China’s local governments are facing an unpleasant liquidity crunch. Subjected to many an unfunded mandate to improve infrastructure and social services, and at the same time prone to relentless banqueting, the outflow of cash has been substantial.
This has become the banking system’s problem. Local governments have borrowed heavily to cover their stimulus obligations, and the banks have moved some of these loans off their balance sheets by selling them to trust companies. In turn, trusts have bundled and securitized the loans – obscuring the actual condition of outstanding loans.
There has been much attention paid to exploring alternatives for local governments to earn revenues, most notably pilot projects experimenting with property taxes that would relieve fiscal dependence on land sales. But others are looking at the borrowing side. What if, instead of borrowing from state banks, China’s local governments issued bonds to pay for special projects?
The advantages of such a policy are myriad. Bonds for popular projects could be sold to private investors, and would provide a flexible alternative source of credit for local governments. They would help develop the national bond market and provide a welcome investment alternative to property and stocks. Such bonds could ultimately be sold abroad to foreign firms, giving foreign investors exposure to the renminbi and deepening the internationalization of China’s financial system.
But for now the suggestion remains entirely hypothetical. The central government can still restructure local government debt. There is no pressing need to facilitate new borrowing through bonds, and the need to slow unnecessary spending is greater than the need for financial innovation.
Second, Beijing has already jailed officials for insider trading related to central government bonds, and a prior experiment with municipal debt in the 1990s resulted in a saturnalia of local graft. This concern is particularly acute given the immaturity of the domestic risk assessment and ratings industry.
The final issue is the legalization process itself. The outgoing set of leaders cannot feasibly make such a fundamental change to China’s budget law on their way out the door; they’ll leave it to the next generation to consider in 2012. Municipal bonds are coming, but they remain several years over the horizon.