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.
The market appears ill-equipped for such explosive growth. It got off to a dubious start in 2014, with impoverished and debt-ridden local governments able to issue bonds at yields below even the central government's sovereign yield.
Analysts blamed high ratings from compliant domestic ratings agencies and possible collaboration between issuers and the state-owned banks that dominate the market.
They also noted that offer documents for such issues lacked proper disclosure, usually doing little more than parroting the provinces' five-year plans.
Only province-level governments will be allowed to issue bonds, making thousands of lower-level city and county authorities dependent on provincial governments for their funding.
"With key players starved of money, a vicious competition may emerge between cities and counties over the distribution of the proceeds of provincial bond issues," said a trader at a Chinese commercial bank in Shanghai.
While making lower-tier governments work harder to justifying spending would be no bad thing, it could create big problems if the process is not handled efficiently, he warned.
Tackling risk-pricing distortions could also prove tough, since few domestic investors believe Beijing would really let a province default on its bonds, and the wording of the cabinet decree suggests central government will play an active role when defaults threaten.
While regulators have promised an end to the days when lending to state-linked actors was a one-way bet, that message has been muted in practice.
In March, China's first public bond default, by Chaori Solar, was initially trumpeted as a sign that Beijing was serious about allowing defaults in the name of better risk pricing, but it ended with a bailout by a government-linked investment consortium.
The implicit state guarantee, combined with high yields relative to developed economy bonds, might well make the bonds attractive to investors looking for exposure to China.
"There will be strong (foreign) interest in muni bonds, which offer more diversity in addition to government and policy bank bonds," said Ivan Chung, senior vice president at Moody's in Hong Kong.
And domestic state-owned banks, which have always been the primary bond-market participants in China, are also likely to remain reliable buyers of the new issues.
But that poses problems for China's broader reform purpose; such muni bonds would outshine private sector issuers, which are considered more risky, aggravating the misallocation of capital in China to less efficient state firms.
Jin Wu, vice president at China Chengxin International Credit Rating Co, said it was already increasingly difficult for small and medium-sized private businesses to issue debt, given the draw of state issuers.
"If you're an SOE and have government backing, you can borrow at a much lower rate for the same rating (as a private firm)."