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　 ? Fiscal income received by local governments has suffered an unprecedented decline due to COVID-19… ? …but funding from other sources, including the central government and local bond sales, is making up the shortfall ? While municipal bonds are ignored by foreign investors, we show why they’re important as they become too big to ignore 7 July 2020

　A dent to the finances of local governments COVID-19 has depleted China’s local governments of a key source of revenue. In the

　first five months of this year, local fiscal income – which comes from taxes on the local economy – dropped by 10.4% y-o-y. In Hubei Province, where Wuhan is the capital, it fell by as much as 42% y-o-y. To make matters worse, spending by local governments is expected to rise, leading to a dramatic rise in their funding gap. All of this is important as local governments are a key part of China’s financial system given these entities have issued vast amounts of debt and fund all sorts of projects. Strong support from the central government, but with conditions attached The good news is there is funding support from a variety of other sources. Transfer payments from the central government are rising, while local governments have been given the green light to issue more municipal bonds (Munis). As a result, total cash inflows into local governments are expected to grow 9.1% this year, based on estimates by Ministry of Finance, not bad at all. Besides, the shadow fiscal system, operated through local government funding vehicles (LGFVs), has been on a fundraising spree in the first four months of this year. However, this time round, conditions have been put in place on local governments by the central government to reduce wasteful investment and careless spending, a different tactic from the “all in” approach during the Global Financial Crisis. Munis: too big to ignore Foreign investors often neglect Munis, and for good reasons. They offer low spreads, poor liquidity and there’s no rating differentiation. However, Munis have grown into the biggest bond class in the onshore market, and most importantly, banks have binged on them at the expense of credit bonds and policy bank bonds. We believe this trend will continue as the Muni supply gets larger. That indicates credit bonds will be unable to rely so much on bank purchases, leaving asset managers to fill the void. Moreover, if banks keep increasing their allocation to Munis, they may ask for more compensation in the form of higher spreads. If that happens, then foreign investors may buy given the low risk, steady supply and long tenor. Helen Huang Analyst, Fixed Income The Hongkong and Shanghai Banking Corporation Limited helendhuang@hsbc.com.hk +852 2996 6585

　Disclosures & Disclaimer This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it. Issuer of report: The Hongkong and Shanghai Banking Corporation Limited

　View HSBC Global Research at: https://www.research.hsbc.com China Fixed Income Credit Local governments’ financial health? Not too bad China Onshore Insights

　 Fiscal income’s COVID-19 crunch

　? An unprecedented drop in local fiscal income is being mitigated by a significant step-up in payments from the central government ? But this may not immediately translate into economic activity as there’s tighter control on local governments over wasteful investment ? Munis have become the largest bond class in the onshore market but their impact is not yet fully appreciated

　This report continues our deep dives into local government debt There is no doubt that the outbreak of COVID-19 has badly hit a key source of revenue for local governments: fiscal income from the local economy. That’s a potential worry as the financial health of local governments has major implications for economic growth. These entities have issued large amounts of debt which fund all sorts of projects and are a critical part of the country’s credit system. In this report, we offer a comprehensive review of cash flow into local governments this year and conclude that the situation is not very bad, for now. This report also continues our previous analysis into this vital part of China’s financial system (see Local government debt: the knowns and unknowns, 4 Oct 2018 and Local government debt: What’s changed? 16 Sep 2019).

　A RMB11.5trn problem

　One important source of revenue for local governments, and certainly the most straight-forward, is self-generated general fiscal income, which comes from taxes on the local economy. This dropped by 10.4% y-o-y in the first five months of this year, an unprecedented decline. Normally it rises and did so even during the Global Financial Crisis (Fig 1). According to the national budget plan published in May, a decline of 3.5% is now expected for 2020. However, at the same time, local governments’ general fiscal spending is expected to increase by 4.2%. That means there’s going to be a widening funding gap, which Ministry of Finance expects to reach as much as RMB11.5trn this year, a historic high (Fig 2). On the face of it, this looks very worrying, though as we later explain, there are also reasons not to be overly concerned.

　1. Growth rate of local governments’ self-generated general fiscal income and general fiscal expenses

　40.0%

　 30.0%

　 20.0%

　 10.0%

　 0.0%

　 -10.0%

　 -20.0%

　2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

　Local government self-generated general fiscal income, growth YoY Local government general fiscal expenses, growth YoY

　Source: Wind, HSBC. Data as of May 2020.

