Local govt bonds are poised for approval

State Council would set quota system on debt, but only under strict conditions

China may allow local governments to sell municipal bonds under narrow parameters in a move to regulate their borrowing and reduce systemic risk.

Qualified provincial-level governments that win approval from the State Council, the country's cabinet, will be able to raise some of the funds needed for construction projects through bonds, if a draft amendment to the Budget Law is approved by the top legislature.

The draft amendment, which was submitted on Monday to the National People's Congress Standing Committee, sets strict conditions for such debt issues.

The scale of any debt issue must be within the quotas approved by the NPC as well as local legislatures. Debt proposals will only be approved if there is a stable revenue stream to cover repayments, and proceeds of such issues can't be used for current expenditures.

Except under these conditions, local governments may not issue bonds or provide a guaranty to any institution or individual.

Officials found to be directly responsible for illegal bond issues will be dismissed, the draft said.

It's the first time for the nation to formulate explicit rules and supervisory principles for local government bond sales.

The current Budget Law, which is some two decades old, bars most debt issues by local governments.

But governments at all levels have managed to raise funds in recent years through bank loans or via local government financing vehicles to pay for a plethora of infrastructure projects.

A survey by the National Audit Office found that as of June 30, 2013, local government debt and contingent liabilities surged to about 17.89 trillion yuan ($2.9 trillion), a 67 percent rise from the previous estimate of 10.7 trillion yuan at the end of 2010.

Much of this debt, especially that raised through LGFVs, poses a systemic risk because of its opacity, said Liu Jianwen, head of the Fiscal and Economic Law Research Center at Peking University.

Liu said Monday's draft marks a breakthrough in that it establishes detailed procedures and criteria for local government bond sales.

"Since local government bond sales have become a prominent issue, it is wiser to regulate them than to ignore them," he said.

But Liu warned that the draft may lead to "underhanded doings" among government officials if local governments squabble over debt quotas.

Under Monday's draft, the State Council will be responsible for mapping out an overall debt plan and submitting it to the national legislature for approval. Qualified governments would then divide the debt pie among themselves and submit the quotas to local legislatures for approval.

Lawmakers could decide whether to put the draft to a vote as early as Wednesday. If the vote is postponed, the draft would be opened to public comment.

Jia Kang, director of the Research Institute for Fiscal Science under the Ministry of Finance, said it is significant that the third draft again mentions the conditions for allowing local governments to raise debt, unlike the second draft, which omitted those provisions.

The first draft amendment, proposed in December 2011, deleted the clause in the current law that banned local governments from raising debts and added that "necessary" debts could be raised with the approval of the State Council, with a designated quota.

However, when the second draft amendment was discussed in June 2012, those sections were deleted, which appeared to close the door to local debt funding.

"The back-and-forth movement shows that the central government, and society at large, are very cautious over the matter," Jia said. "Now they're back to discussing conditions, which in itself is an important change."

He said that if local governments are allowed to raise debt through market channels such as municipal bonds, many LGFVs will fade from the scene, while some will assume specific roles such as "project companies".

Song Li, a researcher with a think tank at the National Development and Reform Commission, said that if municipal bonds, which usually have long maturities and low rates, could replace the current financing vehicles, it would help solve the "maturity mismatch" issue.