Landmark year for local debt sector

Accounting and budget reforms trigger growth in direct borrowing

The fledging regional and local government bond market in China is poised for more significant developments in 2015, with additional steps toward greater transparency and responsibility in borrowing.

The changes expected this year will be in line with the revised budget law that took effect on Jan 1, which will eventually allow some local administrations to issue bonds outside of an existing pilot program. The value of issuance this year will rise by 50% from 2014, according to the 2015 budget proposal .

The decision to expand the bond program dovetails with the State Council guidelines released in October that encourage local governments to begin issuing debt directly to reduce their reliance on riskier indirect borrowing.

The national government wants to develop a genuine municipal bond market because the buildup of opaque local government leverage in recent years could hurt the sovereign and banking sectors.

For example, the Ministry of Finance was reported to have approved a quota of 3 trillion yuan according to which local governments can swap informal legacy liabilities into formal local government debt.

One of the biggest challenges for the development of a municipal bond market is the continued dearth of accurate data on debt and financial performance and the absence of timely disclosure of such information.

Improvements in this area remain a work in progress. Market participants are unable to monitor the indebtedness of individual local governments. Accountability also needs further improvement.

Beyond creating the legal framework for a municipal debt market, the central government is also launching new accounting systems and enhancing disclosure rules to ensure that market participants have the information they need to make investment decisions.

Under the new system, local government debt will be reported in local government budgets, and it will also appear on their balance sheets.

This new framework will contribute to the central government's goal of having local governments take direct responsibility for their debt and encouraging them to borrow and invest more prudently.

To deter local governments from engaging in riskier transactions, such as off-balance sheet borrowing, the State Council debt guidelines introduce tougher sanctions against local officials found guilty of violations. This is an extremely important measure that will force local officials, even at the most senior level, to adopt a more prudent approach to borrowing.

It is difficult to forecast how the market will develop after 2015.

It is also difficult to predict how long it will take for a fully functioning municipal debt market to emerge, because the central government is still establishing the regulatory framework and the accounting systems.

Developments this year will be closely watched by investors. The local debt issued under the pilot program has received a very positive reception from onshore investors.

Investors will also begin to differentiate between the direct debt obligations of local governments and debt issued by local government financing vehicles.

Domestic municipal debt could become a new asset class, allowing investors to fine-tune their exposures. These instruments could also create more trading opportunities.

The author is a vice-president and senior analyst covering sub-sovereign debt at Moody's Investors Service in Beijing.