　2. Widening gap between local governments’ self-generated general fiscal income and general fiscal expenses

　25,000

　 20,000

　 15,000

　 10,000

　 5,000

　 -

　2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020E

　Local government self-generated general fiscal income, RMBbn Local government general fiscal expenses, RMBbn

　 Source: Wind, HSBC, Ministry of Finance estimates

　In provinces that were worst hit by the COVID-19 outbreak, self-generated general fiscal income declined by even more. Table 3 shows that in Hubei Province, where Wuhan is the capital city, this metric dropped by as much as 42% y-o-y in the first five months of this year. As Table 3 shows, out of the 31 provinces, 18 reported double-digit declines in the first four months of this year, and the rest had either negative or flat growth. Perhaps more worrying is that the COVID-19 outbreak is not even the single biggest contributing factor to the recent decline in fiscal income. Some provinces were already struggling with a decline in self-generated general fiscal income because the local economy was slowing and because of tax cuts. The virus has merely accelerated these existing trends. For example, in Hubei Province, growth in self-generated general fiscal income had remained in the low single digits from 2016 to 2019 before the outbreak. And in Chongqing City, general fiscal income declined by 5.8% in 2019 and by 16.8% y-o-y in the first fourth months of 2020. RMBbn

　3. Growth of general fiscal income, by province, as of April 2020

　Provinces

　2019, y-o-y

　Jan – April 2020, y-o-y

　Hubei

　2.5%

　-43.7%

　Hainan

　8.2%

　-30.1%

　Heilongjiang

　-1.6%

　-21.7%

　Inner Mongolia

　10.9%

　-18.9%

　Shanxi

　2.4%

　-18.3%

　Tianjin

　14.4%

　-17.7%

　Chongqing

　-5.8%

　-16.8%

　Shaanxi

　2.0%

　-16.0%

　Jilin

　-10.0%

　-14.9%

　Liaoning

　1.4%

　-14.8%

　Ningxia

　-4.7%

　-14.3%

　Shanghai

　0.8%

　-13.0%

　Gansu

　-2.4%

　-12.8%

　Beijing

　0.5%

　-12.3%

　Sichuan

　4.1%

　-11.9%

　Fujian

　1.5%

　-11.6%

　Xinjiang

　3.0%

　-11.6%

　Henan

　7.4%

　-11.5%

　Guangdong

　4.5%

　-8.5%

　Shandong

　0.6%

　-8.5%

　Hebei

　6.5%

　-8.2%

　Jiangsu

　2.0%

　-7.8%

　Guizhou

　2.3%

　-7.7%

　Hunan

　5.1%

　-6.2%

　Jiangxi

　4.8%

　-4.2%

　Zhejiang

　6.8%

　-4.1%

　Yunnan

　4.0%

　-3.9%

　Qinghai

　3.4%

　-1.3%

　Guangxi

　7.8%

　-0.4%

　Tibet

　-3.6%

　0.4%

　Anhui

　4.4%

　NA

　All provinces*

　Source: Wind, HSBC

　3.2%

　-11.5%

　Note*: Excluding Anhui, which has not reported local fiscal income information this year.

　The resilience of this key metric has also varied widely by region. The coastal East region has fared relatively better in generating tax revenues at a local level than inland regions (see Figure 4 below), thanks to its much larger and active private sector. This supports our argument made in the previous report that the virus outbreak has prompted Beijing to increase the strategic importance of the private sector to help bring more stability to the economy (see our report Default data – what to watch for in a time of COVID-19, 25 March 2020).

　4. Growth rate of self-generated general fiscal income, by regions, as of April 2020

　10%

　 5%

　 0%

　 -5%

　 -10%

　 -15%

　 -20%

　Middle

　Northeast

　West

　East 2016 2017

　2018

　2019 April 2020

　Source: Wind, HSBC

　Note: Middle Region excludes Anhui Province, which has not disclosed general fiscal revenue this year. Middle Region includes Hubei Province, where Wuhan is capital city.

　Payments from the central government is more stable

　However, all this is just one part of the story. Investors shouldn’t rush to a view about the financial health of local governments based just on this metric. Over the past decade, the importance of self-generated general fiscal income has actually declined for local governments. Its share of total cash inflow into local governments has declined from 46% in 2007 to 35% in 2019, and is expected to decline further to 31% this year, according to estimates by Ministry of Finance, as Fig 5 shows.

