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China's promise to allow more bond defaults so markets can accurately price investment risk is being undermined by the government's own mixed messages, and bond investors are still betting that Beijing will come to their rescue.
In March China's Finance Ministry said local governments could swap out 1 trillion yuan ($161 billion) of their estimated $3 trillion of mostly high-yield debt for new, lower yielding municipal bonds, and the localities, not national government, would be responsible for repayment.
The new debt would be issued "according to market principles", the ministry insisted.
But on April 1, regulators said they would allow the national social security fund (NSSF) to purchase local government debt.
Shaun Roache, IMF resident representative in Hong Kong, said the new NSSF policy may be partly aimed at widening the pool of municipal bond buyers and ensuring yields do not rise too far. But it also makes it less likely that Beijing would allow municipal bond defaults, since that would swallow up taxpayers' social security funds.
In China's tightly administered bond market, most companies allowed to issue bonds tend to have some form of state backing, so corporate bond yields fell sharply in response to the news, with AA and AAA-rated bond yields declining around 15 basis points, the sharpest downward move since a surprise interest rate cut in November 2014.
On Tuesday came further evidence that bond investors are not losing sleep. When Chinese internet firm Cloud Live Technology defaulted, bond yields hardly moved, in stark contrast to a year earlier, when a first public default by Chaori Solar caused a sharp spike.
Chaori Solar was bailed out a few months later with the help of local authorities, leaving investors to conclude that if the Chinese system can't stomach the collapse of even economically insignificant firms, there is little likelihood that local governments and linked companies would be allowed to fail.
Allowing the NSSF to buy into local government debt reinforces that conclusion.
"The government has formally agreed to back the debt of these local governments and their affiliated companies. That, from the perspective of analyzing credit risk, is a bad thing," said an investment manager at a major joint venture fund that buys Chinese stocks and bonds.
Markets have, moreover, continued to price Chinese municipal debt and sovereign debt as virtually identical.
"If you look at the municipal bond yields, they're only slightly above the sovereign bond yields, which is very, very low compared to the benchmark bank loans and the LGFV (local government financing vehicle) bonds," said Nicholas Zhu, a senior analyst at rating firm Moody's who covers local government debt.
Yields on the municipal debt index compiled by China's bond clearing house trade only 10 basis points above sovereign five-year bonds yielding 3.5 percent, well below the roughly 5 percent on high-rated commercial debt.
Observers believe Beijing's stated policy that local governments are responsible for their debts masks the reality that central government would step in with fiscal transfers or other measures long before a province runs into trouble with repayment.
"We expect that the Chinese central government would pre-empt any RLG (regional-local government) default in order to protect the country's nascent RLG bond market," a Moody's report from March 10th concluded.
While this would make formal defaults on official municipal debt unlikely, it leaves central government on the hook for any losses.
That could push up yields on sovereign debt if bond holders perceive provincial and central liabilities as interchangeable. Yields on Chinese treasuries have in fact risen by around 15 basis points since the debt swap was first announced.
"We believe the supply shock could raise government bond yields 50-100bp in an extreme case," UBS bond analyst Qi Chen wrote in a report on the Chinese bond market on Wednesday, though this would probably be tempered by deflationary pressure and economic slowdown.