Will municipal bonds save China's urbanization plan?
Increasingly China’s new leadership has revitalized the topic of urbanization. Last November, the vice-premier, Li Keqiang, wrote an article calling urbanization a “huge engine” for future economic growth. More recently, the newly released income inequality plan has even described urbanization as a tool to reduce income inequality.
This renewed emphasis on urbanization appears to have re-opened the topic of financing local infrastructure projects. In the fourth quarter 2012 monetary policy report released earlier this month, the Peoples Bank of China (PBC) wrote an exhibit entitled “the international experience of financing construction for urbanization.” In this exhibit, the Peoples Bank observed a strong correlation between urbanization and municipal bonds across countries from the 1950s to today. They found that the use of municipal bonds backed by tax revenues was the most effective tool for supporting urbanization "no matter whether you have a federal or centralized system of government."
The PBC’s research is well timed to encourage a transition away from local government financing vehicles (LGFVs) to promote the direct issuance of local government debt. The traditional model of indirect financing of projects via credit lines and corporate debt issuance from LGFVs injected with public assets – generally land - is coming under strain. Although highly successful at raising funds since their creation in the late 1990s, the model is opaque and has created confusion in accounting for the costs and risks of infrastructure development in China – particularly in their linking many local projects to land sale revenue. Due to these concerns, regulators led by the State Council have increasingly cracked down on the LGFV channel in 2010, and again last year.
If policymakers were to agree with the PBC and promote a policy transition toward direct debt issuance, they would essentially have two options:
One option is to expand the existing channel for Ministry of Finance (MOF)-backed local government debt. Since 2009, provincial governments have been able to raise some money on the interbank bond market as part of collective provincial government bonds issued by the Ministry of Finance. These bonds operate more like fiscal transfers - they are sovereign bonds with the interest and principal paid by the Ministry of Finance.
The Ministry of Finance also opened another pilot channel in November 2011 to allow creditworthy provinces – Shanghai, Guangdong, Zhejiang, and Shenzhen – to issue their own bonds of 3 and 5-year maturities (see our earlier post). The Ministry of Finance is still responsible for acting as a guarantor and an agent for issuing and collecting the interest on these bonds, yet repayment is ultimately the responsibility of the local government. The arrangement has allowed some variability from treasury yields but ultimately offers little exposure to local risk.
Both types of local government debt issuance are capped by a State Council quota; together amounting to only Rmb 250 million in 2012, up slightly from Rmb 198 million in 2011. In contrast, Barclays estimates that local government financing vehicles issued Rmb 965 million in corporate debt in 2012.
The State Council could increase the annual MOF-backed local government debt quota significantly at the same time it cut down corporate debt issuance by LGFVs. However, such an approach would have some major drawbacks. First, it would inherently limit the financing capacity of local governments to the approval of the Ministry of Finance. Second, MOF-backed provincial bonds would not be as attractive to investors offering yields on par with treasuries.
Another – perhaps more ideal – solution would be to amend the budget law to remove the ban on local government debt issuance, allowing them to issue bonds backed by tax revenue. In contrast to the United States where states, counties, special districts, cities, towns, and even school districts can issue debt secured by tax revenue, Chinese local governments are banned from direct bond issuance. There was discussion to amendment the budget law to allow local government issuance in 2011. However, this amendment was eventually dropped from the draft revision approved by the NPC standing committee in June 2012 due to concerns surrounding excessively high-levels of local government debt.
The reason for dropping the amendment is likely more complex, and potentially political. Direct issuance of local government debt – more clearly than financing vehicles – represents the credibility of a Chinese city or province. This in turn would open up questions as to whether the central government would be implicitly backing such bonds in the event of a default. The Ministry of Finance generally resists taking on such guarantees for fear that it would impact China’s sovereign credit rating. At the same time, not taking on such guarantees runs the risk of restricting direct access to debt financing only to provinces with very high credit ratings – Shanghai, Shenzhen, Zhejiang, Guangdong – something which could exacerbate income inequality between regions.
If opposition to an amendment were to be overcome, municipal bonds would seem ideal for China’s situation. First, it will increase the transparency of financing local government infrastructure projects. Second, it would free local governments from constraints based on land as a source of cash flow. Infrastructure is a public good, which should be subsidized by taxpayers as well as user fees from project cash flows. Third, issuing bonds will help avoid maturity mismatches in infrastructure financing – a common problem in the bank loans given to LGFVs in 2009. Fourth, it will likely reduce financing costs for local infrastructure by basing interest rate calculations on the credit rating of an entire province or municipality rather than the assets of an individual platform company. This fact was borne out by the direct issuance pilot program during which in November 2011 Shenzhen sold a three-year bond price to yield at 3.03 percent compared with a 3.11 percent yield on central government treasuries on the same date.
Direct debt issuance – whatever its form - will not directly solve all the problems of local governments. There is still a large local debt overhang of Rmb 10.7 trillion in 2010. Local governments also need to improve the efficiency of tax collection and build new more sustainable sources of tax revenue.
Nevertheless, the transition away from over-reliance on financing vehicles would be a good step toward improving local government finances and putting Chinese cities on a more sustainable growth path, suggesting re-assessing the ban on local government debt issuance at least warrants further discussion among China’s top leadership. In the meantime, a significant expansion to the existing State Council quota on local government bonds issued by the Ministry of Finance would be a step in the right direction.