Now for the clean-up: China crafts plan for local-debt mess

[BEIJING] More than six years after China unleashed a record credit boom to shore up growth in the grip of the biggest global financial crisis since the 1930s, policy makers are starting to address the shaky financing that resulted.

In a template that could be expanded, regulators laid out ground rules for local governments to swap high-yielding, short- term loans for lower-cost, longer-term municipal debt.

Officials in Beijing are relying on inducements for banks to take on the new bonds, seeking to avoid a nationalisation of the borrowing that would increase the central government's debt- to-gross-domestic-product ratio.

At least part of the exchange they'd like to be done privately, between the existing borrowers and lenders - deals that could minimise disruption to markets.

A successful swap of the initial 1 trillion yuan (US$161 billion) of loans would help limit the risk of a full-blown financing crisis among China's cities and provinces. At stake is ensuring that local authorities retain the wherewithal to continue building infrastructure critical to the nation's urbanisation drive.

The challenge will be convincing financial institutions to make the swaps and purchase the new bonds, part of a broader push by authorities to develop a municipal-debt market. Among the incentives for banks to step up is the ability to use the new securities as collateral for loans from the central bank through three of the People's Bank of China liquidity programs.

"It will significantly reduce the refinancing risk and interest rate burden for local governments," JPMorgan Chase & Co. economists led by Zhu Haibin in Hong Kong, wrote in a May 13 note. "However, in practice the public offering scheme is constrained by inadequate interest from banks due to low yields of the special local government bond."

The transactions also could help bolster banks' lending capacity, by reducing their loan-to-deposit ratios, Mr Zhu said. With new-loan and money-supply creation weakening, that extra firepower could buttress the PBOC's broader monetary easing measures.

Government data Wednesday showed new yuan loans were 707.9 billion yuan in April, less than all 36 forecasts in a Bloomberg News survey. The M2 gauge of broad money rose by the least on record.

Banks buying the securities can pledge them as collateral through the PBOC's Standing-Lending Facility, Medium-Term Lending Facility and Pledged Supplementary Lending programs. The central bank uses the facilities to direct credit to favored purposes at varying maturities.

The cost of the PBOC financing hasn't been made clear, Citigroup Inc. analysts highlighted in a May 13 report. If set at particularly low rates, the funding could be considered as a form of quantitative easing, they said. Medium-Term Lending Facility funds currently cost 3.5 per cent, and a reduction below 2 per cent to 3 per cent would stoke QE speculation, Citigroup analysts led by Shen Minggao in Hong Kong wrote.

Coupon rates on the new securities shouldn't be lower than the average yield on sovereign notes with similar maturities in the five days before the issuance date, according to a document from the PBOC, Ministry of Finance and China Banking Regulatory Commission dated May 8. Rates shouldn't be higher than 1.3 times comparable sovereign yields, according to the document.

Based on current Chinese government bond yields, the rates on one-year notes should range from 2.6 per cent to 3.4 per cent, with those on 10-year bonds set from 3.4 per cent to 4.4 per cent, according to JPMorgan estimates.

"Although banks' earnings will be hurt by the lower yields of bonds (relative to higher interest on loans), we believe the market will value banks' gain in risk reduction and liquidity over their loss in interest revenue," Wang Tao, chief China economist at UBS Group AG in Hong Kong, wrote in a note.

Jiangsu, a province north of Shanghai, may become the first local authority to complete a swap, when it proceeds with a bond sale that it delayed in April, pending steps by the central government to buttress the program. The province now plans to sell 52.2 billion yuan of securities May 18, of which 30.8 billion yuan would be swap securities.

Besides auctions, the central government is encouraging some of the swaps to be done through private placements - which should be completed by August 31, according to the document. The Ministry of Finance didn't immediately respond to a faxed request for comment on the paper.

The Communist leadership team led by President Xi Jinping and Premier Li Keqiang, is addressing the consequences of the policies of its predecessor group, headed by Hu Jintao and Wen Jiabao. The previous administration won plaudits round the world in 2008 for a decisive 4 trillion yuan (US$586 billion at the time) stimulus programme to strengthen growth in what was then the world's third-largest economy.

Most of the financing for that stimulus didn't come from the central government, which has continued to enjoy an internationally low debt-to-GDP ratio, of about 43 per cent, according to the International Monetary Fund. Local authorities, limited from selling municipal bonds under rules dating from the 1990s, set up thousands of off-balance-sheet vehicles to raise funds from banks and other lenders.

After the borrowing went into projects including subways, highways and sewage works, declining revenues from land sales meant local authorities had increasing difficulty in servicing debt payments - spurring national policy makers into action.

Finance Minister Lou Jiwei has said the swap program may be expanded. There's plenty more that could be swapped. Provincial authorities estimated they had 16 trillion yuan in liabilities in a review earlier this year, the China News Service said April 25.

The 1 trillion yuan swap program amounts to 53.8 per cent of maturing regional and local debt this year, based on the stock of debt as of June 2013, according to data compiled by Moody's Investors Service. Speedy implementation "will help relieve debt-servicing pressures for regional and local governments, which have intensified because of the decline in tax revenues and land sales as economic growth and the real estate market slow," said Nicholas Zhu, a Moody's vice president in Beijing.

By encouraging lenders and borrowers to sort through the process themselves, the central government avoids taking direct responsibility.

"If the lenders agree to directly swap maturing loans for bonds, this could be done simply in the form of bookkeeping without the need to inject extra liquidity," China International Capital Corp analysts led by Chen Jianheng in Beijing wrote in a May 12 note.

BLOOMBERG