China is asserting control over once-chaotic local government financing by banning the use of opaque funding vehicles, but filling the gap with a huge expansion of the fledgling municipal bond market will raise a whole new set of problems.
Chastened by promiscuous local investment in response to the 2008 global financial crisis, Beijing wants to restore discipline as part of its wider economic reforms, but the muni bond market, be deviled by price distortions and inadequate disclosure standards, is no quick fix.
China's State Council, the country's cabinet-level political institution, prohibited local government financial vehicles (LGFVs) from raising funds on behalf of local authorities in a decree issued earlier this month.
On Tuesday sources told Reuters the Ministry of Finance had circulated a draft document saying localities would be allowed to issue new muni bonds to pay off old debt.
If the draft becomes law and localities are allowed to roll over a substantial portion of their estimated 18 trillion yuan ($3 trillion) of outstanding debt, the muni bond market would have to expand dramatically from the quota of just 109.2 billion yuan that Beijing has set for 2014.
"We estimate that as much as 1 trillion yuan of new bonds may be issued to fill the financing gap in 2015," wrote UBS economist Tao Wang in a research note this month.