New incentives for local debt

Commercial banks must buy bonds, but securities will be more liquid, say reports

The central government is using a "carrot and stick" strategy to ensure that more than 1.7 trillion yuan ($274 billion) of municipal bond sales this year will go off without a hitch.

The strategy, which was outlined in a document dated last Friday, was revealed in media reports on Wednesday, and it involves coordination among the top monetary and fiscal authorities.

The Ministry of Finance, the People's Bank of China (the central bank) and the China Banking Regulatory Commission jointly issued the document, which establishes detailed measures for promoting bond issues by local governments. None of the government bodies would confirm the reports.

First, the "stick". That is a requirement that commercial banks must buy bonds with the same value as any loans that they previously extended to local governments.

That provision marks a substantial departure from original expectations that all bonds issued under a previously announced swap program would be sold in the public debt markets. The proceeds of these issues would be used to repay legacy debt to creditors, mainly banks.

The "carrot" is that these bonds can be used as collateral to get PBOC loans and to get Treasury and local government deposit. They will thus be relatively liquid assets for the banks.

The three authorities ordered regional governments to complete a previously reported 1 trillion yuan debt-for-bond swap plan by Aug 31, the media said.

Reports of the new document's contents ended nearly a month of speculation over how the central bank would push through the unwieldy bond sale.

The Ministry of Finance in March announced a 1 trillion yuan debt-for-bonds swap plan that would cut local governments' interest payments and extend the maturity of their debt. But that plan hit a snag on April 23 when Jiangsu province had to delay a bond issue after failing to agree on terms with banks.

In addition to that original 1 trillion yuan, the local government debt program includes 500 billion yuan of new general-purpose bonds and 100 billion yuan of special-purpose notes, as well as rollovers of 171.4 billion yuan.

The resulting 1.77 trillion yuan of debt, a gigantic sum for China's bond market, raised concerns of a crowding-out effect that will drain liquidity and drive up interest rates.

The fears have been alleviated by the latest document, because up to 900 billion yuan of bonds will be absorbed via "private placement" with banks, according to analysts at Haitong Securities Co Ltd and Minsheng Securities Co Ltd.

These bonds would go into banks' vaults rather than being traded in the interbank or securities markets, the document stipulated.

Jiangsu province has restarted its bond sale, with plans to sell the debt on Monday, according to a statement on the China Central Depository & Clearing Co's website. But the issue has been scaled down to 52.2 billion yuan from 64.8 billion yuan. All the new bonds will go into the market.

The 52.2-billion-yuan bond has been rated AAA by China Credit Rating Co Ltd. Huo Zhihui, chief analyst at the agency, said that future bond issues by Jiangsu are expected to be sold under the "private placement" method.

He forecast that next week's issue will bear an interest rate that is 5 to 10 percent higher than that for Treasury debt of the same maturity, which would be 3.5 percent to 3.8 percent.

In an apparent sign of concern over the debt costs of local governments, the central government document stipulated that interest rates on new bonds may not exceed those on Treasury debt of the same maturity by more than 30 percent.

Huang Wentao, chief economist at China Securities Co Ltd, said that the plan is similar to a program in 2007, when 1.35 trillion yuan of special Treasury debt was issued directly to Agricultural Bank of China Ltd.

After the latest interest rate and reserve requirement ratio cuts, money-market rates have fallen and banks are flush with cash. Since the PBOC's conditions mean that the debt involved in the local-government plan will be relatively liquid, banks will not lose money on these instruments, Huang said.

Wang Tao, chief China economist with UBS AG, said: "We believe such swaps will not only lower local governments' debt service burden, but also lower potential nonperforming loans for banks, reduce banks' capital charges and improve their loan-deposit ratio.

"Although banks' earnings will be hurt by the lower yields of bonds (relative to higher interest on loans), we believe the market will value banks' gains in risk reduction and liquidity over their loss in interest revenue."