China Lets Local Authorities Convert Debt Into Muni Bonds

China will allow regional authorities to convert some high-yielding debt into municipal bonds in a bid to cut financing costs on liabilities brokerages say have topped $3 trillion, sparking speculation investors may shoulder losses.

The government will permit as much as 1 trillion yuan ($160 billion) of the obligations to be swapped into local-government notes that have lower yields, the finance ministry said in a statement on its website dated March 8. That may reduce interest payments by as much as 50 billion yuan a year, allowing authorities to boost spending, it said. The statement didn’t specify what kind of debts and creditors are involved.

China is seeking to rein in local-government borrowing while accelerating fiscal spending to defend a 7 percent economic growth target. The debt swelled to 17.9 trillion yuan as of June 2013, according to data compiled by the National Audit Office. The liabilities may have already reached 25 trillion yuan, bigger than the size of the German economy, according to estimates from Mizuho Securities Asia Ltd.

“Investors are unfairly shouldering higher risks for lower profits, so they will be the losers in this game,” said Hu Yuexiao, an economist at Shanghai Securities Co. While the new measures should help boost fiscal spending, they will distort market order, Hu said.

‘Eyebrow Burning’

The People’s Bank of China’s two interest-rate cuts in three months have failed to lower borrowing costs for many lower-rated issuers as concern mounts that defaults may spread.

The yield premium for five-year AA rated corporate debt, the most common grade for local-government financing vehicles, has jumped 15 basis points since November, when the PBOC first cut rates. The securities yield 5.62 percent, compared with the 4.42 percent on AAA rated company notes with the same maturity and 3.3 percent on government bonds.

Borrowers will likely be able to extend the maturities on their debt through the conversion, according to Wang Tao, the chief China economist at UBS Group AG in Hong Kong.

While the steps don’t address a big part of China’s total local-government debt, they do help solve “the eyebrow burning urgency” the authorities face on the issue, said Jia Kang, former head of the finance ministry’s research institute.

Easing Anxiety

Debt conversion “will greatly reduce the market’s current worries over local governments’ refinancing risks,” Guotai Junan Securities Co. analysts led by Xu Hanfei wrote in a note Monday. “This shows the government’s determination and intent to resolve the risks of outstanding debt.”

A plan announced last year to stop regional authorities from borrowing through LGFVs has raised concern they may cut spending just as the economy expands at its slowest pace since 1990. Thousands of the financing units were established to finance construction of bridges, roads and sewage works after a 1994 budget law banned provinces and cities from selling bonds directly.

China’s LGFVs are selling bonds at the slowest pace in three years, with issuance slumping 47 percent from a year earlier in the first two months of 2015 to 66.3 billion yuan, data compiled by Bloomberg show.

Law Changes

The latest sign of financial strain among local governments emerged over the weekend when Guo Shuqing, governor of the eastern province of Shandong, said some cities and counties there may need to sell assets to repay borrowings.

Policy makers amended the local budget law last year, stipulating all government borrowings need to be brought into the fiscal plan. While this opens the door for regional authorities to issue notes directly, the municipal debt market is still in an early stage of development.

Nomura Holdings Inc. estimated total local government borrowings may have amounted to 24 trillion yuan at the end of 2013, accounting for 40 percent of China’s economy. UBS put it at 21 trillion yuan at the end of last year.

Opaqueness of the liabilities is a concern even as authorities shift toward more use of muni bonds, which should entail more disclosure, according to Shanghai Securities’ Hu.

“The local government can easily cover the fact that that their new low-yielding municipal bonds were actually converted from riskier debts, partly because the finance ministry or other regulators didn’t specify how they should disclose the information,” Hu said. “This will only make the local government debt and financing problem worse.”

— With assistance by Justina Lee, and Tian Chen

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