China stepped up efforts to curb the expansion of opaque local-government debt, sparking a tumble in riskier bonds and fueling the stock market’s biggest retreat in five years.
Bonds rated below AAA or sold by issuers graded lower than AA are no longer allowed for use as collateral in short-term loans obtained through repurchase agreements, the nation’s clearing agency for exchanges said yesterday. Notes issued by local government financing vehicles paced losses in lower-rated debt today, while the nation’s benchmark stock index sank 5.4 percent as some investors sold liquid assets as an alternative source of cash.
While the change caught traders off guard, authorities in the world’s second-largest economy are trying to rein in the use of lightly-regulated LGFVs as they promote the development of a more transparent municipal bond market. Fitch Ratings Ltd. estimates local government liabilities have climbed to about 30 percent of gross domestic product as cities and provinces take on debt to sustain growth amid the nation’s weakest annual expansion since 1990.
Investors had “under-priced the credit and liquidity risks,” said Ken Hu, the Hong Kong-based chief investment officer for Asia-Pacific fixed income at Invesco Ltd., which which oversaw $790 billion of assets at the end of October. “It’s definitely a wake-up call.”
The China Securities Depository and Clearing Corp.’s move means about 470 billion yuan ($75.8 billion) of outstanding debt can no longer be pledged in repo agreements, according to Haitong Securities Co. In China, credit scores of AA- or below are equivalent to non-investment grades globally, and many LGFV bonds fall into that basket, according to Haitong.
Such debt has boomed in China in recent years as an indirect method for provinces and cities to fund infrastructure and construction projects. A law initially passed in 1994 had banned local governments from selling bonds, forcing them to set up thousands of LGFVs. That law was revised in August, laying the legal framework to let regional authorities raise funds directly.
Premier Li Keqiang is allowing local governments to sell debt themselves after the last state audit showed 17.9 trillion yuan ($2.9 trillion) of regional liabilities in June last year, up 67 percent from the end of 2010. China experienced the first default in its onshore bond market in March.
The Ministry of Finance started to allow the cities of Shanghai and Shenzhen as well as Zhejiang and Guangdong provinces to sell municipal bonds in 2011 as part of a trial program. It added Shandong and Jiangsu provinces in 2013.
This year, the trial expanded to Jiangxi province, Ningxia region, and the cities of Beijing and Qingdao, as the ministry started to require disclosure of basic financial information and credit ratings. The development of China’s municipal bond market is vital in reducing risks from local government use of off-balance-sheet debt, Standard & Poor’s said in a May report.
“Local governments may seek new channels to raise funds,” said Zhang Li, a bond analyst at Guotai Junan Securities Co., the nation’s third-biggest brokerage. “China may expand its municipal bond trial, allowing more local governments to issue debt on their own next year.”
The retreat in LGFV bonds sent yields on Kashi Urban Construction Investment Group Co.’s 800 million yuan of debt due November 2019 up 75 basis points to 7.17 percent, the biggest jump since July, exchange data show. The yield on Yongzhou City Construction Investment & Development Co.’s 1 billion yuan of 2021 notes jumped 94 basis points to 7.55 percent, the largest increase since the debt was sold in December 2011.
The CSDC’s move will help remove riskier debt from the repo market before China requires LGFVs to clarify which bonds are backed by the state, Zhang said.
The Finance Ministry has asked local governments to detail all outstanding borrowings by Jan. 5 as it extends its municipal bond market trial. Only debt identified by local governments by next month will be eligible for refinancing using municipal bonds and fiscal funds, according to a draft document circulated by the Ministry of Finance in October.
The CSDC said in a statement today it fully considered the market’s ability to withstand the impact before issuing the collateral rule. New applications for repurchase agreements have been dropping over the past few weeks, and last week’s net increase amounted to only 5 billion yuan on the exchange market, it said. It also noted that the threshold for bonds that can be used as collateral has been raised in five separate actions, from May to November.
State Grid Corp. of China postponed a 10 billion yuan bond offering originally scheduled for Dec. 10, citing rising interest rates, according to a statement on Chinabond.com.cn, the Chinese govt bond clearing house’s website. Commercial Aircraft Corp. of China also delayed a bond sale because of market volatility.
“The regulation will damp investor demand for lower-rated corporate bonds,” said Yang Feng, a Beijing-based bond analyst at Citic Securities Co., the nation’s biggest brokerage. “That may result in higher borrowing costs for LGFVs.”
The CSDC is the clearing house for bonds that are traded on China’s exchanges, which account for less than 10 percent of all outstanding notes in the country. There were 1.03 trillion yuan of outstanding corporate bonds regulated by the National Development & Reform Commission and traded on exchanges as of Oct. 31, CSDC figures show.
The Shanghai Stock Exchange Composite Index tumbled amid volatile trading, following a rally during the past month that had topped every other market worldwide and sent valuations to a three-year high. The yuan dropped 0.2 percent.
“Negative headlines including the surge in China bond yields today triggered the sharp drop in the yuan,” said Ho Man Chun, a strategist at Bank of Communications Co.’s Hong Kong branch.
LGFVs sold 125.8 billion yuan of bonds in November, the least since January, according to data compiled by Bloomberg. Issuance has totaled 1.5 trillion yuan this year versus 903.7 billion yuan in 2013, the most since Bloomberg started tracking the data in 1999.
“Because low-rated bonds can’t be used for repurchases on the exchange, this will force many financial institutions to deleverage,” said Zhou Hao, a Shanghai-based economist at Australia & New Zealand Banking Group Ltd. “When there’s a liquidity issue, all bonds are sold off.”
— With assistance by Helen Sun, and Judy Chen