Non-rating Action Commentary: The Marketization of China's Local Government Bonds Sees Some Progress, but There Is Still a Long Way to Go


25 Apr 2023

    Enhancing policy support accelerates the marketization of local government bonds in China

    Since 2015, when large-scale issuance of local government (LG) bonds began, the size of the local government bond market has expanded rapidly and is now the largest bond category in the domestic bond market. In the early years of LG bond issuance, due to the market being relatively immature and the lack of an efficient market pricing mechanism, the pricing of LG bonds was primarily based on the guidance price of the Ministry of Finance. The central government bond yields served as the benchmarks for this pricing mechanism, which has transitioned from a fixed yield spread based on the central government bond yield to a floating yield spread within a certain spread interval based on the central government bond yield. Although marketization has slightly improved, it basically remains administrative guidance rather than market-based pricing. This non-market pricing approach has some drawbacks, such as the small difference in the yields of different local governments, which cannot reflect the credit risk differences between regions and projects, and may reduce the efficiency of capital allocation and utilization; there are inconsistencies between the issuance pricing mechanism and the trading mechanism, resulting in low liquidity and a concentrated investor structure in LG bonds' secondary market; and the central guidance pricing model conflicts with the current concept of self-repayment and non-bailout from the central government in local government debt management.

    In November 2020, the Ministry of Finance issued "Opinions on Further Improving the Issuance of Local Government Bonds", proposing to encourage eligible regions to reasonably set bidding ranges based on the LG bond yield curve, and continuously improve the marketization level of LG bond issuance. Administrative interference and window guidance should be removed to ensure that the bond issue yield reasonably reflects regional and project credit differences. This reflects that the regulatory authorities are promoting the marketization of LG bonds through the introduction of new policies. At the implementation level, in early 2022, the Ministry of Finance officially released the "Ministry of Finance-China Local Government Bond Yield Curve". In November of the same year, two LG bond issuances from Guangdong Province were priced for the first time based on the "Ministry of Finance-China Local Government Bond Yield Curve". It can be seen that, with the support of central government policies, the process of marketization of local government bonds has accelerated.

    Increasing differentiation in the issue yield spread of local government bonds

    The issue yield spread between LG bonds and central government bonds has continued to narrow from 2020 to the first quarter of 2023. In 2020, the yield spread of most LG bonds remained at around 25 basis points (bps), with Beijing having the lowest spread of 23 bps. The pricing mechanism anchored to central government bond yields has been set to avoid excessively low LG bond issue yields compared to central government bond yields, but it has also caused some LG bonds to be issued at an unreasonable premium due to market inefficiencies as well as insufficient differentiation in yield spreads among provinces. In 2021, the spread of LG bonds decreased compared to the previous year, with Jiangsu and Hubei provinces having the lowest spread of 20 bps, and Qinghai, Tibet, and Shaanxi having the highest spread of 28 bps. The highest and lowest spreads were lower than those of the previous year. With the promotion of market-oriented LG bond issuance, the LG bond yield spread quickly narrowed in 2022, with the spread of most LG bonds falling below 20 bps, and the differentiation of spreads among provinces significantly increasing. The lowest spread was 11 bps, including Beijing, Guangdong, Hubei, and Jiangsu, while the highest spread was 25 bps, including Xinjiang and Inner Mongolia. The highest spread was more than double that of the lowest. Overall, the yield spreads of LG bonds are narrowing while the differentiation of spreads among provinces is widening, which is more and more closely related to the LGs’ economic and financial conditions. As of the first quarter of 2023, LG bond issue spreads continued their downward trend, with an average spread of a mere 6 bps in Henan.

    The trading activity on the secondary market for LG bonds remains low

    As the largest category of bond in China's bond market, LG bond’s turnover rate is substantially lower than that of other bonds such as central government bonds and significantly lower than that of municipal bonds in the United States. The inactive trading activities of LG bonds indicate that there is significant room for improvement in their level of marketization. 2019 and 2020 were the two most vibrant years for the LG bond market, yet even in those years, the turnover rates for LG bonds only reached 47% and 53%, respectively, which means that almost half of the outstanding bonds were not traded that year. During the same period, the turnover rates of central government bonds were 205% and 223% respectively, and the turnover rates of policy bank bonds were 574% and 484% respectively. After the second half of 2020, the turnover rate tumbled as the issue yield spread of LG bonds narrowed significantly and the enthusiasm of underwriters and market-oriented investors declined. In 2021 and 2022, the turnover rates of LG bonds were 27% and 28% while those of central government bonds were 176% and 213%, respectively, indicating that the decreasing yield spread of LG bonds further restrained investors' trading enthusiasm.

    There are several reasons for the limited liquidity of LG bonds. In addition to the small size of individual bonds leading to insufficient market circulation, the investor structure is dominated by commercial banks, these bonds are more attractive to buy-and-hold investors than to active traders, and there is also a lack of accurate valuation curves in the secondary market and distinguishable credit ratings. Although the Ministry of Finance released the "Ministry of Finance-China Local Government Bond Yield Curve" in 2022, except for Guangdong's trial issuance based on this curve, the pricing of LG bond issuance is still based on the central government bond yield curve, and a widespread "anchor switch" has not emerged. The inconsistency between the issuance pricing mechanism and the secondary trading pricing mechanism persists. In addition, the indistinctive AAA domestic rating for LG bonds cannot accurately capture the differences between the eastern and western regions and the northern and southern regions of the country, which reduces the effectiveness of secondary market trading. Therefore, unifying and improving the issuance and trading pricing mechanisms for LG bonds, increasing the differentiation of LG bond ratings to more fully reflect the credit risk premiums in different regions, will help further promote the marketization of local government bonds.

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    Jameson Zuo, FRM

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    jameson.zuo@cspi-ratings.com

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    Lin Siqi

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    siqi.lin@cspi-ratings.com

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