China to boost municipal bond market with collateral rules

Banks will be allowed to use municipal bonds as collateral for borrowing

China is set to let banks and local governments use municipal bonds as collateral for borrowing, according to sources and an official document seen by Reuters, which could pump prime a fledgling market Beijing hopes will help local authorities manage their unwieldy debts.

China created its municipal bond market in September last year in the hope that by forcing local governments to raise funds only through bond sales, financial markets would impose budget discipline on the governments and curtail their borrowing, which has climbed in recent years to at least $3 trillion.

To combat so far weak demand for the muni bonds, regulators will for the first time let banks use them as collateral when they borrow from the central bank, three sources with direct knowledge of the matter said.

The sources showed Reuters a document issued by the Finance Ministry and People's Bank of China detailing the change, which will be effective this year.

Banks will also be able to use the bonds as collateral in the central bank's repurchase agreement operations, and China's central and local governments can use them as collateral when raising funds for treasury operations.

"Policymakers perhaps have been a little disappointed with the lack of enthusiasm in the market for these bonds. They appear to have misjudged the appetite for these bonds," said Mark Williams, an economist at Capital Economics in London.

"Whether it (the new policy) will work or not remains to be seen," he said. "It will depend to some degree on the yields that these bonds are trading at."

As China's economy slips to its lowest annual growth in a quarter of a century this year, many analysts worry that more local governments will have difficulties repaying their debt, which could saddle banks with more bad debt and destabilise the world's second-largest economy.

Demand for municipal bonds has been so poor that the southern province of Jiangsu, one of China's wealthiest provinces but also its most indebted, was reported in Chinese media to have been forced into delaying a bond auction.

Jiangsu announced on Wednesday, however, that it would relaunch the bond sale on May 18, but scaled down the issue size.

"The new policy and the reduction of the Jiangsu issue size signal that regulators want to smooth the process of municipal bond issuances," said a trader at a Chinese state-owned bank in Shanghai, though he added that pricing would determine how the market treats such bonds.

China's municipal bond market got off to a dubious start last year, with impoverished local governments borrowing at rates below the central government's sovereign yield, giving rise to a suspicion that yields were being manipulated.

To reduce financial risks, China's Finance Ministry said in March that local governments would be allowed to swap 1 trillion yuan ($161 billion) worth of maturing, high-interest local debt for new municipal bonds to reduce interest costs.

But with municipal yields so unattractive, averaging just 3.4% for a five-year bond, or a mere 10 basis points above Chinese sovereign debt, analysts have said it would be hard to entice banks or funds to buy them.

Previous official attempts to drum up support for municipal bonds, including allowing China's $194 billion social security fund to buy more of them, appear to have had limited impact.

The central bank, Ministry of Finance and China's bank regulator were not immediately available for comment.