Only in China Can Riskiest Provincial Debt Get Best Yield

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Ranking provinces by their fiscal and economic strengths puts Jilin at the bottom and Tianjin at the top. In China’s bond market, that’s a waste of time.

Jilin is the riskiest among the nation’s 31 provinces, autonomous regions and municipalities, according to a Bloomberg analysis of their debt and the potential to repay using taxes and land sales. It issued three-year notes Thursday at 2.87 percent, matching the similar-maturity sovereign yield. Tianjin also sold at a zero premium three days earlier.

On the surface, low borrowing costs are a positive sign as Premier Li Keqiang seeks to avoid a local debt crisis by allowing regional governments to issue 2.77 trillion yuan ($446 billion) of municipal bonds that don’t carry finance ministry guarantees. The market’s failure to price in the different default risks suggests an assumption that the central government will step in to repay the liabilities.

“A lack of difference among regions is something that’ll probably continue in this year’s issuance,” Nicholas Zhu, a Beijing-based senior analyst at Moody’s Investors Service, said in a June 10 phone interview. “Banks want to maintain a good relationship with local authorities, and are looking at what other benefits they can get. It’s still the central government’s implicit guarantee that’s playing a role.”

Revenue Drop

Jilin, in the northeast, recorded China’s fourth-biggest decline in provincial fiscal revenue in the first quarter of 2015 as the economy shifted away from heavy industries such as steel and cement production. It sold 2.29 billion yuan of bonds Thursday, with the five- and seven-year yields at 3.25 percent and 3.52 percent, respectively. That matches the five-day average yield for government notes.

Zhejiang province, which has among the highest default risks according to Nomura Holdings Inc., issued five-year bonds on June 9 at yields that were the same as the sovereign. As did Guangxi, graded the safest by Nomura, on May 28.

“Banks, as the dominant buyers of the municipal bonds, are seeking benefits elsewhere by maintaining a good relationship with local governments,” said Gao Guohua, a Shanghai-based analyst at Guotai Junan Securities Co. “People talk about politics in the issuing process.”

No Bailout

Local authorities bear full repayment responsibilities for their borrowings, and the central government won’t bail them out, according to State Council guidelines issued in October. Finance Minister Lou Jiwei repeated that stance in March.

A budget plan this year allowed local authorities to raise 500 billion yuan via general bonds and 100 billion yuan through special notes, which raise money for projects that generate revenue. The Finance Ministry has also doubled a quota to 2 trillion yuan for local governments to convert maturing high-cost debt into low-yielding municipal notes. Before the swap, it identified financing that didn’t qualify, seeking to avoid the perception reckless investments would be bailed out.

“The government has multiple targets: it wants to control financial risks by lowering debt cost, and it wants to avoid the moral hazard,” said Zhong Liang, a Hong Kong-based analyst at Standard & Poor’s. “These goals may not be met all at once. The Finance Ministry is likely to roll out more measures to ensure a fair pricing system, and we may have to wait until the market is big enough for investors to pick and choose.”

The flood of bond sales has pushed up longer-term benchmark borrowing costs. The difference between yields on 10-year and one-year sovereign bonds surged to 191 basis points on Wednesday, the highest since April 2010. The shorter term yield fell 155 basis points this year as the People’s Bank of China cut borrowing costs. Municipal debt issuance will probably exceed 700 billion yuan this month, up from 134 billion yuan in May, SWS Research Co. analysts led by Chen Kang wrote in a June 10 note.

“While there is no risk premium in the municipal notes against the sovereign, the huge supply is holding up the long end, which ultimately is being reflected on the coupon rates of the munis,” Guotai Junan’s Gao said. “This is ‘fair pricing’ in another form.”

— With assistance by Helen Sun

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