Foreign banks to underwrite local bonds

The new year has kicked off with a series of announcements about measures designed to attract more foreign investment to China. The latest, most interesting, is this announcement from Xinhua about foreign banks being encouraged to take part in underwriting local government bonds. It reports that some have already underwritten Guangdong provincial bonds. 

This will be a key development to watch this year. As has been written here since the start of GBI in March last year, it is clear that the country sees the need to attract more international capital. The Foreign Investment Law went into effect on January 1 and, while skeptics have rightly spoken of the need to see how it is enforced, it is designed to attract and protect more foreign investment. More sincere steps are being taken to uphold intellectual property rights, and sectors of the economy are being opened wider to foreign investment. The participation of foreign banks in local government bonds will be a key measure of the effectiveness of these measures in the near term. Supposedly backed by the government, they should be the safest of bets on the Chinese economy. The nine GBA cities inside Guangdong should be among the safest of the safest.

The reason why this will be more fascinating to watch than might be supposed – after all, what’s the big deal about underwriting government bonds – is that local governments here are not like their counterparts in the West. They don’t just build highways, collect garbage and make sure the lights stay on. They also provide social housing, own massive conglomerates that participate in every sector of the economy and, most importantly, they are responsible for an extremely aggressive blueprint for the country’s industrial-upgrading plan. This was previously known as Made in China 2025; in Guangdong, a local variant of the plan is known as the Science and Technology Innovation Corridor. 

This throws up two important considerations for foreign banks looking to invest in local government bonds, safe though they might appear to be, especially in the GBA. The first is whether their governments back home, especially those reporting to the one in Washington, will be comfortable with them investing in the “arming” of China’s rising technology stars. While the US-China trade war seems a week away from being de-escalated by the signing of a “Phase One” agreement, few political analysts believe tensions are likely to subside between the two economic superpowers anytime soon. If the trade war, which is really a tech war, escalates to a financial war, these investments might need to be traded out of.

This is not only an issue for the US. The EU has qualms of its own about China’s economic rise, and 2020 is likely to see these bubble up to the surface of their relationship, too.

The second consideration for the banks is, in fact, the risks inherent in these local-government bonds. As some experienced economists have pointed out in commentaries these past few days, and the PBOC has made crystal clear in announcing its priorities for 2020, the central government’s de-risking program is set to continue for the foreseeable future. That means the potential for blowups in China’s financial system is obviously going to rise this year. In an economic system like China’s, it is local governments that will be on the front line of any instability in the banking system and which will be expected to act on the central government’s direction. This might not always be with market forces uppermost in their minds.

Two of these commentaries are worth watching and reading. One is a Youtube interview with Brian McCarthy of Macrolens. Although it carries the melodramatic headline of “The endgame for China” (the channel’s, not his), McCarthy lays out a compelling narrative for why local-government debt is becoming an increasingly worrying problem, among many other challenges facing policymakers this year.  

Where he may need to face an assumption-check, however, is his belief that China is undoubtedly facing a dollar-liquidity crisis soon. Others are not so sure. One economist worth following regularly is David Brown in SCMP, who writes that it is not a foregone conclusion that the US dollar will remain strong this year. He predicts an epic battle between dollar bulls and bears, which should go toward the bears this year. This should ease pressure on China’s demand for US dollars as investors chasing higher-yielding returns flood into China. In this case, local-government bonds would likely be high on their list.

Brown may need to face his own assumption-check soon, too, as he believes the US-China trade war being settled will bring security back to global investors. If it doesn’t work out as planned, which seems likely to Sinocism, SupChina, and many others, McCarthy’s prediction may have stronger legs to stand on.

What none of these observers concern themselves with, however, is whether the Chinese leadership will, in fact, follow through on its pledges to deregulate the economy and give private enterprise a freer hand. In that case, neither McCarthy nor Brown’s analysis will matter as much, as foreign investors will likely be pushing into newly opened markets in China on the strength of structural reforms. So far, the Chinese leadership is making all the right changes, on paper. Follow-up will be crucial this year.

All in all, it’s another reason to be watching the Greater Bay Area. Whatever is going to happen in any of these scenarios, will likely happen here first.

Stay tuned.

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