## wp18219 - 1. What are the recent developments in the local government bond market and how do those

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### II. RECENT DEVELOPMENTS
- Pre-2014 context
  - Local governments were legally prohibited from borrowing on their own before 2014 except under the five-year pilot bond issuance program starting in 2009.
  - Under the pilot program, the Ministry of Finance issued RMB200 billion local government bonds on behalf of local governments.
  - A small set of provincial governments were later allowed to issue bonds directly (about RMB3–4 billion as of end-2014).
  - Local governments used off-budget financing vehicles (LGFVs) to borrow from banks and capital markets, circumventing legal restrictions.
  - LGFVs are distinct entities owned by local governments, typically established for land development, infrastructure investment, and social housing; they are legally registered as corporations with public-sector objectives. Local governments often shared LGFVs’ responsibilities to service debt and provided debt guarantees.

- Central government response and debt-swap program
  - Revised budget law adopted a strategy of “opening the front door and closing the back door”: tightened off-budget borrowing while allowing provincial governments to issue bonds subject to an annual cap determined by the National People’s Congress.
  - The central government recognized about 22 percent of GDP of LGFV debt as general government debt in 2014–15.
  - A three-year bond-swap program (RMB18 trillion or 25 percent of 2015 GDP) was launched to replace high interest and short duration debt (bank loans, LGFV bonds, trusts and other nonstandard borrowing) with provincial government bonds of 2–20 years maturity.
  - The National People’s Congress authorized an issuance of RMB1.6 trillion in bonds in 2015, of which RMB600 billion was for new financing and another RMB1 trillion was for refinancing maturing LGFV debt deemed general government debt under the three-year debt-swap program.

- Market size and characteristics (2014–2018)
  - The size of the local government bond market grew from RMB1.1 trillion to RMB14.7 trillion between 2014 and 2017.
  - About 90 percent of official local government debt is now in the form of debt securities.
  - The maturity of the bonds ranged from 2-20 years, with an average maturity of about 4.5 years.
  - While the debt-swap program was completed in 2018, further expansion of local government bonds is likely given local governments’ sizeable financing needs.
  - Issuance varies across provinces: more developed coastal provinces have the largest nominal bond issuance but smaller debt burden in percent of GDP than less-developed provinces.
  - Less-developed provinces have debt of over 40 percent of GDP on average and over 80 percent of provincial fiscal resources.
  - Weighted average yields on local government bonds reached 4.3 percent in 2017 (about 140 basis points below the average bank lending rates), and spreads across provinces were minimal within 10–20 basis points.

- International and OECD comparisons
  - About 37 of 53 major economies allow local governments to issue debt.
  - Among OECD countries, subnational government debt accounted for 31 percent of GDP on average for federal countries and about 15 percent of GDP for unitary countries.
  - Official local government debt in China is about 20 percent of GDP.
  - An “augmented” perimeter including off-budget LGFV debt would add an additional 30 percent of GDP.
  - Debt securities account for 45 percent of all subnational government debt across OECD countries on average.
  - United States municipal bonds outstanding were about $3.8 trillion (10 percent of the total bond market or 20 percent of GDP) in 2017.
  - Japan local government debt was about 30.4 percent of GDP in 2015 (17 percent of the total government bonds).

- Regulatory and institutional measures (“opening the front door”)
  - Revised budget law and related directives assigned fiscal responsibility on local government finances to provinces; provincial finance bureaus are responsible for lower-level subnational finances.
  - An early-warning system and risk management guidelines were announced to monitor subnational fiscal risks; measures include potential loss of fiscal authority on local administration while ensuring minimum service levels.
  - New directives allow local governments to issue bonds against land development and income from toll roads.
  - Cross-agency measures aim to rein in proliferation of government guarantees and raise policy coordination.
  - An intergovernmental reform plan aims to realign local government finances by: (1) raising local government tax base and revenues; (2) increasing general transfers to lower-level governments; and (3) shifting a greater share of spending responsibility to the central government.

### III. CURRENT IMPEDIMENTS
- Overview
  - The rapid surge in local government bond issuance was not matched by a corresponding upgrade in bond market development.
  - Key impediments include a narrow investor base, low liquidity, weak credit discipline, and fragmented regulations; these impediments are intertwined and have become more challenging as the market has grown.

