China: Muni sea-change excites overseas investors
Beijing has ambitious plans for market; international funds will find it ‘hard to ignore’.
The Beijing Authorities’ recent decision to strengthen the debt-servicing capacity of China’s municipalities by giving them a green light to issue new bonds is set to trigger a rally in the country’s municipal bond market.
The Chinese municipal bond market will most probably increase to a level at which it becomes difficult to ignore for international investors
The reform involves allowing local and regional governments to swap Rmb1 trillion ($160 billion) of high-yielding debt into less expensive municipal bonds. The 2015 budget also set an Rmb600 billion bond issuance limit, up 50% on 2014, according to Moody’s.
The new limit provides Rmb100 billion for special-purpose bonds linked to specific projects and Rmb500 billion for general-obligation bonds. The debt-for-bond swap initiative should cut the annual interest bill of local and regional government by between Rmb40 billion and Rmb50 billion, Moody’s says. Some estimates have put the anticipated savings at 1.5% of GDP.
According to Shanghai-based financial services consultancy Z-Ben Advisors, last year’s trading volume for Chinese municipal bonds was Rmb106.41 billion. Offshore investors can invest in onshore renminbi bonds through the Renminbi Qualified Foreign Institutional Investors (RQFII), Qualified Financial Institutional Investors (QFII) and People’s Bank of China interbank investment programmes, according to Moody’s. But the limitations in these channels mean the convenience and suitability of investing in the securities could still be improved, according to some analysts.
The debt swap is set to shake up the domestic government funding system and boost an underdeveloped segment for China in the process. The restructuring reclassifies up to a third of the Rmb11 trillion in China’s local government financing vehicles (LGFV) as fiscal liabilities.
There is a clear opportunity for the international bond market to align itself with China’s aims.
“Chinese policymakers aim for making local governments less dependent on bank funding and funding via shadow banking channels,” says Joep Huntjens, portfolio manager, Asian debt hard currency, at NN Investment Partners, formerly ING Investment Management. “Achieving this goal partly depends on how successful the development of the municipal bond market will be in coming years. Even if only a very small part of the local government debt will be replaced by bond funding, a municipal bond market of very substantial size would be created.
“Over time, the Chinese municipal bond market will most probably increase to a level at which it becomes difficult to ignore for international investors,” he continues. “However, in the near term we expect participation in this segment by international investors to be limited given that the size is still small, liquidity relatively low and that international investors will need time to become familiar with risks associated with this new segment.”
The Chinese government has demonstrated in the past that it prefers to tread a careful path with capital markets liberalization rather than make sweeping changes, but the pace of reform in the municipal bond space suggests an unusual level of urgency and reforming zeal that could carve out big opportunities for international investors.
“Substantial amounts of municipal debt have accumulated in China since the financial crisis, so to reduce the interest burden on Rmb1 trillion is a good pre-emptive measure by the Beijing authorities,” says Aaron Russell-Davison, global head of DCM at Standard Chartered Bank.
International appetite for Chinese muni bonds is likely to be limited to those from the highest-quality issuers.
“I could see international appetite for the bigger, more well-known municipalities amongst international investors,” says Devesh Ashra, head of Asia debt syndicate at Bank of America Merrill Lynch. “This would be because they are closely linked to the sovereign… one thing that would help investors would be to know how much issuance to expect. Giving a broad directive of a formal path on this would help the market develop.”
Nicholas Zhu, senior analyst, sub-sovereign group at Moody’s Beijing, says trading of Chinese regional and local government bonds by international investors is at a relatively low level as this new market is at the developmental stage, but he says levels should increase.
“We expect the Chinese regional and local government bond market to take off significantly, with investors from both onshore and offshore,” he says. “It’s part of the Chinese capital markets liberalization plan. The regional and local government bond markets offer more stability and a more diversified approach to taking Chinese risk for international investors than other securities with more specific risks.”