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
Disclosure
This communication is issued by Eurizon SLJ Capital Limited (“ESLJ”), a private limited company registered in England (company number: 09775525) having its registered office at 90 Queen Street, London EC4N 1SA, United Kingdom. ESLJ is authorised and regulated by the Financial Conduct Authority (FRN: 736926). This communication is treated as a marketing communication intended for professional investors only and is provided only for information purposes. It has not been prepared in accordance with legal and regulatory requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. It does not constitute research on investment matters and should not be construed as containing any recommendation, advice or suggestion, implicit or explicit, with respect to any investment strategy or financial instruments, or the issuers of any financial instruments, or a solicitation, offer or financial promotion relating to any securities or investments. ESLJ and its affiliates do not assume any liability whatsoever for the contents of this communication, save to the extent agreed in any written contract entered into between ESLJ and the recipient, and do not make any representation or warranty as to the accuracy or completeness of any information contained in this communication. Views are accurate as at the time of publication. Opinions expressed by individuals are their own and do not necessarily reflect those of ESLJ or any of its affiliates. The value of any investment may change and an investor may not get back the original amount invested. Past performance is not an indicator of future performance. This communication may not be reproduced, redistributed or copied in whole or in part for any purpose. It may not be distributed in any jurisdiction where its distribution may be restricted by law and persons into whose possession this communication comes should inform themselves about, and observe, any such restrictions.
Sources: Eurizon SLJ Capital, Refinitiv Datastream, WIND as at 30th June 2021
ESLJ-180821-I1
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