- Low liquidity and narrow investor base
  - Average turnover of local government bonds was only 4.3 percent of the outstanding amount, much lower than 66 percent for sovereign bonds in 2017.
  - Low liquidity is more pronounced compared to other public-sector issuers such as policy banks and to municipal bond markets in other countries.
  - Low liquidity was partly due to underdeveloped financial market infrastructure such as inactive market-making dealers.
  - More than three-quarters of local government bonds are held by commercial banks.
  - Long-term institutional investors—mutual funds, life insurance—are underrepresented (explicit numbers not provided in source excerpt).

### 4. Subnational Government Bond Spreds

- Market structure and key impediments
  - Sovereign bonds were issued spanning from 3-month to 50-year maturities and the futures markets at 5- to 10-year treasury bonds supported liquidity; overall secondary market activity remains thin.
  - Low liquidity has reduced the role of price referencing typically provided by government securities. As a result, sovereign bonds in China do not provide a liquid benchmark yield curve (Chen, Chow, and Zhang 2018).
  - Under the bond-swap program, banks bought the local government bonds at a low coupon rate. Banks could suffer a marked-to-market loss if bonds are sold.
  - Bond markets in many countries assign greater credit risk premia (spreads over sovereign yields) and lower credit ratings for weaker subnational governments, but in China credit ratings do not seem to differentiate sufficiently, with most local governments receiving an AAA rating.
  - Empirical results based on over 8,000 individual bonds in China suggest that local government bond spreads are not correlated to fiscal fundamentals—measured by provincial growth, debt ratio, and fiscal balances—unlike many advanced countries.
  - Widespread perception of central government bailout creates moral hazard; existing laws do not allow defaults by provincial governments. To date there have been no defaults by provincial government or LGFVs and it remains untested how the resolution will be.
  - Several ministries and agencies regulate and supervise the local government bond market, each handling different aspects; overlapping responsibilities exist (e.g., bond trading) as well as regulatory gaps (such as disclosures and resolution).
  - Local government bonds are traded on both the over-the-counter interbank and exchange markets. Co-existence of two market segments plus current restrictions has segmented investor participation and created room for pricing distortion (for example, similar instruments have a pricing gap of 10–20 basis points).
  - Investors and rating agencies often have limited information to assess local government creditworthiness. Many local governments only provide limited information on uses of funds, without indicating medium-term fiscal positions and resolution steps in case of nonpayment.
  - Prospectus length comparison: China’s local government bond prospectus is typically only 8–10 pages, compared to over 300 pages for municipal bond issuance in the United States.
  - Debt management capacity of provincial governments usually falls short of rising needs to issue bonds and monitor risks, particularly for lower-level finance bureaus and in less-developed provinces.
  - Local governments face misalignment of revenue and spending and do not have a medium-term budget framework. The Ministry of Finance aims to gradually raise capacity at local levels by establishing local debt units and staffing with central government officials.

- Empirical evidence on spreads and fiscal fundamentals
  - Data coverage and key statistics
    - China sample: period 2013-17 for 8,831 local government bonds for 31 provinces, municipalities, and autonomous regions; coupon rates from WIND database in the primary market.
    - Other advanced countries sample (Sola and Palomba 2015): unbalanced panel covering the United States, Canada, Australia, and Germany; 36 sub-national governments and total number of bonds issued at 1,641.
    - Macroeconomic variables: GDP growth, subnational fiscal balance, fiscal transfer to revenue ratio, and debt ratio at subnational levels.
    - Liquidity measures: for other countries, liquidity proxied by outstanding debt stock and volatility by U.S. VIX; for China, liquidity measured as individual bond issuance relative to outstanding stock in that province.
  - Cross-country results
    - For Australia, Canada, and the United States: a one-percentage point increase in fiscal deficit to GDP would raise bond spreads by about 4.2-6.7 basis points.
    - Subnational debt to GDP and liquidity also affect bond spreads in the United States.
    - Germany: fiscal variables do not show a statistically significant relationship with bond spreads; Germany has the smallest variation in subnational bond spreads and a history of central government bailout.
  - China-specific results
    - In China, fiscal fundamentals do not appear to play a significant role in bond spreads in the baseline specification.
    - Robustness checks accounting for nonlinearity in debt ratio or provinces with high debt and deficits also do not show a significant relationship with bond spreads. In some specifications significant coefficients at the 10-percent level have unexpected signs (e.g., higher debt ratio and fiscal deficit associated with lower bond spreads in specifications 2 and 3).
    - Market conditions matter: liquidity has the expected negative sign and is a key determinant for spreads in China and the United States; the magnitude in China is about 10 times smaller than in the United States.

