China is studying the possibility of allowing its local governments to issue bonds to finance urban infrastructure construction projects, a senior expert said yesterday.

The issuance of municipal bonds will give the local governments a new legitimate channel to raise funds, other than Treasury bonds and bank loans, for their massive infrastructure projects, said Li Jiange, deputy director of the Development Research Centre (DRC), a think-tank under the State Council.

"But we need to study carefully how that channel is opened," Li told the International Conference on Urbanization and Municipal Bond Market in China yesterday.

Although China's Budget Law largely bars local governments from issuing bonds, it has made room for exceptions should the State Council pass special regulations to grant permission, he told participants at the conference.

The event was hosted by the DRC's Development Strategy & Regional Economy Department, the Expert Committee of the China Development Bank (CDB) and Merrill Lynch & Co and was organized by Golden State Holding Group Corp.

Permission for a local government to issue bonds came close to being written into China's reform agenda last year, but was shelved because of concerns that, without effective budgetary constraints, strong investment impetus among many local governments would amplify financial risks.

But municipal bonds are expected to play a key role in raising the huge funds needed for China's urban infrastructure projects as the nation strives to further urbanize itself, said Gao Jian, vice-governor of CDB, a policy bank that lends primarily to infrastructure projects.

China's urbanization ratio stood at 40 per cent at the end of last year, well short of the 70 per cent level typical in developed countries. But the ratio is expected to grow to 60 per cent by 2020 to meet the nation's goal of building a well-off society.

The relative weight of fiscal revenue income as a percentage of the national income has continued to decline in the past two decades despite the apparent growth in absolute terms, which helps explain why local governments are unable to sustain urban infrastructure investments through fiscal revenue income, Gao said.

Bank loans provide no sustainable solution either. "Precedents abroad lend tepid support to the merit of bolstering urban infrastructure projects by exploiting credit financing," he said.

"As enormous short-term savings are appropriated to address long-term needs of credit financing driven by urban infrastructure projects, risks of liquidity are lurking with potentially devastating consequences," Gao added.

And China's fledgling capital market can hardly play a dominant role, with financing through stocks and corporate bonds today accounting for less than 1 per cent of aggregate urban infrastructure investment.

Gao's bank is currently a major urban infrastructure lender in China. Its outstanding loans granted to such areas as urban road construction, waste water management, water supply and heating stood at 167 billion yuan (US$20 billion) at the end of last year, with a mere 1.34 per cent ratio of bad loans.

Once local governments shift to the bond market for infrastructure financing, the CDB will "continue to function as the mainstay in rendering the establishment of urban infrastructure in conjunction with co-ordinated support offered by municipal bond financing," Gao said.

Strategists from Merrill Lynch endorsed the need for a municipal bond market in China. Li Yingchen, municipal derivatives strategist at the investment bank, said municipal bonds can provide local governments with a strong tool for flexibility in financial management and reducing the cost of financing.

Such bonds will help diversify risks in China's current financial system dominated by bank loans, and provide an excellent new investment instrument for investors, he said.

The municipal bond market is mature in many developed countries. Issuance in 2003 alone totalled US$385 billion in the United States.

"I believe if you develop a municipal bond market in China, this (number of issuers) will be a very small number," Philip Fischer, municipal bond market strategist at Merrill Lynch, said at the conference.

But further preparations are necessary to pave the way for the launch of a municipal market in China. Gao said the interest rate regime needs to be further liberalized, the credit rating system needs to be improved, and a real over-the-counter market should be established to facilitate trading.

More importantly, Gao said, budgetary constraints must be put into place to ensure that local governments do not borrow beyond their repayment capacity.

Source: China Daily