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Local government bonds issued recently in Shanghai, Guangdong and Zhejiang were well received by the public.

While the aggregate amount raised by the issuance of local government bonds represents only a small proportion of the 10.7 trillion yuan outstanding debt owed by local governments nationwide, the move is a major step towards the establishment of a municipal bond market.

Compared with the national benchmark 3-year and 5-year bonds auctioned by the Ministry of Finance on Nov 22 at 3.12 percent and 3.41 percent respectively, the yields of local government debt were significantly lower, with 3-year bonds yielding only 3.01-3.10 percent, and five-year bonds yielding 3.24-3.30 percent.

The low bond yields reflect strong demand for local government debt. That bodes well for issuances by other provinces in the future.

Of the 10.7 trillion yuan local government debt, only 17 percent is due to mature in 2012, with the four leading banks receiving 460 billion yuan each. Strong investor demand for local government bonds takes some pressure off the banks, helping them limit their credit risk.

This implies that the banks are now free to release more liquidity into the market, justifying a cut in the reserve ratio requirements (RRR) or interest rates.

Many local infrastructure projects have been stalled due to lack of funding earlier this year.

But with the success of the recent issuance of local government debt, these projects can now restart. This has positive implications for the job market.

The successful issuance of local government debt has helped alleviate concerns of defaults by local government financing vehicles (LGFV). The central government is working towards a more transparent and market-oriented capital raising system for city and municipal governments. This is good news for the banks that have become accustomed to fretting over whether local government debt would be repaid.

Bank loans have been the principal source of local government debt. The success of the recent issuances of local government debt paves the way for a higher portion of funds from the bond market.

I believe that the bulk of local government debt, including non-performing loans, will be repaid through a combination of municipal bond issuance, asset sales, balance sheet restructuring, a cap on the rate of economic expansion and local government tax revenues. Taken together, these measures will help lower the risk of default.

The issuance of local government debt will also facilitate a gradual shift towards on-balance sheet financing. It is only a matter of time before on-balance sheet financing will be restored in a bid to ensure better disclosure and more rigorous market regulations.

The author is an associate director and economist at CCBI. The opinions expressed here are entirely his own.

(HK Edition 11/29/2011 page2)