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Beware of China Local Government Bonds (for now)

Our series of ESLJ China Insights aims to shed some light on the complexities of the Chinese local bond market, its structure and main players and how foreign investors can improve their portfolio diversification by increasing their allocation to one of the largest bond markets worldwide.

In this fourth instalment we focus on the second of the four main segments that constitute the RMB bond market, local government bonds.

As we mentioned in our previous Insights, the Chinese bond market is composed of four main market segments: (1) bonds issued by the Central Government (‘CGB’) (consisting of 30% of the benchmark); (2) the Policy Banks (34%); (3) the Local Governments (20%); and (4) Corporates (16%)*.

Until recently, the dominant view in China has been that the job of local governments was to finance the infrastructure necessary to allow their areas to be linked to the world and benefit from globalisation. As a consequence, the size of local government debt has grown rapidly in recent years and is now the largest municipal bond market in the world. On the positive side, aggressive leverage was applied to the development of a strong infrastructure in local areas (railroads, subways, sewage, schools, highways, and airports). On the other negative side, however, the liabilities of Chinese local governments, over time, have reached levels that cannot be unambiguously justified by the large infrastructure projects. As at the end of 2020, local bonds outstanding in China has reached some 27% of GDP (USD3.9trillion)

The first half of 2021 saw...

$

...of local government bonds issued.

Despite having grown significantly in recent years, the Chinese local government market is still immature and, in our opinion, currently doesn’t represent an interesting proposition for foreign investors. This is why:

1. Narrow investor base

More than three quarters of local government bonds (LGBs) are held by Chinese commercial banks, which make up over half of China's banking system. For comparison, US municipal bonds make up only around 2% of the total banking assets. Despite recent reforms by the central government allowing private investors to purchase LGBs from commercial banks, we are still far from having a diversified investor base.

2. Low liquidity

Linked to the above is the segment’s illiquid nature. Due in part to the fact that LGBs are perceived locally as having an implicit government guarantee, hence a very low risk of default, commercial banks tend to hold them to maturity. This feature might be also a consequence of the changes carried out in 2015 that added local government bonds to the list of eligible collateral for various People's Bank of China lending facilities.

3. Unmatched rating and yield premium

Local government bonds have lower credit quality than both central government bonds and policy bank bonds, however, they deliver lower yields than policy bank bonds, which fail to reflect their actual underlying risks.

4. Poor market discipline

Unlike many other countries, where local governments receive greater credit risk premia and lower credit ratings depending on their weaker fiscal fundamentals, most Chinese local provinces hold the maximum AAA credit rating, without differentiation among their various financial conditions. This might be related to the above-mentioned widespread perception that the central government will bail out any local government debt defaults. However, the lack of market discipline is detrimental for the development of a sound bond market.

Despite such weaknesses, we believe the efforts currently undertaken by the central government to contain local governments’ liabilities, provide rules and guidelines, and internationalise its financial markets will ultimately prevail and contain this particular risk.

More from this series

China Insights – Local Government Bonds

By The China Bond Team | August 18, 2021

Our series of ESLJ China Insights aims to shed some light on the complexities of the Chinese local bond market, its structure and main players and …

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China Insights – Central Government Bonds

By The China Bond Team | June 3, 2021

In this issue of ESLJ China Insights series, where we aim to explain the Chinese local bond market and its peculiarities, we are discussing…

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China Insights – Policy Banks

By The China Bond Team | April 29, 2021

In this China Insights article, we explore Policy Banks – a unique and important part of the local bond market…

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China Insights – Market structure

By The China Bond Team | April 20, 2021

Our series of ESLJ China Insights aims to shed some light on the complexities of the Chinese local bond market, its structure and main players and …

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Disclosure

None of the contents of this document should be understood as constituting research on investment matters, or as a recommendations, advice or suggestions, implicit or explicit, with respect to an investment strategy involving the financial instruments discussed, or the issuers of the financial instruments, nor as a solicitation or offer, nor as consulting on investment matters, of a legal, fiscal, or other nature. All the companies of the Intesa Sanpaolo Group, its administrators, representatives, or employees, decline any responsibility (fault-based or otherwise) deriving from indirect damages potentially caused by the use of this communication or its contents, or in any case deriving in relation to this document, nor may they be consequently held liable for any of the above. The information provided and the opinions contained in this document are based on sources considered reliable and in good faith. However no declaration or guarantee is offered by Eurizon SLJ Capital Limited, explicitly or implicitly, on the accuracy, exhaustiveness and correctness of the information, and there is no guarantee that results, or any other future events, will be compatible with the opinions, forecasts, or estimates contained herein.

Views accurate as at the time of publication. Opinions expressed by the authors are their own and do not necessarily reflect those of Eurizon SLJ Capital Limited, Eurizon Capital SGR or the Intesa Sanpaolo Group.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Sources: Eurizon SLJ Capital, Refinitiv Datastream, WIND as at 30th June 2021

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