New Rules Aimed at Reducing Risk of Local Government Bonds Ineffective

By Wang Yu, Cheng Zhiyun
Published: 2010-04-14

News, page 4, issue 463, April 2, 2010
Translated by Tang Xiangyang
Polished by Rose Scobie
Original article:

A notice titled, "Standard Notice to the State Council Pertaining to Problems Related to Providing Direct or Indirect Guarantees for Local Governments and Financing Platforms," has been submitted to the State Council. The notice was drafted by the Ministry of Finance (MOF) and signed by the National Development and Reform Commission (NDRC) and related departments. According to a source close to the MOF, there is still much debate over what impact the new rules will actually have.

The notice forbids local governments and public institutions from providing direct or indirect guarantees for enterprises or local financing platforms. Since over half of the debts used by local governments to promote urban construction (known as urban construction bonds, 城投债) are directly or indirectly guaranteed by local governments and public institutions, the notice has shaken market faith in the quality of these bonds. However, a source told an EO reporter, if the issuance of bonds is carefully considered and supervised, the risks can be controlled. A source close to the National Development and Reform Commission also confirmed that the NDRC is actually accelerating the process of issuing such bonds.

Issuing of Bonds Will Not Be Effected

Both the MOF and NDRC have continually warned of the potential risks associated with urban construction bonds. But according to the above source, even within the MOF and NDRC some people still consider the bonds to be a reasonable financing channel, though they agree that the risks need to be strictly managed.

The NDRC intensified supervision of the issuing of urban construction bonds since the end of last year, requiring prefecture-level cities to issue only one such bond and provincial capitals to have no more than two. Officials with the NDRC have repeatedly issued public statements warning against the risks associated with the bonds.

The above measures have led the NDRC to believe that the risks associated with such debt instruments can be controlled.

In fact, from the issuance of urban construction bonds, our source revealed, we can see from the current process by which qualified urban construction bonds are approved, that the approval process has been sped up, so much so that bonds left unaproved last year have already entered the approval process this year.

An insider said, more than 100 urban construction bonds issuances may take place this year.

China's Banking Regulatory Commission (CBRC), along with the MOF and related agencies under the State Council, have been investigating local financing platforms and coordinating with local governments in order to prevent and control risks.

Currenly, their a four types of local government debt instruments that are being audited and cleaned up: bonds issued by public institutions that have been subsidized by local governments , bonds issued by local financing platforms to support public projects that rely on the injection of government funds to be paid off; bonds that are issued by local financing platforms to construct public projects that raise a steady cash flow and rely mainly on profits to be paid off and debts issued by local financing platforms to construct competitive projects.

According to an insider, the MOF's plan to reorganize existing financing platforms aims to eliminate those local platforms that provide financing for public projects but bear no responsibility for construction and rely mainly on fiscal revenue in order to meet their debt obligations. After the reorganization, the MOF also plans to standardize those local financing platforms that finance public projects but that have a steady revenue stream that they can depend on to pay off their debts, along with those platforms that mainly provide financing for competitive businesses. These two kinds of financing platforms will also be prohibited from relying direct or indirect guarantees from local governments to raise funds.

Risk from Bank Loans Even Greater

It's widely believed among regulators, market participants and credit rating agencies that local financing platforms are most exposed to risk in terms of bank loans.

Debt researchers of securities firms are still recommending existing urban construction bonds to investment agencies and the fixed income departments of some funds and securities firms continue to favor investing in these urban construction bonds.

After the MOF announced that it would standardize local financing platforms, the secondary bond market entered a period of "wait and see". At the time of the MOF's announcement, a bond manager of a fund company located in Beijing said he had no idea about whether to buy or sell urban construction bonds.

But presently, everyone is still relatively optimistic about the prospects of urban construction bonds. The debt manager mentioned above has resumed buying the bonds.

The risks of local financing platforms have gained the attention of Standard and Poor's (S&P), a company which specializes in financial market ratings, which warned in a recent report that in the climate of readily available credit, a proportion of these local financing platforms had raised capital to fund public construction projects, and this may have led to the creation of a massive amount of bad loans.

The S&P report emphasised that most of the risk was concentrated in loans acquired by these local financing platforms.This view was echoed by an analyst at a securities firm who said in terms of the concentration of risk and amount of funds involved, urban construction bonds are much less risky than the bank loans.

China's Banking Regulatory Commission (CBRC) has also urged all banking institutions to guard against and control loan risks accumulated through financing local government construction projects and has required banking institutions to completely evaluate and effectively guard against risks concerning local government financing platforms, and to intensify their follow-up supervision on loans. The CBRC is also urging banks to co-issue loans to limit the degree of risk concerning large-scale and highly-concentrated loans.

The CBRC also requires banks to obey three rules when providing loans for local financing platforms: First, bundled loans are prohibited; second, credit agreements signed with local governments concerning a large amount of money without outlining specified projects are prohibited; third, banks should strictly restrict providing loans to financing platforms with no real capital, management structure, internal control, risk management, strong capital supervision system, or strict loan restrictions. Additionally, the CBRC urges banks to immediately make a concrete agreement with financial platforms to safeguard against risk.