Fiscal changes in China have been taking place at a dizzying pace. Just less than a year ago, in May 2014, the central government allowed 10 regional and city governments to assume full responsibility for organizing the issuance and repayment of municipal bonds. And it was only a little before that, in 2013, that six of these governments were chosen to organize bond issuance, with the Ministry of Finance retaining the responsibility of processing repayments.

 

From this year, provinces can issue domestic bonds to fund capital projects and refinance existing off-budget debts. General government debt could rise as refinancing bonds are issued. However, given what is known of local government debt from a National Audit Commission report in 2013, the amount is unlikely to be material enough to have an impact on the sovereign credit rating on China (AA-/Stable/A-1+; cnAAA/cnA-1+). Moreover, the bond issuances could reduce the risk of contingent liabilities to the central government from the banking sector. Most importantly, the changes reduce the scale of future off-budget borrowing among local governments and, through improved monitoring by the central government, limit the risks to fiscal stability.

 

No longer an exclusive club

 

Under the series of changes from late last year, when the Budget Law was revised, all provincial-level governments are now allowed to issue municipal bonds. The National People's Congress (China's national parliament) will grant annual quotas to each province, with separate amounts for general obligation bonds and project-specific bonds. The specially designated cities of Dalian, Qingdao, Ningbo, Xiamen and Shenzhen can similarly issue bonds if their provincial governments grant them approval. Other sub-provincial level governments can only receive funds from the bond issuances of their provincial governments.

 

Need for growth may be an impetus

 

The need to support economic growth could be a reason why fiscal reforms are progressing so rapidly. Even as the central government tries to rebalance the economic model, public investment is still an important source of growth today. If local governments have to sharply cut new infrastructure spending, it could hurt business confidence and create significant unemployment.

 

This scenario is not unlikely. Many Chinese local governments now face serious challenges in funding new projects. Declining economic growth has been weighing on the rate of increase in budgetary receipts. The ongoing correction in the real estate sector is hurting land sales, another important funding source. And the financing vehicles of local governments, through which the authorities borrow for many capital projects, have seen borrowing costs soar as they turned to non-bank financial institutions for credit. At the same time, continued uncertainties over the repayment of debts owed by these vehicles also weigh on investor sentiment, affecting the financing of local governments and entities related to them.

 

Provincial government bonds are a solution. Such issuance provides low-cost funding to local governments for new capital spending. It also reduces the risks to the financial system, compared with funding through financing vehicles that are already highly leveraged.

 

Relief for bankers

 

Reducing uncertainties in the financial system appears to be an important objective of the provincial government bond program this year. The central government has also allowed provinces to issue bonds to refinance existing debts, in addition to funding new investments. Many of these debts are incurred by financing vehicles related to Chinese local governments in the wake of the 2008 global financial crisis.

 

For this year at least, provincial bond issuances for refinancing will outsize that for new projects. In the budget for 2015, the government allocated a quota of 600 billion renminbi  (US$96.6 billion) for provincial bond issuances. Of this amount, 500 billion renminbi was allocated to general obligation bonds that fund projects that will generate little or no future revenue. The other 100 billion renminbi was for project-specific bonds for funding revenue-generating projects. The quota for refinancing, set outside of the budget, is much larger at one trillion renminbi.

 

Commercial banks are beneficiaries of the program. Many had lent to local government financing vehicles on the expectation that local governments will help in repaying the loans. But it's likely that the banks did not foresee the ferocity of the central government's efforts to rein in local government borrowing or the revenue pressure that local governments are facing. As a result, the risk of significant loan losses is higher than anticipated as the financial positions of local government financing platforms deteriorate.

 

The refinancing bond program reduces this risk to banks. But there are a couple of caveats. One is that the one trillion renminbi program covers only a little more than half of local government-related debt maturing this year, as estimated in the 2013 National Audit Commission's report.. Another is that local governments are likely to be more eager to repay the higher cost of borrowings from non-bank institutions, such as trust companies, to save on interest expense. Still, so long as the bond program relieves the governments' financial squeeze, most of banks' lending to financing vehicles are likely to see typical repayment.

 

Tougher for local officials

 

The local government bond program also allows the central government greater control over risks to long-term fiscal stability. The Ministry of Finance requires more data from local governments regarding their finances to improve monitoring. At the provincial level, the ministry can speed up this process by making financial disclosures necessary for governments seeking to issue bonds.

 

More importantly, the central government can put a stop to off-budget borrowings now that local governments have a formal credit channel. Before the Budget Law revision that comes into effect this year, subnational governments' access to credit had been very limited. In the face of the clear need for public investment, the central government turned a blind eye to off-balance-sheet borrowings. The alternative would have resulted in unmet infrastructural needs and slower economic growth.

 

Now that these governments are allowed to issue bonds, the use of financing vehicles to fund public spending can be stopped. The amount that local governments borrow can also be controlled through annual issuance quotas. So allowing them to borrow can have the effect of reducing their debt accumulation.

 

Local government officials are likely to be less than thrilled with recent fiscal changes. Compared with off-budget borrowing, government bonds are a less-flexible financing option, require more disclosure, and come with a fixed limit. Moreover, officials are now formally accountable for the debts revealed by the 2013 audit and to be brought into the governments' balance sheets when the refinancing bonds are issued. These debts do little for economic development under the officials' watch. However, they limit the governments' future capacity to borrow as the size of annual bond issuance quotas are inversely related to their level of indebtedness. Provincial officials are possibly even less pleased since the finance ministry has made it clear that provincial governments have responsibilities for the debt situation of local governments under them.

 

Back-sliding Is possible

 

The central government will have to remain vigilant to keep local governments away from further off-budget borrowing. The recent reforms did nothing to reduce the controls that local governments have over their financing vehicles and other state-owned enterprises. So it will be difficult to tell if these companies are borrowing for their commercial activities or to finance public spending.

 

Lower-level governments may also continue to face funding shortages despite the changes. It's possible that some provincial governments will not allocate funds from bond issuances to some lower-level governments. This may force these governments to continue their reliance on financing vehicles to fund social investments.

 

The central government may have to continue to tacitly allow off-budget financing, but the scale of such borrowing may be reduce. And that will help to support China's financial stability and creditworthiness.