China State Council issues directive on local debt
汇丰经济研究大中华区经济师王然 汇丰经济研究亚太区联席主管 屈宏斌
The State Council issued more detailed regulations on local borrowing yesterday, setting the stage for a new phase in local government financing. New government bond can only be used to finance public capital spending or repayment and must be budgeted. The size and pace of debt issuance will be centrally managed through a quota system. The directive also outlined the principles of dealing with credit risks and included debt management in local officials' performance assessment. As these regulations come into force, they will help to lower the cost of borrowing and reduce financial risks in the future.
Facts
Regulating fund-raising channels
1) New debt must be directly raised by government, and not through associated companies
2) Only province, municipality and SAR can raise debt, city and country level offices can ask their higher level of governments to raise debt on their behalf
3) Government debt can only take two forms: general debt can be raised to finance public projects with no income, and paid back with budgeted income (hence rely on local governments' credit profile); designated debt (or revenue bond) can be raised to finance public projects with some income, and paid back with cashflow from the project or income from government fund (mostly land sale revenue at the moment)
4) The government will not assume responsibility for any new debt raised through platform companies
5) Attract private capital to participate in public projects with some income. The government can provide special permit, and fiscal subsidies to private sector partners but not assume direct liabilities.
Quota management
1) Both general and designated bond issuances are subject to quota management. Quota are set by the State Council and approved by the NPC or its standing committee
2) Local governments must not incur debt through associated companies
3) Debt can only be issued for public spending, repayment, and not general expenditure
4) All debt will be included in the budget. General debt will be part of the general budget, and designated debt part of government fund budget. Fiscal subsidies provided to private-public joint projects should be included in one or the other depending on the nature of the spending.
Dealing with credit risks
1) The Ministry of Finance will assess the risk in each region based on debt ratio, new debt ratio, debt servicing ratio, overdue debt ratio.
2) In the case of a credit event, a local government should resolve the issue through the market mechanism (cut spending, asset sales etc). If a local government cannot to repay its own debt, it needs to escalate to its higher level of government. The higher level of government then needs to activate plans for dealing with such events, resolve credit risks and ascertain where the responsibilities lie.
Transparency and accountability
1) Local government should compile comprehensive reports detailing its asset and liabilities which will be subject to monitoring
2) Government debt will be a "hard target" in performance assessment for government officials. This aligns local officials' incentives toward risk management for the first time. Local governments (provinces, municipalities and SAR regions) must be responsible for their own debt. Officials will be held accountable for excessive debt raising, illegal debt raising/guarantee, inappropriate use of raised debt, and malicious evasion and cancellation of debts.
3) Financial institutions which help local governments to raise debt illegally must assume its own loss. Its offices and employees will be subject to legal prosecution according to the Law of Commercial Banks and related regulations.
Existing debt
Existing debt (based on the 2013 national audit and any additions after that) will be reviewed. Existing debt will be classified as "local government debt", "corporate debt with local government responsibility", "corporate debt without local government responsibility". The first and second type of debt will be included in the budget and swapped into (formal) local government debt to lower debt servicing cost and optimise duration. Local governments are required to meet their obligations, with asset sales if needed. They are also required to carry out any contingent liabilities as specified in any contractual agreements. On the third type of debt, the government needs to strengthen monitoring and prevent systematic risks.
Implications
Out of the existing stock of local government debt, less than 30% is directly raised by government offices. Compared to other types of financing, government bond issuance is both cheaper and longer term. After the Amendment to the Budget Law established the legal premise for local government bond issuance for the first time, the State Council's directive aimed to provide the framework of regulations that will apply to this market. The directives set the limits on the issuing entities, format and purpose of usage. We believe this will set the stage for the next phase in local government borrowing (see China's Big Bang: New leaders ready to revolutionise the financial system, November 2012)
It banned new debt issuance through platform companies. This essentially means that the government will no longer guarantee any new debt issued by such companies (or the so called "城投债"). The stock of existing platform borrowing will gradually fall, and those which count as government liabilities will be 'swapped' with new debt. This will take place gradually to take advantage of more optimal price and tenure, and reduce repayment risks on existing debt (for background, please see China Inside Out: Local debt: three options, 1 August 2011). Local governments are asked to meet all their contractual obligations with asset sales if necessary. They are also asked to disclose their balance sheet for monitoring from the relevant authorities. These will feed into the decisions on their debt issuance quota as well as the officials' performance assessment (see Balancing the books: Debt, assets and fiscal reform, 7 January 2014).
The directive sets a relatively high threshold for new bond issuance with monitoring from the top level of the central government. New bond can be issued to finance public capital spending (with or without income), but not general expenditures. To the extent that public spending on project with some income needs to be paid back through government fund revenue, local governments' ability to make quasi-public spending will be tied to their respective property market.
The directive also opened the doors for more joint projects between the government and the private sector. However, we will need to see more details to understand how this financing method will work.
Although a lot more details are still needed, the 2nd October directive marked the first set of regulations that will apply to the new municipal bond market. It outlined a framework on how local debt should be borrowed, used and paid back in the future. As these regulations come into force, the existing stock of platform borrowings will gradually fall. This will help to bring down systematic borrowing cost and reduce financial risks in the system.
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