Last week, in “China May Double Down On Debt Swap As ABS Issuance Stumbles,” we discussed the likelihood that China’s local government debt swap pilot program would be expanded in the very near future. To recap, here’s what you need to know about the refi effort:
China’s local governments are sitting on a pile of debt that amounts to around 35% of GDP. That’s a problem because some of this debt was accumulated off balance sheet through LGFVs (an effort to skirt official restrictions on borrowing via shadow banking conduits) meaning in some cases yields are far higher (at roughly 7%) than they would have been otherwise. The idea is to swap this debt for muni bonds and save 300 or so bps, in what amounts to a giant refi effort. The program officially got off the ground midway through last month with Jiangsu province sold paper with maturities ranging from 3 to 10 years at yields between 2.94% and 3.41%.
The program is a big deal for two reasons: 1) China’s local governments simply cannot afford 7% coupons on CNY20 trillion in debt, and 2) thanks to the fact that the PBoC will accept the muni bonds as collateral for cash loans, each new muni issue translates to new credit creation in the real economy — or at least that’s the idea. Shortly after launching the program, Beijing eased restrictions on LGFV financing, meaning that suddenly, local governments were once again able to borrow through the very same vehicles which got them into trouble in the first place. In the end, local governments are essentially able to roll their legacy high-yield LGFV debt via the issuance of muni bonds while re-leveraging via more LGVF financing. Meanwhile, the banks who purchase the newly issued munis pledge them for PBoC cash which is then used to make standard loans to individuals and businesses.
If this sounds convoluted and self-defeating, that’s because it is. It’s a prime example of China attempting to deleverage and re-leverage at the same time. Local governments get to reduce their debt service burden (deleveraging) but the very mechanism which makes that possible also leads to further credit creation (re-leveraging).
Because the total debt burden for China’s local government stands at around 35% of GDP, the debt swap program can theoretically be expanded from the initial CNY1 trillion to as much as CNY20 trillion and indeed, we now have confirmation that the quota on the pilot program has been doubled. WSJ has more:
China will let its cities and provinces issue another 1 trillion yuan ($161 billion) of bonds as it continues an effort to rev up the economy and help local governments refinance their hefty debt burdens.
The move, which doubles the amount Beijing initially authorized, will help local governments refinance 1.86 trillion yuan in debt due this year, according to the official Xinhua News Agency. It said swapping 1 trillion yuan will save local governments about 50 billion yuan in annual interest payments.
The move, which was expected, underscores Beijing’s continued worries about slowing economic growth and mounting debt. China’s 7% first-quarter year-over-year growth rate was the slowest in six years, and recent trade and inflation data continue to point to soft domestic demand.
China’s local governments had run up 17.9 trillion yuan of debt as of mid-2013, or $2.89 trillion at current exchange rates, according to the most recent official data. That was up sharply from negligible levels six years earlier.
Much of the debt was from a massive stimulus push in the wake of the 2008 financial crisis. In recent years, China’s local governments circumvented rules that bar them from borrowing to fund the infrastructure and housing projects that have been essential in maintaining fast economic growth. The debt-fueled investment boom shielded China from the global financial crisis but left the country with greater financial vulnerabilities.
Last month, China’s eastern province of Jiangsu became the first of several provinces to auction bonds. After a brief delay, it sold 52.2 billion yuan of debt at interest rates that ranged from 2.94% for three-year debt to 3.41% for 10-year bonds.
Other local governments that have followed suit include the provinces of Hebei, Shandong, Hubei, Guangxi, and the municipalities of Chongqing and Tianjin.
While the program is unequivocally positive for local governments as it effectively allows provincial authorities to kick the can a little further down the road while retaining access to LGFV financing in the mean time, it's not clear whether the PBoC's move to allow banks to pledge the new bonds for cash loans will be effective in terms of boosting credit creation and lowering real rates.
If three benchmark rate cuts in seven months and two RRR cuts since the beginning of the year haven't done the trick, it's unclear how pumping more liquidity into the system via LTROs is going to effect a meaningful change, especially considering the fact that rising defaults and NPLs are making banks think twice about taking on more credit risk.