- Policy recommendations to develop a sound local government bond market
  - Financial sector policies — improve liquidity and broaden investor base
    - Harmonize current regulations to eliminate market segmentation (including arbitrary limits on bond bidding).
    - Improve market-making and trading arrangements of securities brokerage.
    - Standardize terms (for example, trading and settlement arrangement, and trust methods) and preannounce auctions in advance to enhance market predictability.
    - Develop real-time trade data in secondary markets to allow mark-to-market valuation.
    - Broaden investor base: progress has been made to open the domestic bond market to foreign qualified investors; further efforts could include upgrading regulations on syndications, auction rules, and distribution, and allowing broker dealers and institutional long-term investors as authorized bidders in local government bond auction.
    - Note: foreign institutional investors have been able to invest directly in the interbank bond market or through the “Bond Connect” program since 2017.
  - Fiscal reforms — tighten off-budget borrowing and adjust intergovernmental fiscal relations
    - Reign in new avenues of off-budget borrowing (e.g., government-guided funds and misuse of public-private partnerships).
    - Set bond financing quota for local governments large enough to ensure all off-budget LGFV fiscal spending is brought onto the budget.
    - Intergovernmental reforms to address vertical imbalances:
      - Consolidate public pension and unemployment insurance programs at the national level (with some local autonomy for administration) to gain efficiency from risk-pooling and benefits portability.
      - Consider a recurrent market-value based property tax for local governments; define tax base following national guidelines while allowing local governments to set tax rates within a central government band.
      - Move toward a rules-based general transfer system as opposed to current revenue-sharing and tax rebate programs to improve clarity and predictability and reduce pro-cyclicality; increase size of the funding pool for equalization grants.
  - Supporting fiscal institutions — harmonize regulation, improve disclosures, clarify resolution, and strengthen debt management
    - Harmonize regulation and taxation: clarify respective roles and responsibilities of stakeholders in legislation, establish clear legal mandate for central government financial oversight, and create an enforcement regime for non-compliance; align tax treatments on bond coupon payments and across financial institutions to encourage liquidity.
    - Disclosures: require timely and credible disclosure of local government finances in the context of a medium-term expenditure framework, including balance sheet, debt services, and fiscal risks; align data compilation with Government Finance Statistics Manual.
    - Resolution framework: clarify liability for local government borrowings, consider non-bailout clauses through legislation, provide legal mechanisms for resolving local government defaults, and strengthen ex-post monitoring on uses of funds. Key elements:
      - Definition of a trigger for intensified oversight and resolution procedure.
      - Clear provisions to resolve local government debts collectively and to negotiate debt restructuring.
      - Plans for fiscal adjustment to bring expenditure into line with revenue.
      - Ensure insolvent subnational governments can still deliver essential public services during restructuring; protect creditor rights to reduce borrowing costs and encourage bond market development.
    - Debt management: strengthen debt management capacity under the medium-term budget framework at central and local levels; consider establishing specialized debt management units (both central and subnational). International examples:
      - Municipal Securities Rulemaking Board and U.S. Securities Exchange Commission roles in the United States.
      - Debt Management Office overseeing sovereign and local government debt issuance in the United Kingdom.
    - Over the medium term, when a sound, rules-based framework is established, consider giving local governments greater discretion over modalities of bond issuance to better smooth debt services and manage refinancing risks.

- Conclusions
  - The local government bond market has grown rapidly and is becoming a key part of China’s capital markets, but remains underdeveloped.
  - Severe impediments include low liquidity, weak credit culture, narrow investor base, and fragmented regulatory structure.
  - Developing a sound local government bond market requires a coordinated set of fiscal and financial sector policies: harmonized tax and regulation systems, greater liquidity, significant upgrades to supporting institutions (trading, disclosures, debt management, and resolution framework), and parallel fiscal reforms to rein in off-budget borrowing and align intergovernmental relations.

