The Chinese central bank's recent move to open the interbank bond market to certain foreign institutional investors will diversify the investor base and is likely to boost aggregate demand for local government bonds, said Fitch Ratings.
This will benefit the ongoing local government debt-for-bonds swap program and have significant positive implications for local government credit, said Fitch, one of the Big Three rating agencies.
The central bank on July 14 allowed foreign institutional investors, including central banks, international financial institutions and sovereign wealth funds, to invest in China's onshore interbank bond market.
The onshore market is estimated at around 35.3 trillion yuan (5.7 trillion U.S. dollars) by the end of May, according to the central bank, with government bonds accounting for about 30 percent of the total outstanding.
Fitch said these reforms would facilitate the swap program initiated by the Ministry of Finance (MoF), which aimed to lower the financing costs of local governments by converting high-cost debt into municipal bonds.
The swap is significant for local government credit and will reduce liquidity risks by extending debt maturities and lowering financing costs. The MoF has initiated two rounds of swaps thus far, of 1 trillion yuan apiece. Fitch expects another 1-trillion-yuan debt swap in 2015, bringing the total to 3 trillion yuan.
The scale of the debt swap is such that demand from onshore investors may not meet the substantial increase in government bond supply. It is notable that a large proportion of local government bonds thus far are held by big commercial banks, and the take-up from other onshore investors has been relatively limited.
Therefore, opening the interbank bond market to foreign investors will help diversify the investor base for the local government bond market at a time when significant new supply is coming, according to Fitch.
Investing in local government bonds on the onshore interbank market will allow foreign institutional investors to gain quasi-sovereign mainland China exposure. Fitch maintains that Chinese local government bonds will continue to have an implicit sovereign guarantee.
The agency maintains though, that the increase of aggregate demand through foreign investment is likely to be a gradual process, and the market for local government bonds will continue to be dominated by onshore investors for the short to medium term.