　 5. Breakdown of total cash inflows into local governments per year, 2007 to 2020e

　100%

　90%

　80%

　70%

　60%

　50%

　40%

　30%

　20%

　10%

　0%

　2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020E

　General fiscal income: self-generated General fiscal income: transferred from central gov

　Gov fund income Income from SOE ownership Net Muni issuance

　Source: Wind, local governments, HSBC, Ministry of Finance estimates

　0%

　19%

　0%

　3%

　2% 0%

　2% 2% 3%

　1%

　6%

　1%

　22%

　22

　1%

　%

　30%

　26

　%

　22

　22%

　15%

　1%

　%

　28

　27%

　5%

　31%

　32

　29

　28%

　%

　27%

　%

　26

　%

　6% 47%

　44

　%

　41%

　44

　%

　46

　%

　%

　35

　%

　%

　31

　 %

　%

　 %

　 %

　 %

　4

　 38

　41

　 39

　 43

　42

　 44

　%

　 27

　 %

　%

　%

　%

　%

　%

　 24

　 25

　 26

　26

　26

　3

　27

　%

　%

　%

　%

　%

　%

　 28

　 26

　0%

　 29

　0%

　 30

　%

　119%

　1%

　1%

　7%

　2%

　32

　As Chart 6 below shows, local government’s fiscal book is split into two accounts: the general fiscal account and the government fund account, and each account collects revenue from different sources and conducts spending for different purposes. The most badly hit item – self- generated general fiscal income – is just one part of this sprawling funding system for local governments and does not tell the whole story. General fiscal account The general fiscal account collects revenue mainly from taxes on businesses and individuals. More than half the income under the general fiscal account is generated at a local level, referred to as self-generated general fiscal income, which as mentioned above declined by 10.4% y-o-y in the first five months of this year. But payments from the central government which also contribute to the general fiscal account is an important source too, as shows in Item 1 in Chart 6. The final source of cash for this account is from the issuance of General Muni (municipal) bonds. Appetite for these bonds rests on the ability of local governments to collect tax as well as payments into the general fiscal income account from the central government. Money in the general fiscal account is spent on items like wages for government staff and subsidies for local schools and corporates. Such spending is considered an “expense” because the spending will not form assets that can generate cash flow in the future. Government fund account The other separate fiscal account is the government fund account. Revenue under this account is collected mainly from land sales at a local level. The central government has historically made very small transfer payments to local governments under this account. The remaining cash flow is provided by the issuance of Project Muni (municipal) bonds. Appetite for these rests on local governments’ ability to sell land and to collect income from projects built by the proceeds of these bonds. Funds from this account are spent on items like cleaning up a piece of land for auction, building a road or a utility plant. These items are considered “investments” because the spending will form assets that are able to generate cash flow in the future. Theoretically, in rare situations where the government fund account dries up and attempts to refinance Project Muni bond fails, these bonds can default and local governments do not bear any obligation to use tax income in the general fiscal account to pay back bondholders of Project Munis. For this reason, the issuance of Project Munis is not counted in China’s official fiscal deficit. To be clear, only two types of bonds are counted: Chinese Government Bonds (CGBs, though excluding special CGBs to be issued this year) and General Munis. All three items marked in Chart 6 are expected to be either stable or to grow significantly this year. They are a stable source of cash for local governments, especially now when self-generated general fiscal income faces challenges. We will discuss below these three items one by one. 6. Structure of local governments’ fiscal accounts, illustration Local governments’ fiscal book

　Source: Ministry of Finance, HSBC

　General fiscal account

　Government fund account

　In coming

　Out coming

　In coming

　Out coming

　=

　=

　Proceeds from issuance

　3 of Project Muni

　central government

　2 Transfer payment from

　 2 Self-generated government fund income (mainly from land sales)

　Proceeds from issuance

　3 of General Muni

　1 Transfer payment of general fiscal income

　from central government

　 Self-generated general fiscal income

　(mainly from taxes)

