Chinese munis will help curb shadow banks; Beijing to hasten launch of municipal bond market

April 15, 2014 6:38 am

Chinese munis will help curb shadow banks

By Henny Sender

Beijing to hasten launch of municipal bond market

It is never a good idea to have an overdeveloped capital market, as is the case in the US. Nor is it a good idea to have an under-developed capital market, as is the case in China. But at least governments can address the former more easily than the latter.

Thus, after years of talking about it, China is finally hastening plans to develop a domestic municipal bond market. When the Ministry of Finance included the launch of the municipal bond market as one of its objectives this year, many people shrugged. But there is a new urgency that has caused the bureaucrats to move more quickly.

That urgency has to do with the challenge of trying to curb the shadow banking system, which now accounts for as much as 50 per cent of all new credit in China. Developing the bond market will bring activity out of the shadows, while also helping to minimise destabilising defaults.

Many of the issuers in that unofficial market are local government financial platforms, which have borrowed as much as Rmb5tn, according to data from Société Générale. Regulators are now telling the banks that, with few exceptions, they cannot increase their exposure to these platforms, though they can roll over existing exposures, according to Haibin Zhu, the China economist for JPMorgan.

But in other cases the platforms have pet projects that the banks are not allowed to lend to at all, such as property development. Unfortunately though, the average maturity in the shadow market is less than two years, while such projects tend to be more long term.

Debt restructuring

There are about 10,000 such platforms in China, SocGen calculates. Assuming that the projects for which they borrowed are viable in the first place, (which is not always a safe assumption) these local government platforms have liquidity issues rather than solvency issues. That is to say there is little chance they can repay their obligations in that short timeframe.

So the coming municipal bond market is designed to help them restructure their debt, transforming debt with, say, 20 months to run, into bonds with a maturity of up to 10 years, while paying a far lower rate of interest than in the unofficial market.

The municipal bond market, in other words, is the vehicle through which the obligations of these borrowers will be restructured. In the past, Beijing has issued debt in the market on behalf of local governments and then allocated the money to particular projects. But now the authorities will encourage more direct access.

The exact timing of this reform is not clear though, because among the big issues still being debated is who should have access to the market, according to one government official with knowledge of the matter. The Ministry of Finance is reluctant to set the bar too low lest there be defaults, this official says.

It is also not clear where demand will come from to absorb what could potentially be a huge wave of supply. For example, the listed banks that had been forced to invest in the bonds of other state owned entities, such as policy bank China Development Bank, are suffering from tighter liquidity as their depositors flee their branches in search of higher yields elsewhere.

Curbing shadow banks

In any case, though, the development of a bond market, like the pledge to liberalise interest rates, is testimony to Beijing’s determination to proceed with reforms that will help bring the shadow banks back into the sunlight at the same time as it moves to rein in hidden leverage that can threaten its financial stability.

Still, as China speeds up some reforms, it may go slower on others, such as the promise to swiftly dismantle controls on its capital account. That is partly because it has abruptly shifted from a policy of gradual appreciation of the renminbi to one that has seen the currency fall about 2.5 per cent against the dollar since the end of February. (Before that change in course, Beijing had the opposite problem of too much money coming in; it has always been easier to bring money into the country than to take it out.)

Beijing’s caution contrasts with the US, which often seems to pursue liberalisation for the sake of liberalisation, as if the development of financial markets is an end in itself.

It is precisely because China lacks complicated financial instruments and is proceeding with reforms at its own pace that the most pessimistic comparisons with the US are unwarranted. China is not likely to have a Lehman moment because it does not have the impossible-to-value opaque securities that led to the global financial crisis. Indeed, China seems to have absorbed the lesson of that episode more deeply than the US itself.