### Key statistics and figures (preserved verbatim)
- RMB200 billion (pilot program issuance)
- RMB3–4 billion (provincial direct issuance as of end-2014)
- 22 percent of GDP (LGFV debt recognized as general government debt in 2014–15)
- RMB18 trillion or 25 percent of 2015 GDP (three-year bond-swap program size)
- RMB1.6 trillion (authorized issuance in 2015)
- RMB600 billion (of the RMB1.6 trillion for new financing)
- RMB1 trillion (of the RMB1.6 trillion for refinancing maturing LGFV debt)
- RMB1.1 trillion to RMB14.7 trillion (local government bond market size, 2014–2017)
- 90 percent (share of official local government debt in form of debt securities)
- 2-20 years (bond maturities under the swap program)
- average maturity of about 4.5 years
- 4.3 percent (weighted average yields on local government bonds in 2017)
- 140 basis points (yield gap versus average bank lending rates)
- 10–20 basis points (spreads across provinces)
- over 40 percent of GDP (debt in less-developed provinces on average)
- over 80 percent of provincial fiscal resources (debt burden in less-developed provinces)
- 37 of 53 major economies (allow local governments to issue debt)
- 31 percent of GDP (average subnational debt in federal OECD countries)
- 15 percent of GDP (average subnational debt in unitary OECD countries)
- about 20 percent of GDP (official local government debt in China)
- additional 30 percent of GDP (off-budget LGFV debt, "augmented" perimeter)
- 45 percent (debt securities share of subnational government debt across OECD)
- $3.8 trillion (US municipal bonds outstanding, 2017)
- 10 percent of the total bond market or 20 percent of GDP (US municipal bonds, 2017)
- 30.4 percent of GDP (Japan local government debt in 2015)
- 17 percent (Japan local government bonds as share of total government bonds)
- Average turnover of local government bonds: 4.3 percent (outstanding)
- Average turnover of sovereign bonds: 66 percent (2017)
- More than three-quarters (share of local government bonds held by commercial banks)

*Source: wp18219 - 1. What are the recent developments in the local government bond market and how do those (IMF working paper content provided).*

### 1. What are the recent developments in the local government bond market and how do those

### wp18219 - 1. What are the recent developments in the local government bond market and how do those

### II. RECENT DEVELOPMENTS
- Pre-2014 context
  - Local governments were legally prohibited from borrowing on their own before 2014 except under the five-year pilot bond issuance program starting in 2009.
  - Under the pilot program, the Ministry of Finance issued RMB200 billion local government bonds on behalf of local governments.
  - A small set of provincial governments were later allowed to issue bonds directly (about RMB3–4 billion as of end-2014).
  - Local governments used off-budget financing vehicles (LGFVs) to borrow from banks and capital markets, circumventing legal restrictions.
  - LGFVs are distinct entities owned by local governments, typically established for land development, infrastructure investment, and social housing; they are legally registered as corporations with public-sector objectives. Local governments often shared LGFVs’ responsibilities to service debt and provided debt guarantees.

- Central government response and debt-swap program
  - Revised budget law adopted a strategy of “opening the front door and closing the back door”: tightened off-budget borrowing while allowing provincial governments to issue bonds subject to an annual cap determined by the National People’s Congress.
  - The central government recognized about 22 percent of GDP of LGFV debt as general government debt in 2014–15.
  - A three-year bond-swap program (RMB18 trillion or 25 percent of 2015 GDP) was launched to replace high interest and short duration debt (bank loans, LGFV bonds, trusts and other nonstandard borrowing) with provincial government bonds of 2–20 years maturity.
  - The National People’s Congress authorized an issuance of RMB1.6 trillion in bonds in 2015, of which RMB600 billion was for new financing and another RMB1 trillion was for refinancing maturing LGFV debt deemed general government debt under the three-year debt-swap program.

- Market size and characteristics (2014–2018)
  - The size of the local government bond market grew from RMB1.1 trillion to RMB14.7 trillion between 2014 and 2017.
  - About 90 percent of official local government debt is now in the form of debt securities.
  - The maturity of the bonds ranged from 2-20 years, with an average maturity of about 4.5 years.
  - While the debt-swap program was completed in 2018, further expansion of local government bonds is likely given local governments’ sizeable financing needs.
  - Issuance varies across provinces: more developed coastal provinces have the largest nominal bond issuance but smaller debt burden in percent of GDP than less-developed provinces.
  - Less-developed provinces have debt of over 40 percent of GDP on average and over 80 percent of provincial fiscal resources.
  - Weighted average yields on local government bonds reached 4.3 percent in 2017 (about 140 basis points below the average bank lending rates), and spreads across provinces were minimal within 10–20 basis points.

