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| Local Government Implicit Debt and the Pricing of Chengtou Bonds |
| LIU Xiaolei, LV Yuanzhen, YU Fan
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Guanghua School of Management, Peking University;
Anderson School of Management, UCLA;
Claremont McKenna College |
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Abstract The recent explosion of Chinese local government debt has raised alarm among investors and regulators.According to China's National Audit Office's government debt report, Chinese local governments had accrued implicit and explicit debts totaling 17.89 trillion renminbi (RMB) by June 2013.The lack of a systematic measurement system for Chinese local government debt has long been a problem, especially for city-level governments, as their debt is mostly implicit.Chengtou bonds, a unique type of bond that combines the features of municipal and corporate bonds, are deeply rooted in the history of the Chinese government's administrative system reform.Lacking the authority to independently issue debt due to the 1994 Budget Law, Chinese local governments set up local government financing vehicles (LGFVs) to issue so-called chengtou bonds.While these bonds are commonly understood as carrying an implicit government guarantee, the identity of the implicit guarantor is unclear.
In this article, we examine to what extent local government implicit debt affects the pricing of chengtou bonds.We further explore variations in the implicit guarantor that is recognized by the market.We first construct a measure for city-level local government implicit debt.As debt owed by LGFVs accounts for a large portion of city-level governments' debt, using the public disclosures of bond-issuing firms, we total all of the outstanding interest-bearing debt of LGFVs under the jurisdiction of a local government to obtain a proxy for total implicit city-level debt.We then divide the total interest-bearing debt by local government revenue, local gross domestic product (GDP), and local fixed-asset investment to obtain three local government implicit debt ratios.
We first hypothesize that if the market believes that chengtou bonds carry an implicit government guarantee, local government implicit debt ratios should be related to the yield spread of chengtou bonds.Consistent with this hypothesis, we find that higher local government implicit debt ratios are associated with higher yield spreads of chengtou bonds at the city level.This result holds in both the secondary and primary market samples.
Next, we explore the time-varying identity of the implicit guarantor using default events and government policy changes.In April 2011, Yunnan Highway, a LGFV owned by Yunnan Province, defaulted on some outstanding bank loans.Although the crisis was not directly related to chengtou bonds and was finally resolved with government intervention, this event may have significantly impacted investors' recognition of the risks associated with chengtou bonds.We find that the relationship between the city-level government implicit debt ratios and the yield spreads of chengtou bonds did not exist prior to the Yunan Highway default event and became significant only afterwards.This result is consistent with the arguement that investors initially believed the central government to be the guarantor of chengtou bonds and ignored the implicit debt burden of local governments.Investors only began paying attention to city-level government implicit debt after the 2011 default event.
In October 2014, the State Council issued Directive No.43 to clarify the relationship between local governments and LGFVs.This document makes it clear that city governments can swap their LGFVs' debt for municipal bonds issued directly by provincial governments.We thus hypothesize that after the issuance of Directive No.43, provincial government implicit debt ratios become important in the pricing of chengtou bonds issued by city-level LGFVs.Indeed, we discover that provincial government implicit debt ratios are significantly positively related to chengtou bond yield spreads after October 2014.
In summary, our evidence suggests that the identity of the implicit guarantor of city-level chengtou bonds has shifted over time from the central government to city-level governments, and more recently, to city-plus province-level governments.
Although implicit guarantees reduce the borrowing costs of local governments, due to the lack of formal legal protection, the pricing of chengtou bonds is significantly affected by market events and government regulations that shift market perceptions regarding the identity of the implicit guarantor.The uncertainty related to the implicit guarantee creates unnecessary risk and may potentially increase local governments' borrowing costs in comparison to them raising debt independently.
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Received: 21 May 2020
Published: 01 January 2022
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