　Investment type of government spending

　Expense type of government spending

　1. Transfer payment of general fiscal income from the central government This is a mechanism whereby the Ministry of Finance collects revenues from local economies and then re-distributes it back to local governments. To be exact, VAT, corporate income tax and individual income tax are collected from local economies and then split between local and central governments. The amount that goes into local governments become part of their self-generated general fiscal income, and the amount that goes into central governments are pooled together and then re-distributed to local governments. Rich provinces are net payers and poor provinces are net receivers, making it an important channel for wealth redistribution in the country. Transfer payments to local governments significantly increased in 2019 as the central government stepped up to support local governments to help them weather a reduction in tax revenue after a tax cut on corporates and individuals. This year, the Ministry of Finance will further increase transfer payments to local governments under this account by RMB950bn to RMB8.4trn (Fig 7), representing a growth rate of 12.8% y-o-y. This extra money comes from the increased issuance of China Government Bonds (CGB). According to the budget plan published in May, the issuance quota of normal CGBs for this year is expanded by RMB950bn to RMB2.78trn, and all proceeds from this increase will be transferred to local governments’ general fiscal income.

　7. Transfer payment of general fiscal income from the central government

　9,000

　8,000

　7,000

　6,000

　5,000

　4,000

　3,000

　2,000

　1,000

　-

　 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020E

　General fiscal income: transferred from central gov

　General fiscal income: transferred from central gov, growth YoY, RHS

　30.0%

　 25.0%

　 20.0%

　 15.0%

　 10.0%

　 5.0%

　 0.0%

　Source: Wind, Ministry of Finance, HSBC

　2. Government fund income As mentioned earlier, government fund income comes mainly from sales of local land to property developers. Historically, the Ministry of Finance has made small transfer payments to local governments under this account. It also fluctuated a lot from year to year, depending on the sentiment of the property market. For this year, because of the slowdown in land sales, local governments’ self-generated government fund income declined 3.1% y-o-y in the first five months and is expected to decline 3.3% for the whole year, according to the budget plan published in May. The central government though is stepping in to support and make up the shortfall. It plans to make as much as RMB800bn of transfer payments this year to local governments under the government fund account. That compares to 2019 when the central government only transferred RMB90bn. As to where the money comes from, the central government will issue RMB1trn of special CGBs this year and all proceeds will be used to make transfer payment to local governments. With this large one-off transfer payment from the central government, the government fund income is expected to grow 5.5% y-o-y in 2020, as Fig 8 shows. RMBbn

　8. Government fund income, amount and growth y-o-y

　10,000

　9,000

　8,000

　7,000

　6,000

　5,000

　4,000

　3,000

　2,000

　1,000

　-

　 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020E

　Gov fund income (including transfer payment from central government)

　120.0%

　100.0%

　80.0%

　60.0%

　40.0%

　20.0%

　0.0%

　-20.0%

　-40.0%

　Gov fund income (including transfer payment from central government), growth YoY, RHS

　Source: Wind, HSBC, Ministry of Finance estimates

　3. Enlarged Muni issuance quota Lastly, this year’s Muni issuance quota is expanded significantly to help local governments raise cash. As Fig 9 shows, the net Muni issuance quota, including General Munis and Project Munis, increased by 54% this year to RMB4.73trn, which is roughly equivalent to 4.5% of the country’s GDP. It is worth noting that the rapid increase of Muni issuance quota is largely driven by growth in Project Munis. And as mentioned above, there are clear restrictions as to how local governments can spend the proceeds raised from these bond sales. Specifically, the proceeds can only be used to invest in projects that can generate cash flow to pay back Project Muni bondholders. As an example, local governments cannot use the proceeds from the issuance of Project Munis to distribute cash to local residents to boost local consumption. Some local governments struggle to find enough viable local projects that can generate reasonable cash in the future, and without enough viable projects, the issuance quota may not be fully tapped. Restrictions to the usage of Project Muni proceeds also mean that not all the local fiscal power can be freely translated into immediate economic activity or corporate bailouts. This is one aspect that shows that China’s fiscal stimulus approach today is more conservative than during the Global Financial Crisis, when “all in” was the theme. More considerations are now given to the sustainability of fiscal stimulus. 9. Muni issuance quota vs. GDP