- International and OECD comparisons
  - About 37 of 53 major economies allow local governments to issue debt.
  - Among OECD countries, subnational government debt accounted for 31 percent of GDP on average for federal countries and about 15 percent of GDP for unitary countries.
  - Official local government debt in China is about 20 percent of GDP.
  - An “augmented” perimeter including off-budget LGFV debt would add an additional 30 percent of GDP.
  - Debt securities account for 45 percent of all subnational government debt across OECD countries on average.
  - United States municipal bonds outstanding were about $3.8 trillion (10 percent of the total bond market or 20 percent of GDP) in 2017.
  - Japan local government debt was about 30.4 percent of GDP in 2015 (17 percent of the total government bonds).

- Regulatory and institutional measures (“opening the front door”)
  - Revised budget law and related directives assigned fiscal responsibility on local government finances to provinces; provincial finance bureaus are responsible for lower-level subnational finances.
  - An early-warning system and risk management guidelines were announced to monitor subnational fiscal risks; measures include potential loss of fiscal authority on local administration while ensuring minimum service levels.
  - New directives allow local governments to issue bonds against land development and income from toll roads.
  - Cross-agency measures aim to rein in proliferation of government guarantees and raise policy coordination.
  - An intergovernmental reform plan aims to realign local government finances by: (1) raising local government tax base and revenues; (2) increasing general transfers to lower-level governments; and (3) shifting a greater share of spending responsibility to the central government.

### III. CURRENT IMPEDIMENTS
- Overview
  - The rapid surge in local government bond issuance was not matched by a corresponding upgrade in bond market development.
  - Key impediments include a narrow investor base, low liquidity, weak credit discipline, and fragmented regulations; these impediments are intertwined and have become more challenging as the market has grown.

- Low liquidity and narrow investor base
  - Average turnover of local government bonds was only 4.3 percent of the outstanding amount, much lower than 66 percent for sovereign bonds in 2017.
  - Low liquidity is more pronounced compared to other public-sector issuers such as policy banks and to municipal bond markets in other countries.
  - Low liquidity was partly due to underdeveloped financial market infrastructure such as inactive market-making dealers.
  - More than three-quarters of local government bonds are held by commercial banks.
  - Long-term institutional investors—mutual funds, life insurance—are underrepresented (explicit numbers not provided in source excerpt).

### Key statistics and figures (preserved verbatim)
- RMB200 billion (pilot program issuance)
- RMB3–4 billion (provincial direct issuance as of end-2014)
- 22 percent of GDP (LGFV debt recognized as general government debt in 2014–15)
- RMB18 trillion or 25 percent of 2015 GDP (three-year bond-swap program size)
- RMB1.6 trillion (authorized issuance in 2015)
- RMB600 billion (of the RMB1.6 trillion for new financing)
- RMB1 trillion (of the RMB1.6 trillion for refinancing maturing LGFV debt)
- RMB1.1 trillion to RMB14.7 trillion (local government bond market size, 2014–2017)
- 90 percent (share of official local government debt in form of debt securities)
- 2-20 years (bond maturities under the swap program)
- average maturity of about 4.5 years
- 4.3 percent (weighted average yields on local government bonds in 2017)
- 140 basis points (yield gap versus average bank lending rates)
- 10–20 basis points (spreads across provinces)
- over 40 percent of GDP (debt in less-developed provinces on average)
- over 80 percent of provincial fiscal resources (debt burden in less-developed provinces)
- 37 of 53 major economies (allow local governments to issue debt)
- 31 percent of GDP (average subnational debt in federal OECD countries)
- 15 percent of GDP (average subnational debt in unitary OECD countries)
- about 20 percent of GDP (official local government debt in China)
- additional 30 percent of GDP (off-budget LGFV debt, "augmented" perimeter)
- 45 percent (debt securities share of subnational government debt across OECD)
- $3.8 trillion (US municipal bonds outstanding, 2017)
- 10 percent of the total bond market or 20 percent of GDP (US municipal bonds, 2017)
- 30.4 percent of GDP (Japan local government debt in 2015)
- 17 percent (Japan local government bonds as share of total government bonds)
- Average turnover of local government bonds: 4.3 percent (outstanding)
- Average turnover of sovereign bonds: 66 percent (2017)
- More than three-quarters (share of local government bonds held by commercial banks)

