China lets local governments sell bonds for the first time

BEIJING (Reuters) - China has made a watershed move of letting 10 local governments sell and repay their own bonds in an experiment to straighten out its messy state budget, and start the clean-up of its $3 trillion (1.77 trillion pounds) public debt problem.

The finance ministry said the governments in Shanghai, Zhejiang, Guangdong, Shenzhen, Jiangsu, Shandong, Beijing, Qingdao, Ningxia and Jiangxi will be part of a pilot test that effectively creates China's first-ever municipal bond market.

This is the first time China has given its blueprint for the market, which has been heralded by experts as a key step to sorting out the country's fiscal debt woes.

The announcement of the plans on Wednesday, just a day after the top economic planner identified the creation of a municipal bond market as part of key changes for 2014, also suggests that China's policy makers are committed to continuing reforms in spite of a stumbling economy.

In a significant break from the past, the experiment lets local governments issue their own bonds and be responsible for repayments, contravening Chinese laws that bar local governments from directly borrowing from any parties.

The change implies that China's leaders are prepared to amend current budget laws that were previously resisted by fiscal conservatives.

The latest pilot expands on the previous programme. Local governments had depended on the Ministry of Finance to sell bonds on their behalf, an arrangement that left the ministry responsible for repayments.

In a statement on its website, the ministry said the experiment was effective immediately, and that the amount of cash governments can raise by selling bonds would be capped by a ceiling set by the Chinese cabinet.

Any government that fails to sell all the bonds that it is entitled to in a year cannot carry its unused rights into the next year. Bonds must trade in the interbank market or on the securities exchange.

"This opens a normal channel for local governments to raise funds," said Lian Ping, the chief economist at Bank of Communications in Shanghai.

REGULATED BY INVESTORS, HOPEFULLY

A state audit in December showed Chinese local governments owed a total of $3 trillion, after they created financing firms that borrowed on their behalf.

The creative financing methods that officials invented to circumvent the rules convinced experts that the only way to slow China's fast-rising debt pile was to set up a legal and transparent municipal bond market regulated by investors.

The hope was that this would subject local governments to investor scrutiny, leaving the weakest borrowers out of the market and forcing provinces to improve their fiscal health.

Indeed, the ministry said that any cash raised by issuing municipal bonds must be accounted for in official budgets, taking aim at the incessant government spending and borrowing in China that are not accounted for in state budgets.

And in a sign that authorities want to fix the maturity mismatch in public debt, the ministry said governments must sell bonds in five-, seven- and 10-year maturities in the proportion of 40 percent, 30 percent and 30 percent, respectively.

Many Chinese governments in the past took out bank loans to pay for big infrastructure works. But repayment was often problematic because many loans were due well before projects generated income, resulting in a mismatch in maturities.

The 10 governments picked for the latest experiment are among the wealthiest in China and are, therefore, unlikely to have repayment problems, said Lian from Bank of Communications.

Any bond issued must be rated by ratings agencies and its price must be benchmarked against central government bonds.

If the yields of municipal bonds are set below the yields of central government bonds -- thereby implying that local government debt is safer than central government debt -- officials must submit an explanation to the finance ministry.

China said in March that local governments can sell 400 billion yuan worth of bonds in 2014, so the value of municipal bonds that the 10 governments can sell under this experiment is expected to count towards the 400 billion yuan limit.

Although China's huge public debt load has raised concerns of rising defaults as economic growth grinds to an expected 24-year low, government debt is still sought after by investors.

It is unclear who the biggest buyers of government debt are, but the fact that no sale of public debt has failed -- and that buying interest is actually rising -- shows that investors are sanguine about default risks.

But Guan Youqing, an economist at Minsheng Securities, is concerned about who ends up buying municipal bonds.

"I am a little bit worried that local governments would force state firms to buy their bonds," he said.

(Reporting by Koh Gui Qing and Shao Xiaoyi in BEIJING and Lu Jianxin in SHANGHAI; Editing by Jacqueline Wong)