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Stimulus-linked bonds could whet local appetite for debt
Updated: 2009-03-27 10:57

When China's northwestern Xinjiang Autonomous Region issues 3 billion yuan ($439.88 million) in local government bonds next Monday, with the Ministry of Finance as the legal debtor, it will be taking part in a financial experiment.

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Xinjiang's bonds are part of a 200-billion-yuan program of bond issues by the central government on behalf of localities. The program is a compromise reached during the annual legislative session earlier this month, between provincial and municipal governments that want to issue bonds on their own and a central government that is watching local finances carefully.

Lawmakers, mainly from the more-developed regions such as the city of Shanghai and the provinces of Guangdong and Liaoning, strongly urged the National People's Congress to allow local borrowing. What resulted was an agreement by the legislature to allow the central government to issue the bonds on behalf of all local governments, the wealthier areas as well as less-developed ones whose fiscal positions aren't so strong.

The debt will help finance the central government's 4-trillion-yuan economic stimulus package, announced in late 2008. The central government will provide 1.18 trillion yuan, with the remainder to be contributed by local governments and corporate investors.

According to Zhang Ping, head of the National Development and Reform Commission (NDRC), the local governments' part of the funding could be raised in three ways: the 200-billion-yuan bond program, undertaken by the Ministry of Finance on behalf of local governments, policy loans and more local corporate bonds.

Gray regulatory zone

Some economists, however, warn that a rush of local corporate bonds could trigger demand for more local debt issues, which are still in a "gray" zone of regulatory barriers.

Under a 1995 budget law, China's local governments are banned from issuing bonds directly or running budget deficits. The law was intended to prevent excessive borrowing because most local governments, those from less-developed regions in particular, are still financially weak and heavily dependent on central government funds.

Most of their fiscal expenditure is covered by transfer payments from the central government, while most of their fiscal revenues are required to go into the central coffer.

Proceeds from the centrally sponsored bonds will be incorporated into provincial budgets, with special approval by the State Council, China's cabinet. Chinese officials believe that the central government's involvement will increase the creditworthiness of the local government bonds.

The money raised will go mostly into projects designed by the central government, such as low-income housing, infrastructure construction, projects to improve rural living standards, environmental protection, post-earthquake reconstruction in the southwest and similar projects.

The Ministry of Finance will pay the principal and interest on the bonds and local governments will repay the ministry. The payments are secured, in the sense that the central government will deduct any unpaid amounts from transfer payments it owes to the local governments, according to the ministry.

Economists warned that the central government might end up footing the bill for some poorer regions, which might not be able to repay the Finance Ministry. But, they said, the central government could not undertake all risks for any possible debt issues that local governments might want to make to pay for their portion of the stimulus package.

Great demand

Ai Hongde, president of the Dongbei University of Finance and Economics based in Shenyang, capital of northeastern China's Liaoning Province, said there were latent risks in the 200-billion-yuan plan. Ai said the effect might be to loosen constraints on local governments, which might seek to take on more debt to deal with their fiscal difficulties.

Zhang's comments on local government financing methods could open the floodgates for local governments to issue their own debt through corporate bond issues or other disguised channels.

For some, that could be a big financial risk.

As the Ministry of Finance noted, fiscal revenues of local governments had been hit by the economic downturn and the tax breaks being offered to support growth.

For instance, the underdeveloped Anhui Province received 12.42 billion yuan in fiscal revenue in January, up 5.6 percent year-on-year - the lowest growth rate in seven years. Other localities are little better off.

Jia Kang, head of the research institute of financial science under the Ministry of Finance, said that in January, Liaoning Province's fiscal revenue was up only 6 percent, compared with 57-percent growth a year earlier. Zhejiang's fiscal revenue fell 5.4 percent, Shanghai's slid 8.5 percent, Chongqing municipality's declined 25.2 percent and Xiamen city in the eastern province of Fujian saw fiscal revenue sink 15.2 percent.

