Giving credit where it's due in the debt market

Changes are in the works for borrowing by the country's local governments, including a modern rating system

The national government will introduce a credit rating system for provinces, cities and counties as it seeks to establish a foundation for a well-regulated municipal debt market.

Sources said the Ministry of Finance conducted a nationwide study last year on the feasibility of a credit rating system. The Economic Observer has reported that the results of the study will yield a special regulation on credit ratings.

The ministry has consulted Dagong Global Credit Rating Co Ltd about the issue, the sources said. And at least one institution under the Chinese Academy of Social Sciences - the top government think tank - has been consulted, they said.

For the first time, China said in its urbanization plan, jointly issued by the Central Committee of the Communist Party of China and the State Council (the cabinet) on March 15, that it will allow local governments to issue municipal bonds.

But first a credit rating system has to be established so that the market can get information about issuers and determine prices.

Assuming these initiatives are implemented, the changes represent a momentous shift in China's government debt management, experts said.

Under the Budget Law, which is about two decades old, local governments can't issue bonds or run deficits. If they need to issue bonds, the debt will be issued through the Ministry of Finance.

To circumvent the ban, local governments often borrow heavily through several thousand local government financing vehicles.

But these entities, which are under local governments' direct supervision, are often badly managed and rife with cronyism, experts said. And with no rules on financial transparency, LGFVs' debts have ballooned in recent years.

According to a survey conducted by the National Audit Office, the debts of 13,000 LGFVs stood at a cumulative 6.97 trillion yuan ($1.13 trillion) as of June 30 last year, out of the 17.89 trillion yuan in total debts.

A significant weakening of China's economy this year has raised grave concerns about repayment of these debts.

The central government said it plans to ensure that local governments can obtain funds through well-regulated channels, a strategy described by Premier Li Keqiang as "opening the front doors while blocking the side doors".

A statement following the Third Plenum of the 18th Central Committee of the Communist Party of China also outlined a system of local government debt issuance based on credit rating.

Many local credit ratings agencies have offered their services to local governments in the past, but they only evaluated corporate bonds with the implicit backing of local governments.

Competition among credit rating agencies for business has become fierce, with executives at major agencies complaining that smaller companies are inflating ratings to get business.

Another problem for credit rating firms is local governments' reluctance to share information. In some cases, the larger domestic credit rating agencies such as Dagong have declined to provide ratings when they couldn't get the required data from prospective issuers.

Another major rater, China Chengxin Credit Rating Co Ltd, an affiliate of Moody's Investors Service Inc, has said it's "less interested" in government-related bond business.

"We would rather leave the market to small firms," said Chengxin President Ma Li.

The heated competition means that national regulations covering the credit ratings market are crucial, said Liu Qiao, a finance professor at the Guanghua Management School of Peking University.

Liu said that in addition to the private sector, the academic community should be involved in drawing up criteria for ratings.

Liu's research team has devised a framework to gauge local governments' repayment ability and tested it with seven cities so far. But he also acknowledged the difficulty of finding cities that are willing to share information.

Despite initiatives from the private sector and academia, experts said it's still critical to have a "top-level design", making information disclosure mandatory for local governments.

The Ministry of Finance annual work report indicated that "institutional design" is already on the government's agenda.

The report discussed a series of related reforms, such as increasing budgetary transparency by requiring comprehensive reporting and disclosure of all revenue and expenditures; fiscal plans spanning several years, including three-year projections; introduction of accrual accounting and reporting of local government debt in budgets.

For example, accrual accounting, as an alternative to cash accounting, measures the performance and position of a corporate or government entity. Accrual accounting recognizes economic events regardless of when cash transactions occur. So when a government signs a contract with a developer, for example, the value is classified as a liability of the government, even though it hasn't yet made any cash payment.

These reforms, analysts said, are crucial to strengthening the fiscal prudence of local governments, whose true liability positions will be immediately exposed to higher authorities, acting as a bar to lavish spending by local officials who leave the debts to their successors.

But these reforms take time to materialize, and consistency is a problem because there are various rating standards practiced now, people familiar with the matter said.

Guan Jianzhong, chairman of Dagong, suggested that taking a laissez-faire approach to credit ratings can't work, because it will create a conflict of interest: Governments will choose firms that give them high ratings.

"A possible solution is to let the Finance Ministry pay (ratings fees) for local governments. Two or three firms could be introduced to conduct ratings.

"Most important, certain criteria should be adopted to limit the number of participants," Guan said.