The volume of China’s outstanding municipal bonds has risen to more than half that of the United States. This tremendous growth is surprising since China didn’t even have a local government bond market just three years ago.
But unlike in the United States, where the municipal bond market is primarily household-driven, China’s muni bond growth has been predominantly driven by banks. In the United States, for example, households hold more than $1 trillion worth of muni bonds—both directly and indirectly through mutual funds—making them the single biggest class of investors in the muni market. In China, financial institutions own almost all local government bonds, while household ownership of these bonds is negligible.
But that’s now likely to change. And when it does, it will be a direct result of government policies, which have created a challenging environment for local governments.
Since the beginning of 2017, when Beijing ramped up its campaign to rein in banks’ off-balance sheet investment activities, demand for all types of bonds in China has collapsed. Although Beijing’s campaign was intended to rein in shadow banking, it had the unintended consequence of squeezing banks—the biggest buyers of all classes of Chinese bonds—which meant they had less funds to purchase bonds.
That bodes poorly for local governments. In order to roll over maturing debt and also finance additional spending, China’s local governments need to sell more than 4 trillion yuan ($600 billion) worth of bonds this year. And that is where Chinese households come into the picture: Beijing’s solution to the funding shortfall has been to encourage household retail investors to fill the gap left by the banks.
In the past, local government bonds were sold almost exclusively through the inter-bank market—which is open to financial institutions only—or via private placements, which were typically not made available to retail investors. Even though China’s Ministry of Finance has been quietly encouraging the sale of local government debt to households since at least 2016, little progress had been made until recently.
Now, both the Shanghai and Shenzhen stock exchanges allow retail investors to purchase local government bonds over their trading platforms. And both of the exchanges, as well as the state media, have been heavily promoting the new market. “The risk is low, and the returns are fixed, allowing for happiness in old age,” the Shanghai stock exchange claims in a marketing brochure—one in whose pages it recommends local government bonds as a sound investment for the elderly.
This can be easily dismissed as a mere marketing ploy, but there is actually some truth to it. That is because local government bonds are a relatively sound investment when measured against the rest of China’s increasingly complex financial system. For instance, Chinese households already own far riskier financial assets, such as the wealth management products (WMPs) that Beijing is bent on restricting.
Demand has been modest for these local government bond products so far, but has the potential to grow. In July, the Shanghai stock exchange raised 50 million yuan ($7.5 million) when it sold its first batch of local government bonds to a few thousand retail investors. In early August, the Shenzhen stock exchange followed suit, selling more than 70 million yuan ($10.5 million) worth of local government bonds to more than 18,000 retail investors.
But if households were to convert even a small part of their 13 trillion yuan ($1.9 trillion) worth of funds invested in WMPs into local government bonds, then Beijing would notch a win in its campaign for greater financial stability. Shifting the burden of holding local government debt away from the banks and onto households will, in fact, improve the overall soundness of China’s financial system for two simple reasons: first, because local government bonds are a better investment than many of the wealth management products on the market that households have hitherto preferred; and second, because the banks that hold the bulk of local government bonds are especially exposed. Banks currently hold more than 10 trillion yuan ($1.6 trillion) worth of local government debt. By reducing their exposure, banks could put themselves onto a sounder footing.
Meanwhile, the migration of bond ownership from banks to households may ultimately help to improve the quality of local authorities’ fiscal governance. Whereas local authorities can lean on banks to buy their bonds, they do not have the same leverage over individual citizens. Retail investors vote with their wallets. Assuming Beijing sticks to its “no bailouts” mantra, it can be expected that households will pay close attention to the borrower’s fiscal health when choosing between local government bond products.
The day is still a long way off when activist Chinese investors demand greater transparency and accountability from authorities that seek to raise funds from the public. Beijing clearly much prefers to assume responsibility for supervising local finance itself, an approach that hasn’t worked very effectively. Still, retail investors could punish spendthrift and badly managed local governments by increasing the premium they must pay to issue debt.
In short, the enfranchisement of retail investors adds another stakeholder to help push for local fiscal discipline.
One way or another, China’s public will increasingly find that it has a vested interest in ensuring the prudent management of local finances. China’s local governments are projected to run up trillions of yuan worth of deficits in the coming years, potentially leading to higher taxation or reduced public services spending—both of which will hurt the interests of Chinese citizens in localities across the country. Moreover, China is entering a period of rapidly shifting demographics, with an aging population that will mean mounting unfunded social security liabilities for every level of government.
Resolving conflicts between creditors, taxpayers, and retirees is a challenge that is new to China, but will inevitably lead to changes in economic and political institutions. The push to have households invest more in local government debt may seem like a relatively small development, but it presages bigger fiscal and institutional changes to come.