China’s risk crackdown rattles its municipal bond market

Bloomberg

China’s deleveraging campaign is providing a reality check to the fledgling municipal bond market. Set up in 2015 to bring transparency to local-government borrowing practices, the new market benefited from the perception that Beijing had the provinces’ backs, with yields largely on par with the sovereign despite some weak municipal balance sheets.
Not anymore — a clampdown on risk and record levels of debt in China’s financial system is spurring a reassessment of the market, with the premium demanded by investors on muni bonds over central government debt surging to a record as volumes in the secondary market slide.
While the shift to pricing based on risk is a step toward a more mature, world-standard bond market, for now at least it poses a challenge given plans for a record year of issuance.
“The regulatory crackdown is tightening liquidity, and with limited cash, local government debt is among the first to be ditched,” said Wu Sijie, a bond trader at China Merchants Bank Co. in Shanghai. “This is a reversal of last year’s situation, when flush funds competed with each other to find things to buy regardless of the quality.”
China’s banking regulator has spearheaded the latest moves to reduce leverage in the financial system, after the central bank started pushing up money-market rates late last year.
Investors are also starting to price different local governments according to their credit profiles, a change from the first year of the muni market, when yields were basically uniform across the map.
The province of Zhejiang, located southwest of financial-sector powerhouse Shanghai, enjoys a similar coupon rate on its bonds as China’s central government, while Liaoning — a rust-belt region in the northeast which just emerged from a recession — paid a record premium of 58 basis points when it sold bonds last month.
The two-year-old market faces a torrent of issuance this year as a deadline for provincial governments to convert borrowing into muni bonds looms. Sales in the local-government debt market are set to reach an all-time high of 1.63 trillion yuan ($237 billion) in 2017, according to a target set at China’s National People’s Congress in March.
“The credit premiums may widen further on tightening liquidity as a result of the central bank’s monetary policy fine-tuning and the regulatory enhancement,” said Amanda Du, a senior analyst at Moody’s Investors Service in Shanghai.
Du flagged a double disadvantage for local-government bonds. On one hand, their liquidity isn’t as attractive as for sovereign securities. But in terms of yields, they’re not as high as for corporate debt. And liquidity is tightening further — turnover in municipal bonds fell by two-thirds in the first quarter to 256 billion yuan from the previous three months.
China’s Finance Ministry is reported to have boosted its oversight of local government debt as well, vowing in February to halt illegal borrowing, and curbing local governments’ abilities to guarantee other companies’ loans. Officials launched an inspection of the muni bond market in March to check whether funds raised were being used in line with the law, according to the 21st Century Business Herald.
On Wednesday, the ministry asked local governments to stop any illegal financing guarantees by the end of July, and to submit a report on their debt activities by Aug. 31. This latest move shows Beijing wants to get “stricter” when it comes to reining in municipalities’ fiscal risks, analysts at Industrial Securities Co. wrote in a note Thursday.