicates that upper-tier RLGs could display robust characteristics because of their close ties with the sovereign.

Such features suggest that the RLGs would, in turn, exhibit ratings - if they were rated - in a tight range, and that the weakest of this group would be rated at most only two notches lower than China's sovereign rating of Aa3.

On the RLG bond market specifically - which is limited to upper-tier RLGs - the central government will pre-empt any RLG default to protect the nascent market. Therefore, as indicated, central government support is the dominant factor in our assessment of the creditworthiness of upper-tier RLGs. The strength of such support outweighs the RLGs' own idiosyncratic credit profiles.

The author is managing director and China country manager with the global credit rating agency Moody's Investors Service. bizopinion@globaltimes.com.cn

  

Posted in: Comments

blog comments powered by Disqus