　5,000

　4,500

　4,000

　3,500

　3,000

　2,500

　2,000

　1,500

　1,000

　500

　-

　Source: Wind, HSBC

　 2013 2014 2015 2016 2017 2018 2019 2020

　Muni issuance quota - General Muni Muni issuance quota - Project Muni

　Muni issuance quota as % of GDP, RHS

　5.0%

　4.5%

　4.0%

　3.5%

　3.0%

　2.5%

　2.0%

　1.5%

　1.0%

　0.5%

　0.0%

　RMBbn

　RMBbn

　Thanks to multiple sources of cash, local government’s consolidated income that includes transfer payments from the central government and the government fund income is expected to grow at 3.9%. Moreover, total cash inflows that also include proceeds from net Muni issuance is expected to grow at 9.1%, as Fig 10 shows. To put it more specifically, this year local governments’ self-generated general fiscal income is expected to reach RMB9.75trn, while total cash inflow into local governments is expected to reach as much as RMB31.65trn, as Fig 11 shows. This amount is equivalent to as much as 31% of China’s GDP in 2020, all in cash.

　 10. Growth rate of local governments’ fiscal income and total cash inflow, y-o-y

　45.0%

　40.0%

　35.0%

　30.0%

　25.0%

　20.0%

　15.0%

　10.0%

　5.0%

　0.0%

　-5.0%

　-10.0%

　2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

　2020E

　 General fiscal income: self-generated Consolidated local government income Total cash inflows

　 Source: Wind, HSBC, Ministry of Finance estimates

　11. Amount of local governments’ self-generated general fiscal income and total cash inflow

　35,000

　 30,000

　 25,000

　 20,000

　 15,000

　 10,000

　 5,000

　 -

　2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020E

　 General fiscal income: self-generated Consolidated local government income Total cash inflows

　 Source: Wind, HSBC, Ministry of Finance estimates

　RMBbn

　 The shadow fiscal system is back

　Unfortunately, the story is not yet complete. Up to now, we have discussed the local governments’ explicit fiscal system, but they have also built a massive shadow fiscal system that centres on local government funding vehicles (LGFVs). These help to make investments and conduct spending that local governments are not able to make through their explicit fiscal accounts. And LGFVs raise money from the market on the back of both the implicit guarantee provided by local governments and LGFVs’ own credit fundamentals, to a certain extent. Thanks to easy monetary conditions and that China’s deleveraging campaign has been put to one side for now amid the economic doldrums, LGFVs received a windfall in financing up to April of this year, surpassing even 2016, which was the previous peak (see Fig 12). Issuance has slowed down since May as the policy stance towards monetary easing turned more cautious. But with a vast amount of funds already raised, it is difficult to foresee LGFVs running into major financing difficulties in the second half. Though as we argued before (Local

　government debt: What’s changed?, 16 Sep 2019), credit differentiation will continue to deepen in the LGFV sector, and those with weak fundamentals are particularly at risk.

　 12. Net issuance by LGFVs in the onshore bond market

　1,400

　 1,200

　 1,000

　 800

　 600

　 400

　 200

　 -

　 (200)

　2015 2016 2017

　2018

　2019 2020

　 Source: Wind, HSBC. Data as of June 2020.

　Many investors may ask why local governments’ fiscal accounts have to be so complicated. Well, for the sake of simplicity, we have actually skipped various other mechanisms like balancing funds, income and expenses related to the management of SOEs and social security funds that are also closely correlated with local fiscal management. For decades, local governments have been constrained by tight control over their official deficit, which has led them to develop alternative funding channels. This is also how the sprawling shadow banking system started in the first place, providing additional financing to local governments’ investment initiatives as well as property developers’ land purchases, in which the payment for land ultimately goes to local governments. Some progresses have been made since 2015 in cleaning up local governments’ fiscal system, but we believe far more needs to be done. Such changes would require painful reforms and tough negotiations between central and local governments, and could take years if not decades. Developing China’s financial system in a healthy manner would depend on the progress of fiscal Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

　RMBbn

　reforms, because that will help redefine the role of both local and central government in participating in economic activity. While uncertainty remains over the long-term fiscal condition of local governments, our analysis shows that for this year, the impact of the COVID-19 outbreak on local governments’ overall fiscal situation is manageable, in our view.

　Munis – too big to ignore

　In the last section of this report, we explain the world of Munis. Issuance of these local government bonds started in 2009 but only took off in 2015. Since then, growth has been so fast that in less than six years’ time, it has become the biggest bond class in the onshore market. Munis do not offer much attraction for foreign investors for obvious reasons: low yields and low liquidity. As of March 2020, foreign investors based offshore hold only RMB2.6bn of Munis. But Munis occupy so much space in the onshore market that their influence on overall market sentiment is very significant, and that is not always fully appreciated.

