City is first local government to raise funds under trial program

SHANGHAI - The auction of Shanghai's direct issuance of local government bonds, the nation's first, met with strong demand on Tuesday, enabling the municipal government to get financed at favorable rates.

Shanghai's issuance is part of a four-region trial program launched by the central government on Oct 20. Analysts say letting regional governments sell debt directly into the market will help make governments' books more organized and prevent chaotic accumulation of debt through financing vehicles, which came under the spotlight this year.

The government of Shanghai auctioned 3.6 billion yuan ($567 million) in three-year bonds at a rate of 3.10 percent and 3.5 billion yuan in five-year bonds at 3.30 percent. The issuance starts on Wednesday.

The rate is 1.7 percentage points lower than the 5 percent average yield of the five-year bonds sold by companies set up by the city to fund infrastructure, according to data compiled by Bloomberg.

In fact, the yields are almost the same as those of risk-free national bonds on the secondary market. Fixed-rate three-year central government bonds on the interbank market yielded 3.15 percent on Monday, with five-year debt yielding 3.30 percent.

"The fact the Ministry of Finance pays interest on behalf of local governments means that the bonds have the same credit ratings as those previously issued by the ministry," China International Capital Corp Ltd, the country's biggest State-owned investment bank by assets, said in a research note.

"Liquidity is relatively rich now in the market. The current economic fundamentals and policies are also preferable for the bond market, resulting in lower yields," the note said.

On Oct 25, Premier Wen Jiabao said monetary policies will be "fine-tuned", after inflation slowed to 5.5 percent in October year-on-year from a three-year high of 6.5 percent in July.

Shanghai's issuance makes it the first regional government to issue debt directly, under a trial program launched on Oct 20 that also covers Guangdong and Zhejiang provinces, as well as the city of Shenzhen.

The southern province of Guangdong plans to auction 6.9 billion yuan in bonds on Friday.

Before Oct 20, local governments were banned from directly issuing debt - the bonds were issued by the Ministry of Finance on their behalf.

The ministry issued 200 billion yuan in bonds on behalf of regional governments in 2009 and again in 2010, far less than the amount local governments actually needed.

Lacking a funding channel, regional governments set up a number of financing vehicles, or trust companies, to bypass the law and borrow from financial institutions. The National Audit Office said in June that 6,500 such entities borrowed 10.7 trillion yuan at the end of 2010, 27 percent of the gross domestic product that year.

Allowing regional governments to issue bonds directly will help improve transparency in local government debt, said Wang Jianhui, chief economist at Southwest Securities Co Ltd.

"The direct issuance is a breakthrough," he said. "It will make regional governments' books more transparent, exposing problems before they get worse."

The issuers of bonds are required to publish annual reports and stipulate clearer obligations than those financing vehicles do.

Liu Ligang, head of Greater China Economics at ANZ Banking Group, cautioned that direct issuance also needs proper supervision.

"We view this reform (the trial) as a milestone in the development of China's fiscal system and capital market," he said. But measures should be taken "to prevent the local government bond market from being a conduit for soft budget constraint".

In a research note, he suggested that the central government establish a set of institutions to prevent excessive debt issuing and draft a local-government bankruptcy law to provide an orderly resolution of a local-government default.

Meanwhile, rating agencies should be encouraged to participate in the local government rating process. Liu said he believes a debt limit of no more than 40 percent of local GDP should be adopted as a precaution.