But while local revenues are weakening, local spending to raise living standards and the environment is increasing, as more administrative power has been decentralized. Anhui's planned spending on livelihood projects increased 29 percent year-on-year to 22 billion yuan this year.

Gray area

Tongling City, Anhui, has decided to provide 400 low-rent apartments for low-income households, which is a stimulus-package demonstration project. Yao Xinsheng, head of the municipal finance department, told Xinhua Thursday that the municipal government wanted to buy the apartments at market price from local developers to support the real estate sector and the municipal economy.

Yao said the city would pay 1,800 yuan per sq m for the apartments, of which only 300 yuan would come from central government funds. The city would have to make up the difference some other way.

It's gaps like these that are driving China's local governments to look for loopholes that will allow them to borrow more from the public, both institutional and individual investors, in "hidden" ways. Economists call these methods "quasi" or "gray" local government bond issuance.

Many localities might try to use these methods, because the planned 200-billion-yuan bond program isn't nearly big enough to satisfy all their needs.

Less than requested

According to Li Miaojuan, head of the development and reform commission of Guangdong, the province, which contributed 13.8 percent of the nation's fiscal revenue, got a bond issue quota of 2 billion yuan to 5 billion yuan from the 200-billion-yuan plan, less than 10 percent of what it sought.

The Ministry of Finance wants more capital from the bond plan to flow to less-developed central and western regions, to narrow the gaps between the poor and wealthy regions.

For Xinjiang, the quota is 5.5 billion yuan - 3 billion yuan to be issued Monday and the remaining 2.5 billion yuan set for July. For Sichuan Province in the southwest, which sustained massive damage from last year's earthquake, the quota is 20 billion yuan.

Unclear risk

According to Jiang Hong, researcher on public economy and management with the Shanghai University of Finance and Economics, the "quasi" local government bonds are issued mainly in two ways: local-government-backed corporate bonds and trust products secured by local governments.

Sun Ziduo, head of the economics research institute under the Anhui Academy of Social Sciences, said usually local governments issued their own debt, with companies as the issuers on their behalf.

Statistics from the NDRC show that from the fourth quarter of 2008 to date, there were 45 corporate bond issues in China that raised more than 130 billion yuan. Most of them were backed by local governments. It's here that the gray area becomes a potential issue.

In December, Shanghai's Urban Construction Investment and Development Corp(Shanghai Chengtou), issued 3 billion yuan in debt on behalf of the municipal government. The five-year bonds pay 3.95 percent annually, with the proceeds intended for the construction of municipal utilities.

Subsequently, Beijing Infrastructure Investment Co Ltd. issued 2 billion yuan worth of five-year bonds, with the support of the municipal government. The proceeds are intended to support urban infrastructure.

As noted, local governments are banned by a 1995 law from issuing their own debt. Under a second 1995 law on bond guarantees, local governments are also banned from guaranteeing corporate debt issues. The laws were intended to strengthen the central government's macroeconomic control capacity by centralizing the management of local revenue and spending.

But in both cases, the companies that issued the debt are local government companies. Thus, it's unclear where default risk ultimately lies.

Jiang and Ai said that most all local governments had issued debt in such disguised ways, but it was difficult to estimate the scale of these debts. However, Jiang said, local governments were keen to issue debt. In March alone, Beijing, Shanghai and Guangdong issued medium-term bills on the inter bank market, raising 25 billion yuan. The issues were made through similar means as those described above.

Another "gray area" is trust products. CITIC Trust, a private company, issued 3 billion yuan in three-year trust products to finance infrastructure construction, rail transport, water and environmental protection projects in the northern city of Tianjin.

Jiang said that there were no unified criteria defining what sort of company was allowed to issue "quasi" local bonds.

There was also regulatory risk, because the guarantees were technically illegal.

All these gray areas and loopholes helped expose investors in "quasi" local bonds to latent default risks, especially in the absence of a credit assessment system, Jiang noted.

"It's difficult for investors to analyze credit risks of such bonds, because they are often sold through private placement instead of public bidding," he added.

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