*Source: wp18219 - 1. What are the recent developments in the local government bond market and how do those (IMF working paper content provided).*

### 4. Subnational Government Bond Spreds

### 4. Subnational Government Bond Spreds

### Market structure and key impediments
- Market liquidity and activity
  - Sovereign bonds were issued spanning from 3-month to 50-year maturities and the futures markets at 5- to 10-year treasury bonds supported liquidity; overall secondary market activity remains thin.
  - Low liquidity has reduced the role of price referencing typically provided by government securities. As a result, sovereign bonds in China do not provide a liquid benchmark yield curve (Chen, Chow, and Zhang 2018).
  - Under the bond-swap program, banks bought the local government bonds at a low coupon rate. Banks could suffer a marked-to-market loss if bonds are sold.
- Underdeveloped market discipline
  - Bond markets in many countries assign greater credit risk premia (spreads over sovereign yields) and lower credit ratings for weaker subnational governments, but in China credit ratings do not seem to differentiate sufficiently, with most local governments receiving an AAA rating.
  - Empirical results based on over 8,000 individual bonds in China suggest that local government bond spreads are not correlated to fiscal fundamentals—measured by provincial growth, debt ratio, and fiscal balances—unlike many advanced countries (Table 4 and Annex; IMF 2018b).
  - Widespread perception of central government bailout creates moral hazard; existing laws do not allow defaults by provincial governments (Ji and others 2017). To date there have been no defaults by provincial government or LGFVs and it remains untested how the resolution will be.
- Fragmented regulatory framework
  - Several ministries and agencies regulate and supervise the local government bond market, each handling different aspects; overlapping responsibilities exist (e.g., bond trading) as well as regulatory gaps (such as disclosures and resolution).
  - Local government bonds are traded on both the over-the-counter interbank and exchange markets. Co-existence of two market segments plus current restrictions has segmented investor participation and created room for pricing distortion (for example, similar instruments have a pricing gap of 10–20 basis points).
- Lack of disclosure
  - Investors and rating agencies often have limited information to assess local government creditworthiness. Many local governments only provide limited information on uses of funds, without indicating medium-term fiscal positions and resolution steps in case of nonpayment.
  - Prospectus length comparison: China’s local government bond prospectus is typically only 8–10 pages, compared to over 300 pages for municipal bond issuance in the United States.
- Limited debt management capacity
  - Debt management capacity of provincial governments usually falls short of rising needs to issue bonds and monitor risks, particularly for lower-level finance bureaus and in less-developed provinces.
  - Local governments face misalignment of revenue and spending and do not have a medium-term budget framework. The Ministry of Finance aims to gradually raise capacity at local levels by establishing local debt units and staffing with central government officials.

### Empirical evidence on spreads and fiscal fundamentals
- Data coverage and key statistics
  - China sample: period 2013-17 for 8,831 local government bonds for 31 provinces, municipalities, and autonomous regions; coupon rates from WIND database in the primary market.
  - Other advanced countries sample (Sola and Palomba 2015): unbalanced panel covering the United States, Canada, Australia, and Germany; 36 sub-national governments and total number of bonds issued at 1,641.
  - Macroeconomic variables: GDP growth, subnational fiscal balance, fiscal transfer to revenue ratio, and debt ratio at subnational levels.
  - Liquidity measures: for other countries, liquidity proxied by outstanding debt stock and volatility by U.S. VIX; for China, liquidity measured as individual bond issuance relative to outstanding stock in that province.
- Cross-country results
  - For Australia, Canada, and the United States: a one-percentage point increase in fiscal deficit to GDP would raise bond spreads by about 4.2-6.7 basis points.
  - Subnational debt to GDP and liquidity also affect bond spreads in the United States.
  - Germany: fiscal variables do not show a statistically significant relationship with bond spreads; Germany has the smallest variation in subnational bond spreads and a history of central government bailout.
- China-specific results
  - In China, fiscal fundamentals do not appear to play a significant role in bond spreads in the baseline specification.
  - Robustness checks accounting for nonlinearity in debt ratio or provinces with high debt and deficits also do not show a significant relationship with bond spreads. In some specifications significant coefficients at the 10-percent level have unexpected signs (e.g., higher debt ratio and fiscal deficit associated with lower bond spreads in specifications 2 and 3).
  - Market conditions matter: liquidity has the expected negative sign and is a key determinant for spreads in China and the United States; the magnitude in China is about 10 times smaller than in the United States.

