China Insights – Local Government Bonds
August 18, 2021
4 Mins Read
By Eurizon SLJ Capital’s China Bond Team
Beware of China Local Government Bonds (for
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).
The first half of 2021 saw...
...of local government bonds issued.
Local government bond issuance
Source: Refinitive Datastream & Eurizon SLJ Capital as at 30th June 2021
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
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
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
* Eurizon SLJ Capital, Refinitiv Datastream, WIND as at 30th June 2021.