　 13. Munis outstanding in the China’s onshore bond market

　30,000

　 25,000

　 20,000

　 15,000

　 10,000

　 5,000

　 -

　2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020E

　Munis outstanding, RMBbn

　 Source: Wind, HSBC, Ministry of Finance estimates

　Issuer mix There are 38 issuers in the Muni space, which include 31 provinces, five cities that enjoy vice- provincial administrative ranking, one special corporate that enjoys provincial administrative ranking (Xinjiang Production and Construction Corps) and the Ministry of Finance (Table 14). The RMB59bn of Munis outstanding that have the Ministry of Finance as the nominal issuer is a legacy product: before 2011, local governments could only issue Munis through the Ministry of Finance, who would then distribute the issuance proceeds to local governments. But from 2011, selective local governments also began to issue Munis under their own names. In 2015, the Ministry of Finance stopped issuing Munis on behalf of local governments. RMBbn

　14. Muni bonds outstanding by issuer

　Issuer Administrative ranking

　Amount outstanding, RMBbn

　% in total amount outstanding

　Jiangsu Provincial

　1,660

　6.9%

　Guangdong Provincial

　1,371

　5.7%

　Shandong Provincial

　1,331

　5.6%

　Sichuan Provincial

　1,198

　5.0%

　Zhejiang Provincial

　1,164

　4.9%

　Hunan Provincial

　1,125

　4.7%

　Guizhou Provincial

　1,015

　4.2%

　Hebei Provincial

　993

　4.1%

　Henan Provincial

　909

　3.8%

　Yunnan Provincial

　906

　3.8%

　Anhui Provincial

　893

　3.7%

　Hubei Provincial

　879

　3.7%

　Inner Mongolia Provincial

　761

　3.2%

　Fujian Provincial

　723

　3.0%

　Shaanxi Provincial

　710

　3.0%

　Liaoning Provincial

　697

　2.9%

　Guangxi Provincial

　694

　2.9%

　Jiangxi Provincial

　657

　2.7%

　Chongqing Provincial

　631

　2.6%

　Shanghai Provincial

　619

　2.6%

　Beijing Provincial

　594

　2.5%

　Tianjin Provincial

　572

　2.4%

　Heilongjiang Provincial

　523

　2.2%

　Xinjiang Provincial

　522

　2.2%

　Jilin Provincial

　477

　2.0%

　Shanxi Provincial

　395

　1.7%

　Gansu Provincial

　360

　1.5%

　Hainan Provincial

　242

　1.0%

　Qinghai Provincial

　229

　1.0%

　Ningxia Provincial

　174

　0.7%

　Tibet Provincial

　28

　0.1%

　Ningbo Vice-provincial

　208

　0.9%

　Dalian Vice-provincial

　200

　0.8%

　Qingdao Vice-provincial

　186

　0.8%

　Xiamen Vice-provincial

　105

　0.4%

　Shenzhen Vice-provincial

　72

　0.3%

　Central Ministry of Finance State

　59

　0.2%

　Xinjiang Production and Provincial Construction Corps

　41

　0.2%

　Total

　23,920

　100.0%

　Source: Wind, HSBC. Data as of 26 June 2020.

　 Tenor For the RMB23.9trn of Muni bonds outstanding, their remaining tenors are distributed quite evenly from 1 year to 10 years, as Fig 15 shows. In the primary issuance market, however, the most popular tenors are 5 years, 7 years and 10 years, as Fig 16 shows. Clearly, Muni bonds have much longer tenors than most corporate bonds.

