China’s national government came to the rescue of its regional and local governments to give them an escape route for their staggering debt problem.

The National People’s Congress (NPC) on August 31 passed a set of amendments to the budget law that include the establishment of a legal framework allowing some regional and local governments to issue bonds directly.

The new measure is mainly for the reduction of funding costs and repayment of local governments’ existing debts, says Kim Eng Tan (陈锦荣), senior director and analytical manager, sovereign ratings, Asia-Pacific, at Standard & Poor’s Ratings Services. In contrast to other analysts, he disagrees that the softening property market poses a big threat to domestic government financing.

Until July this year, home prices were up 4.7% year-on-year but sales value went down 8.2%, S&P data shows. The rating agency forecasts a 5% decline in home prices and no volume growth in 2014.

However, only about 20% of local government revenue is property related, with 6% from land sale, 6%-7% from property companies’ business tax and the rest from stamp duty and land appreciation, Tan offers. “So the direct impact of a declining property market on local government is not that big,” he adds.

Domestic governments have been largely dependent on local government financing vehicles (LGFVs) for funding. In the division of multiple government-related issuers, 39% were from LGFVs, 23% from government departments and organizations, 18% from state-owned or holding enterprises and 13% from business units funded by the government, according to Moody’s statistics.

As the central government tightens credit expansion, the LGFVs have to tap the shadow banking system for funding where the costs are much higher. “That brings huge pressure to LGFVs,” Tan points out.

Economic constitution

To facilitate a cheaper way to finance local spending, NPC or China’s parliament, has finally passed the new budget law, or the “economic constitution” of the country, after four revisions in the past 10 years, a research note by CITIC Securities comments.

“Allowing local governments to issue municipal bonds will provide them with more transparent, stable and lower-cost sources of financing, replacing the current non-transparent system of borrowing through local government financing vehicles and corporate channels, mainly in the form of bank loans and some in shadow banking credit,” explains Tao Wang, head of China economic research at UBS.

The official announcement was made after a pilot programme in May this year where the ministry of finance selected 10 provinces and cities (Guangdong, Zhejiang, Jiangsu, Shandong, Jiangxi and Ningxia provinces as well as Shanghai, Beijing, Shenzhen and Qingdao cities) to issue bonds for the first time in their own names.

“Local governments’ bond issuance will enjoy a long-term development, as it is related to their social and economic responsibilities,” Guan Jianzhong (关建中), chairman of Dagong Global Credit Rating, the largest Chinese-owned credit rating agency, tells The Asset.

Dagong released a whole suite of local government rating standards. It cannot proactively rate every local government in China because their debt information is generally not open to the public, so the rating is only done as a mandate from certain local governments. So far, Dagong has rated three out of the 10 provinces and cities in the pilot programme namely the Ningxia Hui autonomous region and the cities of Qingdao and Shanghai, according to Guan.

Under the new legislation, the State Council will determine which provinces can borrow and will also set annual quotas for local government borrowing. Only 31 upper tier governments, including provinces, autonomous regions and four special municipalities, will be permitted to borrow.

Furthermore, these entities will be allowed to only issue bonds because of the greater level of disclosure required compared to bank loans and other forms of borrowing. In addition, the authorities want to discourage alternative financing, such as trust and wealth management products, which have proven to be riskier. Finally, bond sales can only be used to finance capital expenditures, as opposed to day-to-day operations, according to Moody’s research.

The offering of more transparent and longer-dated local bonds should attract domestic institutions and savers, and foreign investors (through schemes as Qualified Foreign Institutional Investor and Renminbi Qualified Foreign Institutional Investor, for example), predicts Wang.

In addition, the new budget law also aims to tackle some fundamental issues such as the proper formulation and consolidation of government budgets, mandatory disclosure under increased NPC scrutiny, reduction of revenue-linked spending and transfers, and a clearer separation of government and corporate responsibilities.