Beware of China Local Government Bonds (for now)

Our series of ESLJ China Insights aims to shed some light on the complexities of the Chinese local bond market, its structure and main players and how foreign investors can improve their portfolio diversification by increasing their allocation to one of the largest bond markets worldwide.

In this fourth instalment we focus on the second of the four main segments that constitute the RMB bond market, local government bonds.

As we mentioned in our previous Insights, the Chinese bond market is composed of four main market segments: (1) bonds issued by the Central Government (‘CGB’) (consisting of 30% of the benchmark); (2) the Policy Banks (34%); (3) the Local Governments (20%); and (4) Corporates (16%)*.

Until recently, the dominant view in China has been that the job of local governments was to finance the infrastructure necessary to allow their areas to be linked to the world and benefit from globalisation. As a consequence, the size of local government debt has grown rapidly in recent years and is now the largest municipal bond market in the world. On the positive side, aggressive leverage was applied to the development of a strong infrastructure in local areas (railroads, subways, sewage, schools, highways, and airports). On the other negative side, however, the liabilities of Chinese local governments, over time, have reached levels that cannot be unambiguously justified by the large infrastructure projects. As at the end of 2020, local bonds outstanding in China has reached some 27% of GDP (USD 3.9 trillion).

Local government bond issuance

Despite having grown significantly in recent years, the Chinese local government market is still immature and, in our opinion, currently doesn’t represent an interesting proposition for foreign investors. This is why:

1. Narrow investor base
More than three quarters of local government bonds (LGBs) are held by Chinese commercial banks, which make up over half of China's banking system. For comparison, US municipal bonds make up only around 2% of the total banking assets. Despite recent reforms by the central government allowing private investors to purchase LGBs from commercial banks, we are still far from having a diversified investor base.

2. Low liquidity
Linked to the above is the segment’s illiquid nature. Due in part to the fact that LGBs are perceived locally as having an implicit government guarantee, hence a very low risk of default, commercial banks tend to hold them to maturity. This feature might be also a consequence of the changes carried out in 2015 that added local government bonds to the list of eligible collateral for various People's Bank of China lending facilities.

3. Unmatched rating and yield premium
Local government bonds have lower credit quality than both central government bonds and policy bank bonds, however, they deliver lower yields than policy bank bonds, which fail to reflect their actual underlying risks.

4. Poor market discipline
Unlike many other countries, where local governments receive greater credit risk premia and lower credit ratings depending on their weaker fiscal fundamentals, most Chinese local provinces hold the maximum AAA credit rating, without differentiation among their various financial conditions. This might be related to the above-mentioned widespread perception that the central government will bail out any local government debt defaults. However, the lack of market discipline is detrimental for the development of a sound bond market.

Despite such weaknesses, we believe the efforts currently undertaken by the central government to contain local governments’ liabilities, provide rules and guidelines, and internationalise its financial markets will ultimately prevail and contain this particular risk.