　15. Muni bonds outstanding, breakdown by remaining tenor

　16. Muni bonds outstanding, breakdown by issuance tenor

　 Source: Wind, HSBC Source: Wind, HSBC

　Rating All Muni bonds that were publicly issued have a bond rating of AAA by domestic rating agencies. For those that were issued privately to selective investors instead of publicly auctioned in the open market, no rating is provided. No ratings on issuers, which are local governments, is provided either. So there is no rating differentiation for Munis at all. A point that can slightly mitigate this is that Muni’s credit risk, either for General Munis or Project Munis, is very limited. Most Munis will be refinanced when they come due, and the chances of them failing to do so is quite small, given how important they are to the onshore credit market. Investor mix Banks have always been the dominant investors in the onshore bond market, and it is particularly so in the Muni space. As Fig 17 shows, 86% of Munis outstanding were held by commercial banks as of March 2020. This amounts to RMB19.4trn of Munis on commercial banks’ balance sheets, accounting for 6.4% of commercial banks’ total assets and 40% of their total bond holdings, as of March 2020 (Fig 18). Note that commercial banks’ large holdings of Munis have been built up in pretty much just six years – Munis accounted for only 5% of commercial banks’ bond holdings in Dec 2014 (Fig 19). In fact, the supply of Munis has been so large and so overwhelmingly absorbed by commercial banks that over the period from 2015 to March 2020, 62% of the RMB29.48trn net increase in bond holdings by commercial banks were Munis. Such dynamics have had major implications for the onshore credit bond space, which has had to increasingly turn away from banks and rely on non-bank investors for funding. More specifically, the percentage of credit bonds held by commercial banks declined from 32% in Dec 2014 to 23% in Mar 2020, as Fig 20 shows. Policy bank bonds have gone through a sharper decline with holdings by commercial banks falling from 80% to 57% during the same period. More participation by non-bank investors in the credit space certainly helps improve liquidity. However, at the same time, non-bank investors are much more sensitive to market sentiment than banks, because their own funding costs are higher and more volatile than banks. Such dynamics are likely to continue too, as the supply of Munis remains large because of the fiscal stimulus. On the positive side, if the credit bond space slowly drifts away from being dominated by banks holding the majority of them, it could leave more opportunities for asset managers to play a bigger role in credit investment. 20Y

　3% 30Y

　5% 2Y 0.2%

　15Y

　3% 3Y 5%

　10Y

　26%

　5Y 33%

　7Y 25%

　>10Y <=1Y 10%

　12% 7-10Y

　16% 1-3Y

　23%

　5-7Y

　17%

　3-5Y

　22%

　17. Munis outstanding, breakdown by investor type Domestic branch of foreign banks 0.18%

　Non-bank financial institutions

　4%

　Offshore foreign investors 0.01%

　Others

　3%

　Policy banks

　7%

　Other domestic commerial

　banks 13%

　 National commercial banks

　73%

　 Source: Wind, HSBC. Data as of March 2020.

　18. Bond holdings by commercial banks, breakdown by type of issuers, Mar 2020 19. Bond holding by commercial banks, breakdown by type of issuers, Dec 2014

　Muni 5%

　 Source: Wind, HSBC Source: Wind, HSBC

　20. % of bonds held by commercial banks, Dec 2014 vs Mar 2020 100%

　 80%

　 60%

　 40%

　 20%

　 0%

　 Source: Wind, HSBC

　 CGB

　 Munis

　 Dec 2014

　 Policy bank bonds

　 Credit bonds

　 Mar 2020

　 All bonds

　Credit 21%

　CGB 20%

　Policy bank

　19%

　Muni 40%

　Credit

　25%

　CGB

　30%

　Policy bank

　40%

　Trading venues Like CGBs, Munis are allowed to be dual-listed in multiple trading venues. Most Munis (or 86% of total outstanding amount) are listed in both the interbank and stock exchange market. Others, or 14% of total outstanding amount, are listed in the interbank market only. Liquidity Poor liquidity has remained a big issue for Munis. As Fig 21 shows, Munis have the second-lowest turnover ratio among all types of bonds in the onshore market, slightly better than complex asset- backed securities (see Asset-backed securities: The time is right, 3 June 2020). This is because of several reasons. A lack of non-bank investors doesn’t help. The dominant investors, commercial banks, do not tend to trade bonds that much in the secondary market. And although the Muni space is large, it is segregated into 38 sub-spaces by the number of issuers, and even the biggest issuer of Munis – Jiangsu Provincial Government – has only RMB1.66trn of bonds outstanding. The market understandably does not tend to trade actively in a small space.

　 21. Turnover ratio of onshore RMB bond products, 2020 annualised

　7.0

　6.0

　5.0

　4.0

　3.0

　2.0

　1.0

　-

　Policy Bank Bonds

　CD Others* CGB Overall Corporates Financial

　institutions

　Muni ABS

　 Source: Wind, HSBC

　Note: Others are mainly government-sponsored institutions, including China Railw...

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