A framework to handle local government debt

Shortly after the passage of China's budget law amendments in August, the State Council issued new guidelines for the management of local government debt. With both, the central government has effectively established a framework for dealing with the flow and stock of local government debt. This is the most comprehensive framework unveiled since serious investor concerns first emerged over the rapid accumulation of local government debt following the global financial crisis.

This new framework offers much clearer guidance on who may borrow and for what purposes at the local government level than before. Provincial-level governments can issue general purpose bonds and special project bonds, either on their own or on behalf of county and city governments.

Debt can be issued only for public project investments but not for recurring current spending, and debt repayment funds must come either from budgetary revenue, specified public funds or, in some cases, state asset disposals. Local government bond issuance will be subject to central government-set quotas and approval by the National People's Congress.

For the financing of other infrastructure projects, such as public utilities or transportation, the guidelines encourage the use of public-private partnerships that may borrow via all available means in the market. Under these partnership arrangements, however, local governments will not be responsible for any debt incurred by special purpose companies. Therefore, future local government debt would be more narrowly defined than under current practice.

Debt financing

Moreover, the debt of local government financing vehicles that falls under the "government debt" category will be taken over by local governments, which can swap the debt with new government bonds or pay them down with government revenue or state asset disposal proceeds.

Finally, the new framework attempts to limit moral hazard by clearly separating local government debt from corporate debt, explicitly linking local debt levels and payment issues with local officials' performance evaluations, and asking creditors to take responsibility for their own lending actions.

How will local government investment be financed in the future?

In the future, local public investment and infrastructure spending will be grouped under different categories and thus financed separately.

Public works with no cash returns may be financed by issuance of general-purpose local government bonds. Public projects with some cash return may be financed by issuance of project-specific local government bonds. Utilities and infrastructure projects that earn commercial rates of return and can attract corporate participation will, in principle, raise financing within a public-private partnership. Commercial and business projects should conduct all financing via the market, separated entirely from local governments.

Local government debt under the new framework will be general or special purpose bonds. The upper issuance limits will be set by the State Council and approved by the National People's Congress.

We estimate that new bonds issued to fill the financing gap in 2015 could be as much as 1 trillion yuan (US$163 billion).

In 2014, the central government was budgeted to issue 400 billion yuan of treasury bonds on behalf of local governments, including a pilot scheme of 109 billion yuan to be issued and repaid independently by 10 local governments. From 2015 onward, we assume that most such bonds will be raised independently by local governments.

In the first nine months of 2014, about 1.5 trillion yuan of various types of local government financing vehicle bonds were issued — a figure that we think could reach 1.8 trillion yuan for the full year. Assuming a third of such debt qualifies for local government bond issuance under the new framework, it would mean an additional 600 billion yuan of local government debt.

Debt stock

How will the stock of local debt be addressed? The State Council has asked debtors and creditors to work together to examine and regroup the stock of local government debt and contingent liabilities based on the 2013 National Audit Office audit result.

Debt borrowed by local governments and agencies, or payable by local governments should be categorized as general or special local government debt. Local governments can apply to issue bonds to replace existing debt to lower interest payments and lengthen debt duration. Local governments should also work to pay down such debt, including via local asset disposals.

Debt borrowed by enterprises and institutions for which local governments are not liable should be paid according to market rules.

Based on the National Audit Office results, we think 6-10 trillion yuan of the 17.9 trillion yuan of local government debt stock as of June 2013 would be categorized as local government debt under the new regime. This would either need to be swapped with bonds issued under the new local government bond scheme, or be paid down with fiscal revenue or local government asset disposal proceeds.

The swapping of old local government debt with new local government bonds may take at least a year to complete. Rather than relying only on the market, debt swaps may be arranged via private placements with institutional investors.

The speed of state asset disposals may depend on the pace of state-owned enterprise reform and prevailing conditions in China's equity market.

Implications on economy

Empowering local governments to borrow through legal, transparent and cheaper channels will help improve local debt sustainability and reduce systematic risk caused by debt overhang.

Placing local government debt into a more standardized budgetary management system should help curb the escalation of high-risk, opaque financing activities.

Securing local governments' financial footing for ongoing projects and via the use of public-private partnerships will help avoid a sudden collapse of local government-led investment and ensure continued financing support for infrastructure.

Allowing formal local government bond issuance to replace often opaque local government financing vehicle debt should increase the depth of and liquidity in China's bond market. This is positive for domestic and foreign institutional investors alike.