Cover, issue no. 407, February 23, 2009
Translated by Liu Peng, Tang Tang
Original article: [Chinese]

Last week, China's top legislators scrutinized a State Council report on the plans to issue local government bonds, expected to be implemented soon if all went smoothly.

The EO learned that the planned bonds totalled 200 billion yuan, with the central government acting as the surrogate issuer, while local governments would pay the principal interests and the issuance fee.

It was exciting news for local governments. At the end of last year, the central government announced a stimulus package of 4 trillion yuan while simultaneously requiring various local governments to front another 600 billion.

However, the financial capacity of local governments could only afford 300 billion. Thus, the local bonds scheme has come at an opportune time, as the central government could not allocate credit capital through administrative order given that the banking system has become market-oriented.

However, history has its many lessons, many of which are applicable here. Trust funds were a popular method for the local government to finance construction before 1998. In October of that year, the Guangdong International Trust Fund Investment Company was mired in a debt crisis that ended in bankruptcy and liquidation.

The episode reflected pitfalls in local governments' financing systems, which led to an overhaul of the trust industry for many years.

During the Asian financial crisis in 1997-1998, China also transferred to local governments some long-term treasury bonds funding issued by the central government in order to increase their capital.

But repayment for the debts was disappointing, with some poor provinces failing to cope, the central government ultimately covered the loans.

To avoid the same mistakes, systemic risks must be removed, and officials need to make the process as transparent as possible to allay suspicions. The public is currently only slightly informed.

Given these bonds would be issued by the central government on behalf of local governments, these papers would share the same high credit rating as treasury bonds.

The central government clearly stated that the principal interest and issuance costs should be shouldered by local governments. But failing that, would it step in in the end?

Local governments as of the end of 2007 had accumulated some 4 trillion yuan in debt, excluding some implicit debt insured by them. Because local governments have been barred from floating loans by China's Budget Law, no description on their debt status can be found in local fiscal budgets.

These debts would lead to increasing underlying risks if not put under budgetary controls and more forceful supervision.

It is a good thing to shed light on local government debt by allowing them to float loans. But this also calls for a long-term program. Thus, for the time being at least, the central government should grant local government more fiscal and administration power and establish a sound risk evaluation and control system.

In addition, local government debt management should be put under budgetary controls and subject to the oversight of people's congresses at all levels.

If the latest local bonds issuance was only reckoned as a special solution to a short-term fund shortage problem, local governments would likely float massive, reckless loans and leave the mess to the next administration or central government.

Such debt, ultimately, would be borne by the tax-paying public.