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Capital Markets

Strong debut for Chinese local government bonds

New channels for domestic investment; Eastern governments pay lower premiums

Investors have widely welcomed access to the provincial bond market in China, generating high demand last month for local government bonds as part of a pioneering pilot scheme led by officials in Beijing.

The scheme provides Chinese investors with new, accessible avenues in which to pump savings.

“There is excess demand for onshore and offshore issuance of local government bonds”

Chi Lo, HFT

"China is a country that saves money," says Chi Lo, chief executive of HFT Investment Management in Hong Kong. "As a result, there are few places to park these savings." These investment opportunities include the stock market and central government, but these markets are small and immature relative to savings in China.

The development of a provincial bond market was embraced by domestic investors for offering a way to diversify portfolios. "[Already] there is excess demand for onshore and offshore issuance of local government bonds," says Lo.

Demand offshore might even result in local government bonds being sold in Hong Kong. Lo says selling local government bonds offshore "will need central government approval before it can go ahead, but because the central government hasn’t yet said anything about restricting provincial governments to tapping only the onshore market, the Hong Kong market could potentially be another channel for investors."

In a recent effort to clean up local government balance sheets, Beijing allowed four local governments to issue bonds. Shanghai became the first to issue bonds in 17 years as part of this pilot scheme. On November 17, the municipality launched public bidding for Rmb7.1 billion ($1.1 billion)-worth of local government bonds. Schemes in Shenzhen, Guangdong and Zhejiang followed, and demand has been positive.

However, despite initial optimism surrounding the scheme, "[it] is too small to be significantly material," says Arthur Kroeber, non-resident fellow of foreign policy at the Brookings-Tsinghua Centre in Beijing. "The scheme is mainly significant at the moment because it indicates the direction of future funding for local governments."

China
Local government debts and fiscal revenues
Source: National Audit Office, China, HFT (HK) estimates 

Indeed, the success of the scheme is not guaranteed. "There have been a few false starts in capital markets," says Kroeber. "For example, in 2005, the commercial paper market grew quickly for the first two to three years, but after this initial period, it began to stall. [As a result], it’s too early to tell if this scheme will take off." Further speculation surrounds the risks involved in the bond market.

In aggregate terms, central and western governments account for around 25% of local government borrowing. However, aggregate provincial revenues amount to only 18%. A relatively large deficit of 7% means that central and western local governments are borrowing way beyond their means.

Therefore, easing pressure on local government’s bank balances will be easier for some local governments than others. "When central and western local governments come to market, they will need to pay higher premiums compared with the eastern governments," says Lo.

It might take years before local governments are able to clean up their balance sheets, given the pilot scheme is in its infancy and not applicable to all. "This is the beginning of a big programme," says Lo.

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