Caps on local government debt quota pose more questions than answers

China's top legislature has approved the local government debt quota for this year, but the market is still scrambling to figure out what the actual quota is, a critical question that is unanswered.

Finance Minister Lou Jiwei presented the debt limit proposal to the Standing Committee of the National People's Congress on Monday, and the latter passed it. This is a due procedure under the new Budget Law which stipulates that an approved limit was necessary to rein in local government debt. After the overall ceiling is determined, the central government can allocate limits for each region.

According to a statement issued after Lou's briefing, the actual debt quota for this year would be the combination of the local governments' outstanding debt by the end of 2014 and the new debt quota for this year. The NPC earlier this year approved a 600 billion yuan ($94 billion) new debt quota, but the outstanding debt level is still anybody's guess.

However, this year's aggregate debt quota is critically important as it would decide whether the current debt-for-bond program will be expanded. China in March, and then in June granted a total 2 trillion yuan quota under which local governments could issue new low-cost bonds to replace high-yielding legacy debt. But market circles believe that the amount is not big enough to cover all the maturing debt this year and expect more such quota.

Latest indications that the debt quota for this year would be a combination of outstanding debt in 2014 and new issuance this year, raise the possibility that the 2 trillion yuan quota could be added, because previously granted quota is designed to swap existing debt before June 2013, instead of before the end of 2014.

Based on national auditor's survey results, as of mid-2013, local governments have amassed 17.9 trillion yuan of liabilities, and they have to repay 1.86 trillion yuan maturing debt this year. Since then, more debts have been raised and based on legacy debt as of the end of 2014, local governments have to repay 2.9 trillion yuan this year, China International Capital Corp estimated.

"If this year's quota is based on end-2014 outstanding debt, it is logical to assume a higher probabilities that the 2 trillion yuan swap quota would be extended," said Nicholas Zhu, a senior analyst with global ratings agency Moody's Investors Service Inc. "But expanding the quota is not the only solution, and Beijing has to take into account the market's appetite for more municipal bonds."

CICC in a June report projected another 1 trillion yuan quota so that the 2.9 trillion yuan debt could be covered. Repaying the due debt with local governments' own income would not be an option because their debt servicing ability has been weakened due to the slower fiscal revenue growth and declines in land sale revenue. In addition, using their own income would squeeze their infrastructure expenditure, which runs at odds with central government's effort of stabilizing growth.

But on the other hand, domestic market has been under great pressure to absorb local governments' massive low-yielding bonds. Liaoning province's recent failure to sell all its municipal bonds, and other regions' rising coupon, have demonstrated market's aversion to the instruments.

The province is among 33 provinces and cities that have issued a total of 1.6 trillion yuan bonds to swap maturing debt under the 2 trillion yuan quota.

Zhu said Beijing's central responsibility is to regularize and improve local governments' refinancing environment, and that is not necessarily through granting more swap quota. The financial bonds issued by policy banks, and the loosening requirement for issuing corporate bonds all "opened alternative debt refinancing channels", Zhu said.

Beyond the specific quota, Zhang Yingjie, general manager of the research branch of China Chengxin International Credit Rating Co, said "quota management" is an important step in enhancing transparency and accountability. The publication of detailed debt information is urgently needed to help the market identify credit risk, he said.