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| Marketization of Urban Investment Bonds: A Comparative Study of Implicit and Explicit Guarantees |
| OUYANG Yuanfen, WANG Qiushi
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| School of Innovation and Development, Central University of Finance and Economics |
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Abstract In recent years, the rapid expansion of local government debt has become a substantial threat to financial stability and economic growth. The financial strain induced by the COVID-19 pandemic has exacerbated these tendencies, further elevating the risks posed by implicit debt to China's financial system. In response to these challenges, the Ministry of Finance has implemented several debt management policies aimed at diminishing market expectations of government bailouts and controlling the disorderly expansion of financing platforms. This study examines the relationship between implicit government guarantees and credit enhancement mechanisms within the bond market, particularly under evolving bailout expectations. This paper explores how market-based credit enhancement mechanisms can serve as alternatives to implicit government guarantees, promoting greater transparency in bond pricing and reducing financing costs. The study further analyzes the distinct roles of implicit guarantees and credit enhancement at various stages, revealing the shift from reliance on implicit government support to market-driven credit enhancement strategies, and thoroughly discussing the substitutive dynamics between the two.
This paper uses changes of local debt management policies and the COVID-19 pandemic as quasi-natural experiments to assess how policies influence the roles of implicit government guarantees and credit enhancement mechanisms in the bond market. By comparing bond issuance pricing before and after the implementation of these policies, the study reveals how implicit guarantees and credit enhancement mechanisms function as substitutes.
Our dataset, spanning from January 1, 2010, to May 31, 2022, includes key characteristics of Urban Investment Bonds, such as guarantee terms, issuing entities, and debt sizes. The data is taken from the Wind and Resset databases, ensuring its completeness and reliability, providing a solid foundation for the empirical analysis.
The findings reveal that the presence of implicit government guarantees has allowed Urban Investment Bonds to benefit from lower financing costs. These implicit guarantees reduce investors' perception of default risk associated with local government financing platforms, resulting in more lenient pricing of these bonds. However, as policy reforms were progressively implemented, particularly with the introduction of Document No. 88 and Document No. 50, market expectations regarding implicit government guarantees began to diminish.
Our empirical analysis demonstrates that the weakening of implicit guarantees has significantly enhanced the effectiveness of credit enhancement mechanisms, particularly for bonds involving private enterprises and third-party guarantors, where the ability to share risk has steadily improved. Moreover, a clear substitution effect between credit enhancement mechanisms and implicit guarantees has emerged, as the market's reliance on implicit government backing decreased, shifting toward a greater dependence on credit enhancement as a tool for mitigating risk. However, following the outbreak of the COVID-19 pandemic, increased economic pressure on local governments and tighter financial controls led to a resurgence in investors' expectations for government bailouts. The study further identifies significant differences in the development of various guarantee types and guarantor entities, with credit enhancements provided by private enterprises and third-party guarantees proving to be more effective alternatives to implicit guarantees.
Based on these findings, this study offers the following policy suggestions: First, efforts should continue to be made to reduce market expectations of implicit government guarantees by sending clear policy signals that limit the government's role in backing local financing platform debts. This will encourage more accurate risk pricing. Second, further development of market-based credit enhancement mechanisms is needed, especially on improving the effectiveness of professional guarantee companies and collateral-based services. The government should also promote greater involvement of private enterprises and third-party guarantors to enhance risk-sharing.
The key contribution of this paper lies in its in-depth analysis of the interaction between implicit guarantees and credit enhancement mechanisms, providing a comprehensive framework for understanding how implicit guarantees can undermine the effectiveness of credit enhancement mechanisms. By exploring the diverse characteristics of guarantors and different types of guarantees, this study deepens the current understanding of bond guarantee systems and market-based pricing models, offering practical policy suggestions to facilitate the marketization of Urban Investment Bonds. Moreover, the research brings a new perspective to local government debt risk management, proposing market-driven solutions to reduce the reliance on implicit debt guarantees and promote greater transparency and efficiency in the bond market.
For future research, it would be valuable to further explore the long-term effects of policy reforms on the sustainability of local government debt, particularly in contexts where the development of credit enhancement mechanisms remains uneven.
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Published: 01 September 2024
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