### Policy recommendations to develop a sound local government bond market
- Financial sector policies — improve liquidity and broaden investor base
  - Harmonize current regulations to eliminate market segmentation (including arbitrary limits on bond bidding).
  - Improve market-making and trading arrangements of securities brokerage.
  - Standardize terms (for example, trading and settlement arrangement, and trust methods) and preannounce auctions in advance to enhance market predictability.
  - Develop real-time trade data in secondary markets to allow mark-to-market valuation.
  - Broaden investor base: progress has been made to open the domestic bond market to foreign qualified investors; further efforts could include upgrading regulations on syndications, auction rules, and distribution, and allowing broker dealers and institutional long-term investors as authorized bidders in local government bond auction.
  - Note: foreign institutional investors have been able to invest directly in the interbank bond market or through the “Bond Connect” program since 2017.
- Fiscal reforms — tighten off-budget borrowing and adjust intergovernmental fiscal relations
  - Reign in new avenues of off-budget borrowing (e.g., government-guided funds and misuse of public-private partnerships) (Gao, Ru, and Tang 2017).
  - Set bond financing quota for local governments large enough to ensure all off-budget LGFV fiscal spending is brought onto the budget.
  - Intergovernmental reforms to address vertical imbalances:
    - Consolidate public pension and unemployment insurance programs at the national level (with some local autonomy for administration) to gain efficiency from risk-pooling and benefits portability (Wingender 2018).
    - Consider a recurrent market-value based property tax for local governments; define tax base following national guidelines while allowing local governments to set tax rates within a central government band.
    - Move toward a rules-based general transfer system as opposed to current revenue-sharing and tax rebate programs to improve clarity and predictability and reduce pro-cyclicality; increase size of the funding pool for equalization grants.
- Supporting fiscal institutions — harmonize regulation, improve disclosures, clarify resolution, and strengthen debt management
  - Harmonize regulation and taxation: clarify respective roles and responsibilities of stakeholders in legislation, establish clear legal mandate for central government financial oversight, and create an enforcement regime for non-compliance; align tax treatments on bond coupon payments and across financial institutions to encourage liquidity.
  - Disclosures: require timely and credible disclosure of local government finances in the context of a medium-term expenditure framework, including balance sheet, debt services, and fiscal risks; align data compilation with Government Finance Statistics Manual.
  - Resolution framework: clarify liability for local government borrowings, consider non-bailout clauses through legislation, provide legal mechanisms for resolving local government defaults, and strengthen ex-post monitoring on uses of funds. Key elements:
    - Definition of a trigger for intensified oversight and resolution procedure.
    - Clear provisions to resolve local government debts collectively and to negotiate debt restructuring.
    - Plans for fiscal adjustment to bring expenditure into line with revenue.
    - Ensure insolvent subnational governments can still deliver essential public services during restructuring; protect creditor rights to reduce borrowing costs and encourage bond market development.
  - Debt management: strengthen debt management capacity under the medium-term budget framework at central and local levels; consider establishing specialized debt management units (both central and subnational). International examples:
    - Municipal Securities Rulemaking Board and U.S. Securities Exchange Commission roles in the United States.
    - Debt Management Office overseeing sovereign and local government debt issuance in the United Kingdom.
  - Over the medium term, when a sound, rules-based framework is established, consider giving local governments greater discretion over modalities of bond issuance to better smooth debt services and manage refinancing risks.

### Conclusions
- The local government bond market has grown rapidly and is becoming a key part of China’s capital markets, but remains underdeveloped.
- Severe impediments include low liquidity, weak credit culture, narrow investor base, and fragmented regulatory structure.
- Developing a sound local government bond market requires a coordinated set of fiscal and financial sector policies: harmonized tax and regulation systems, greater liquidity, significant upgrades to supporting institutions (trading, disclosures, debt management, and resolution framework), and parallel fiscal reforms to rein in off-budget borrowing and align intergovernmental relations.

*Source: IMF Working Paper chapter "4. Subnational Government Bond Spreds" (wp18219).*

---


_Source: https://www.imf.org/-/media/files/publications/wp/2018/wp18219.pdf_