Beijing's efforts to restructure local government debt look set to boost the size of China's nascent municipal bond market by up to twenty times, analysts say.
China is in the midst of unraveling the web of local government debt in the shadow banking system and, in the process, kick start its long held plan to promote a market driven municipal bond market.
Once the central government finalizes a proposed debt swap with commercial banks, China's municipal bond market could grow by nearly twenty times, to up to 2 trillion yuan ($322 billion) this year, according to Societe Generale rates strategist Frances Cheung.
Last year, Beijing started taking tentative steps to move municipal debt out of the shadows. A handful of cities, including Beijing, were authorized to issue 100 billion yuan of bonds in 2014, after a central government audit recognized local government debts issued through financing vehicles to banks of 18 trillion yuan ($2.9 trillion), more than a quarter of China's 2014 GDP of 63 trillion yuan.
To make sure the commercial banks have enough liquidity to handle the latest and bigger restructuring of around one trillion yuan, Beijing has cut the reserve requirement ratio (RRR) twice over the past few months, most recently on April 19, by a full percentage point to 18.5 percent.
"We see the recent reserve ratio rate (RRR) cut by the People's Bank of China [as] very much related to this issue," Aberdeen Asset Management's Head of Asian Fixed Income Adam McCabe told CNBC by email. The commercial banks will be the main buyers of the local government debt, and a reduction of the RRR would ease the liquidity burden, he said.
And, with local investors swimming in excess liquidity, China's municipal bond market could finally be ready for take-off.
"The municipal bond market should grow by 20 to 30 percent every year for the next few years," ANZ Greater China chief economist Li-Gang Liu told CNBC by phone.
To be sure, it's still not clear if banks can be persuaded to trade in loans paying interest of 7 percent for municipal bonds, with maturities of between two to five years, that are only likely to pay around 0.50 percent over bonds issued by the central government. Five-year Chinese government bonds are currently quoted at around 3.287 percent, compared to 1.548 percent for U.S. Treasuries and 0.067 percent for German bunds of the same maturity.
Still, flush with the PBOC's 1.2 trillion yuan liquidity injection, analysts expect the commercial banks to come around, and pour that extra cash into the new municipal bonds when issuance starts in earnest from June.
"The market needs to pause and digest, but the government is committed to dealing with the [local government debt] issue," Moody's senior analyst Nicholas Zhu said by phone.
Better disclosure needed
Foreign investors will still have some lingering concerns, particularly over local government finances, however.
Municipalities would need to improve the disclosure of their accounts, and the central government will probably need to impose debt limits as well as authorize the big three U.S. agencies to start rating the municipalities, said ANZ's Li-Gang.
Still, he sees no shortage of potential investors, including foreign ones.
In a world of low interest rates, "the yields are just too attractive," Li-Gang said.