To examine the implicit guarantee provided by Chinese local governments to local government financing vehicles (LGFV), we create a proxy for local governments’ implicit debt ratio and find it correlated with the credit spread of LGFV bonds. More importantly, this relationship varies with government policies and macroeconomic conditions, suggesting that investors’ views about which level of government is the implicit guarantor change over time.

The increasing level of Chinese local government debt has led regulators and investors to pay attention to local government credit risk. The two main types of bonds in local governments’ liabilities are local government bonds (issued and backed by local governments) and local government financing vehicle (LGFV) bonds (Chengtou bonds in Chinese), which are issued by financing vehicles owned by local governments. China’s tax-sharing reform in 1994 leads to a mismatch between the financial and administrative powers of local governments. In addition, since the 1995 Budget Law forbids local governments to issue bonds, local governments set up numerous LGFVs to borrow money for infrastructure construction, particularly during the period when the Chinese government launched the “RMB 4 Trillion” investment program. The amended 2014 Budget Law allows local governments, mainly provincial governments, to directly issue local government bonds. However, the direct issuance of bonds by local government didn’t displace LGFV debt. These two types of bonds coexist in the market.

Although LGFV bonds are nominally corporate bonds and their prices reflect issuers’ own credit risk, a more important pricing factor is the implicit guarantee that the controlling local government provides. Chun et al. (2018) found that in the U.S. market, a higher guarantor credit risk leads to a higher credit risk in municipal bonds backed by the guarantor. Using Chinese data, studies have found that the credit risk of local government debt is related to local real estate industry development (Ambrose, Deng, and Wu 2015; Ang, Bai, and Zhou 2019), policy uncertainty (Ang, Bai, and Zhou 2019), and other factors. In this study, we argue that the ability of a local government to provide guarantee critically depends on its debt ratio. Whether the implicit debt of local governments is priced into LGFV bonds largely depends on which level of government investors believe is the guarantor. This could be rather uncertain. For example, if an LGFV defaults on its bond repayment, which level of government is expected to bail it out: municipal government, provincial government, or central government? Or is no government bailout to be expected?

We address this question by considering three indicators that measure a local government’s implicit debt burden, and empirically assess the impact of each on the LGFV bond (offering and trading) credit spread from May 2008 to April 2018. The results indicate that the higher the local government’s implicit debt ratios, the greater the LGFV bond’s credit spread, with or without firm-fixed effects. This evidence confirms that although LGFV bonds are nominally corporate bonds, investors regard them as part of local governments’ implicit debt.

We conduct a time-series analysis based on two major market events to trace changes in investors’ identification of the implicit guarantor. In April 2011, Yunnan Provincial Highway Development and Investment Co., Ltd. informed its creditor bank that it would default on the principal repayment. This triggered widespread concern among investors over LGFV credit risk and eventually led to investor panic and shrinking market liquidity, prompting investors to focus on the ability of local governments to offer implicit guarantees for the LGFVs they control. We thus divide the sample into subsamples before and after April 2011. The regression results of the subsample before April 2011 show that government implicit debt ratios are not statistically significant, whereas for the subsample after April 2011, the coefficients are positive and statistically significant. This indicates that in the early phase of the LGFV bond market, investors generally believed that the central government was the implicit guarantor, but after the credit crisis triggered by the Yunnan Highway default, the market began to consider the implicit debt of controlling municipal governments. One possible alternative explanation is that in the early period, investors believe that land sales revenue is sufficient collateral for LGFV bonds regardless of the local government debt ratio. However, we find that the land revenue as a percentage of general budget revenue variable is insignificant in the early period and became significantly negative only in the later period. This evidence is inconsistent with investors caring about land sale revenue in the early stage and is more consistent with the central government guarantee explanation.

The State Council’s Guidelines on the Improvement of Local Government Debt Management (hereafter “Directive No. 43”) was issued in October 2014. It proposed a sustainable management system to regulate the “borrowing, use, and repayment” of debt by local governments. It also required local governments to set up a well-regulated financing system to isolate their financing from the operation of LGFVs they control. This significantly affected investors’ views on local government implicit debt and bond pricing. Directive No. 43 specifies that whether LGFV bond repayment should be covered by the local government budget depends on the cash flow coverage of the funded projects. According to the statistics published by the China Credit Rating Corporation, China’s total outstanding LGFV bonds reached RMB 2.23 trillion by the end of 2013. However, the audit report released by the National Audit Office in June 2013 indicated that only RMB 1.18 trillion of outstanding bonds (excluding government bonds) were guaranteed or possibly guaranteed by local governments. Thus, at least 47.03% of these outstanding bonds would be classified as corporate bonds and would not be covered by the fiscal budget. Since a lack of transparency regarding the use of funds from bond issuance is common, and the cash flow coverage in funded projects is rarely disclosed, investors will find it difficult to evaluate which bonds are backed by fiscal budgets. However, regardless of whether LGFV bond repayments are actually covered by fiscal budgets, the importance of implicit debt ratios in LGFV bond pricing should increase after the release of the directive. On one hand, for those bonds covered in the budget, the credit risk would definitely be more closely linked to the financial conditions of local governments.On the other hand, for those bonds not covered, since Directive No. 43 encouraged governments to inject quality assets into LGFVs, the credit risk would be indirectly linked to local governments. We find that after the release of the directive, local government implicit debt ratios become more significant, and their coefficients are higher as well.

Meanwhile, Directive No. 43 encourages debt swaps, where provincial governments are allowed to issue government bonds to swap LGFV debts with higher interest rates. This transfers a proportion of LGFV debts onto the balance sheets of provincial governments. We find that during the pre-Directive No. 43 period, provincial governments’ implicit debt ratios are not statistically significant, but they become significant after the directive was released. This indicates that investors deem LGFV debts to be liabilities borne by not only LGFVs and the local governments that directly control them, but also by provincial governments.

In summary, we analyze the effect of local governments’ implicit debt burden on LGFV bond prices by constructing implicit debt ratios of municipal and provincial governments. We find that these ratios are statistically significant to LGFV bond pricing, and their influence increases after the Yunnan Highway default and the release of Directive No. 43. Results also suggest that investors’ view on the level of government that provides implicit guarantee shifts over time, from the central government to municipal governments, and then to both municipal and provincial governments.

Our study has important policy implications. As implicit guarantee is based on investors’ expectations and is sensitive to policy changes, frequent changes in such expectations would increase price volatility. Our study suggests that shifting local government guarantees from implicit (LGFV debt) to explicit (local government debt) would help alleviate uncertainty caused by investors’ belief in the roles of different level of governments in local government debt market.

References

Ambrose, Brent, Yongheng Deng, and Jing Wu. 2015. “Understanding the Risk of China’s Local Government Debts and Its Linkage with Property Markets.” Penn State University Working Paper. http://dx.doi.org/10.2139/ssrn.2557031.

Ang, Andrew, Jennie Bai, and Hao Zhou. 2019. “The Great Wall of Debt: Real Estate, Political Risk, and Chinese Local Government Financing Cost.” Georgetown University McDonough School of Business Research Paper No. 2603022.  http://dx.doi.org/10.2139/ssrn.2603022.

Chun, Albert Lee, Ethan Namvar, Xiaoxia Ye, and Fan Yu. 2019. “Modeling Municipal Yields With (and Without) Bond Insurance.” Management Science, 65 (8): 3694–3713. https://doi.org/10.1287/mnsc.2017.3007.