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China's Risk Crackdown Is Rattling its Municipal Bond Market

  • Yield premium over Chinese sovereign debt widens to a record
  • Municipal debt ‘first to be ditched’: China Merchants trader

China’s deleveraging campaign is providing a reality check to the fledgling municipal bond market.

Set up in 2015 to bring transparency to local-government borrowing practices, the new market benefited from the perception that Beijing had the provinces’ backs, with yields largely on par with the sovereign despite some weak municipal balance sheets.

Not anymore -- a clampdown on risk and record levels of debt in China’s financial system is spurring a reassessment of the market, with the premium demanded by investors on muni bonds over central government debt surging to a record as volumes in the secondary market slide. While the shift to pricing based on risk is a step toward a more mature, world-standard bond market, for now at least it poses a challenge given plans for a record year of issuance.

“The regulatory crackdown is tightening liquidity, and with limited cash, local government debt is among the first to be ditched,” said Wu Sijie, a bond trader at China Merchants Bank Co. in Shanghai. “This is a reversal of last year’s situation, when flush funds competed with each other to find things to buy regardless of the quality.”

China’s banking regulator has spearheaded the latest moves to reduce leverage in the financial system, after the central bank started pushing up money-market rates late last year.

Read more: China Ups the Ante in Bid to Quash Financial Risk: QuickTake Q&A

Investors are also starting to price different local governments according to their credit profiles, a change from the first year of the muni market, when yields were basically uniform across the map. The province of Zhejiang, located southwest of financial-sector powerhouse Shanghai, enjoys a similar coupon rate on its bonds as China’s central government, while Liaoning -- a rust-belt region in the northeast which just emerged from a recession -- paid a record premium of 58 basis points when it sold bonds last month.

Record Sales

The two-year-old market faces a torrent of issuance this year as a deadline for provincial governments to convert borrowing into muni bonds looms. Sales in the local-government debt market are set to reach an all-time high of 1.63 trillion yuan ($237 billion) in 2017, according to a target set at China’s National People’s Congress in March. Deutsche Bank AG and Standard Chartered Plc project the market will be bigger than that for sovereign bonds by year-end.

“The credit premiums may widen further on tightening liquidity as a result of the central bank’s monetary policy fine-tuning and the regulatory enhancement,” said Amanda Du, a senior analyst at Moody’s Investors Service in Shanghai. “Institutional investors have to adjust their portfolios.”

Du flagged a double disadvantage for local-government bonds. On one hand, their liquidity isn’t as attractive as for sovereign securities. But in terms of yields, they’re not as high as for corporate debt.

Investors in company bonds are also watching the provinces, read more here.

And liquidity is tightening further -- turnover in municipal bonds fell by two-thirds in the first quarter to 256 billion yuan from the previous three months.

China’s Finance Ministry is reported to have boosted its oversight of local government debt as well, vowing in February to halt illegal borrowing, and curbing local governments’ abilities to guarantee other companies’ loans. Officials launched an inspection of the muni bond market in March to check whether funds raised were being used in line with the law, according to the 21st Century Business Herald.

On Wednesday, the ministry asked local governments to stop any illegal financing guarantees by the end of July, and to submit a report on their debt activities by Aug. 31. This latest move shows Beijing wants to get “stricter” when it comes to reining in municipalities’ fiscal risks, analysts at Industrial Securities Co. wrote in a note Thursday.

“As the market size expands quickly, investors have become pickier,” said Zhao Quanhou, a researcher at the Chinese Academy of Fiscal Sciences, a research institution in Beijing that’s affiliated with the Finance Ministry. “The market may be concerned about whether the ministry’s investigations into off-book or contingent debt will have consequences on the governments’ own debt.”

China started developing a municipal bond market in 2011 after local governments -- barred by law from borrowing themselves -- set up thousands of separate financing vehicles to raise funds for infrastructure projects in the wake of the global financial crisis. The debt accumulated by these entities became a symbol of China’s ballooning leverage problem, which the government says it’s intent on addressing. The budget law was changed in 2014 to allow provinces to borrow themselves.

The amount of muni notes outstanding already increased to a record 11 trillion yuan at the end of March.

“Local governments have less bargaining power to attract institutions to buy the bonds,” said Huang Weiping, a senior analyst at Industrial Securities Co. in Shanghai. “And the market has become more investment-driven from one that was closely tied to politics.”

— With assistance by Helen Sun, Jing Zhao, and Xize Kang

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