◎ The CCP is putting its political credit on the line by making local bonds available over the counter.
Edited on April 18, 2019.
Starting from March 25, commercial banks in Zhejiang, Shandong, Shaanxi, Sichuan, Beijing, and Ningbo began piloting the sale of local government bonds (henceforth referred to as local bonds) over the counter to individual and small and medium-sized institutional investors. According to mainland media reports, local bonds sold quickly after they were allowed to be purchased over the counter.
Other noteworthy points about the over the counter local government bonds include:
- The bonds have a credit rating of AAA and are endorsed by local governments;
- The bonds have interest rates between 3 to 3.33 percent and have higher yields than national government bonds (henceforth referred to as government bonds) and bonds issued by the China Development Bank (CDB issues bonds to finance China’s policies);
- Like book-entry government bonds, local bonds can be sold on the secondary market after they are listed;
- The minimum purchase amount for local bonds is 100 yuan ($14.89).
The background
1. On Nov. 15, 2018, the People’s Bank of China, the Ministry of Finance, and the China Banking and Insurance Regulatory Commission jointly issued a notice on making available local bonds over the counter. According to the PBoC’s press release on the notice, local bonds would join book-entry government bonds, policy bank bonds, and CDB bonds as another instrument available to investors over the counter. The press release also encouraged local governments to give priority to local investors in purchasing and trading local bonds.
2. On Feb. 27, the MoF issued a notice on launching the issuance of local bonds over the counter. The notice encouraged local governments to issue special bonds through commercial banks.
3. Li Keqiang’s 2019 government work report lists plans to issue 3.1 trillion yuan worth of local bonds this year, or an increase of 900 billion yuan from the previous year. Special bonds will make up 2.15 trillion yuan of the 3.1 trillion yuan, or an increase of 800 billion yuan from 2018; the increase in issuance of special bonds in 2019 makes up 89 percent of the overall increase in local bonds.
4. During the 2019 Two Sessions, MoF officials said that the authorities strictly forbids local governments from taking on fresh implicit debts or creating new government-backed investment firms. The officials added that the central government would not rescue such companies if they run into trouble.
5. According to Chinese financial service provider Wind, local governments had issued over 1.1 trillion worth of local bonds as of March 26. Wind estimates that local bond issuance in the first quarter of 2019 will be about 1.4 trillion yuan, or 5.5 times that in the same period a year ago.
The big picture:
The 2019 CCP government work report proposed planned tax and fee cuts of about 2 trillion yuan, but did not mention a reduction in government spending. The report then calls on local governments to “lead frugal days” and “find ways to raise funding,” but does not provide any solutions.
Our take:
1. We believe that the CCP has to pass substantial tax cuts and slash fees to save the real economy as China’s economy continues to deteriorate. But shrinking the size of government is unthinkable for the CCP because it needs to maintain Party rule.
To secure funding for government spending without laying off government workers, the CCP appears to have resorted to requiring state and Party-owned enterprises to cough up more of their profits to the central government, as well as increase the issuance of local bonds.
2. Local governments encountered difficulties in moving debt in the first half of 2018. While the State Council planned to issue 1.35 trillion yuan of special bonds, local governments only managed to issue 367.3 billion yuan of special bonds in H1 2018. After that, the central government kept promoting local bonds to increase purchases. Eventually, the central authorities made local bonds available for sale over the counter, a move which transfers risks over to the individual investors and the bulk of the population.
Previously, local bonds were only sold and traded on the interbank bond market and on the mainland stock exchanges. The main buyers of local bonds were banks, brokers, hedge funds, and other large financial institutions. However, these financial institutions grew cautious about buying local bonds in 2017 after the CCP government launched a deleveraging campaign, tightened liquidity, and saw its debt risks increase.
Two government documents issued last year suggest that local governments are having trouble finding buyers for local bonds.
On Aug. 14, 2018, the MoF issued an opinion which urged local governments to speed up the issuance of special bonds. A China Securities Journal report published at the time said that the central government was even considering reducing the risk weight of local bonds carried by commercial banks from 20 percent to zero. Further, the central government was planning to put local bonds in the same category as government bonds to lower bond risks and make local bonds more appealing to institutional investors.
On Sept. 20, 2018, the CCP General Office and the State Council General Office issued an opinion on strengthening the asset and liability constraints for state-owned enterprises. The opinion proposed that local government financing platforms that have become insolvent will have to be mandated by law to declare bankruptcy and undergo restructuring or liquidation.
To find buyers for local bonds (and hence cover up for the lack of income from tax and free cuts) and speed up the issuance of those bonds, the central government introduced a policy in November 2018 to allow commercial banks to sell local bonds over the counter to individual and small and medium-sized institutional investors.
3. We believe that buyers of the first batch of local bonds sold over the counter are exposed to relatively lower risks. The strong demand for local bonds could pave the way for the subsequent introduction of riskier instruments.
The lack of suitable investments (low risk, low barrier of entry) outside of the stock markets and the property market could have driven the strong demand for local bonds. For instance, the central authorities are cracking down on P2P lending platforms and many investors have become so-called “financial refugees”; the stock markets are in a technical “bull market” and are always at risk of a crash; dabbling in the property markets requires substantial financing but provides poor liquidity; and buying wealth management products from banks is out of the question for investors who do not meet the minimum asset level (10,000 yuan at the lowest). Thus, the 100 yuan minimum purchase amount for local bonds is very appealing to those in the middle to lower income groups.
4. The CCP has “suspended” a financial crisis by transferring debt risk to the people and alleviated a government financial crunch by selling over the counter local bonds. But the CCP is also putting its political credit on the line by making local bonds available to the bulk of the population. The central government will face greatly increased political risks if local governments are forced to default on their bonds.
