China May Give Banks More Sweeteners to Buy Muni Bonds, S&P Says

Standard & Poor’s says China may give banks more sweeteners to buy municipal bonds after the nation introduced incentives including letting them use the securities as collateral for loans.

Chinese regulators issued a paper, with details of a previously announced debt-swap plan, that says local government bonds can be used as collateral for borrowing from the central bank, according to a copy of the document obtained by Bloomberg. The notes can also be used as backing to get treasury and local government fiscal deposits.

“The new feature is to make those bonds more attractive to bond investors,” said Liao Qiang, a banking analyst at S&P in Beijing. “More sweeteners could still come such as to increase the yield on the muni bonds.”

China’s banks are searching for a higher return on lending as steps to liberalize interest costs threaten to push up the rates they pay depositors, an issue highlighted Sunday when the central bank announced an increase to the deposit-rate ceiling. A delayed offering last month by the eastern province of Jiangsu flagged concern about demand for some 1.8 trillion yuan ($290 billion) of notes authorized for sale this year in the program to convert high-cost debt into lower-yielding munis.

“Banks have demonstrated lukewarm interest in buying those muni bonds so the government is trying to make them more liquid to compensate for the lower yields,” S&P’s Liao said. “It’s a bargaining process between the banks and central government.”

Sacrificing Returns

Coupons on the new muni bonds should not exceed the yields on sovereign bonds with the same maturity by more than 30 percent, according to the document.

“The local government financing vehicle debt replacement is negative for banks’ net interest margins because banks have to sacrifice their return to buy into those lower-yielding municipal bonds,” said Zhao Yang, the chief China economist at Nomura Holdings Inc. in Hong Kong. “But by swapping into those muni bonds, banks also get explicit guarantees from regional governments, compared to the implicit guarantees on old-style LGFV debt.”

There’s an unprecedented amount of debt at stake. China’s local-government obligations may have already reached 25 trillion yuan, bigger than the size of the German economy, according to estimates from Mizuho Securities Asia Ltd. That compares with the figure of 17.9 trillion yuan as of June 30, 2013 given by the National Audit Office.

The swap program aims to manage risks from local debt by spreading it out beyond the banks. Authorities are encouraging qualified institutional investors and individuals to buy local notes including those sold through the restructuring program, according to a statement on the finance ministry website dated March 18.

“Overall, banks’ risk exposure will come down via the swap, but their profitability will also come down,” S&P’s Liao said. “So it’s hard to say net net whether the swap is positive for the banks if the local government bonds would stay illiquid.”

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