Local Government Implicit Debt and the Pricing of LGFV Bonds

Abstract

Chinese local governments have issued a large number of local government financing vehicle (LGFV) bonds since 1994 when the Budget Law was promulgated, where local governments were prohibited from raising debt on their own. Although LGFV bonds are implicitly backed by governments, there has been no consensus on which level of government is expected to bail out the issuer in the event of financial distress. Based on the public disclosures of bond-issuing firms, we create a proxy for total municipal implicit debt using the total outstanding interest-bearing debt of LGFVs under the jurisdiction of a local government, and further analyze the impact of this debt on a LGFV bond’s credit spread in both the primary and secondary markets. In this way, we can also identify the level of government that is considered as an implicit guarantor. We find that a LGFV bond’s credit spread is positively correlated with local governments’ implicit debt ratios and that their correlation changes with government policies and macroeconomic conditions. The Yunnan Highway default event focused investors’ attention on the implicit debt of municipal governments. After the later release of the State Council Directive No. 43, which governs local governments’ debt swap arrangements, provincial governments’ implicit debt ratios became another key pricing factor. These results suggest that investors’ views about which level of government is the implicit guarantor change over time.

Keywords: local government implicit debt; implicit government guarantee; credit spread; local government implicit debt ratios

JEL Classification: G15, G18, H72, H74