Local debt swap is the right step in restructuring local debt and this should be done on a much larger scale. It is estimated that total local government debt reached 21 trillion yuan by the end of last year, of which at least 11 trillion yuan will be deemed direct responsibility of local governments (the rest could be classified as corporate debt), with average interest rates of 6.5-7 percent.
Current interest rates of LGFV bonds are around 4.7 percent for 3-year and 5-year durations. Therefore, replacing 10 trillion yuan old debt with new bonds could save annual interest payments by up to 300 billion yuan. In addition, extending the maturity from 3-5 years to 7.15 years could reduce current principal payment by 800-1,000 billion yuan per year.
Given that local governments are facing increasing pressure to service debt due to the ongoing property downturn and slowdown in tax revenue, lowering debt service costs by replacing old and high cost debt with new bonds at lower interest cost and longer maturity at a large scale would bring much needed relief to local finance, improve debt sustainability, and reduce the pace of NPL formation.
Banks to benefit from debt swap
Large scale debt swap will benefit banks in more than one way. At the moment there is much concern among investors on whether banks and other current local government debt holders will be pressured to accept lower-yielding bonds and lose on interest revenue. Despite such a likely loss in interest revenue, banks will benefit from the debt swap through the lowering of risk assets, increasing capital adequacy ratio, improving loanable liquidity and improving asset quality.
First, debt swap could enhance banks' capital adequacy by reducing the size of risk assets. Current local government debts are mainly in the form of bank loans to LGFVs, which have 100 percent risk weighting, but new provincial bonds will carry explicit provincial government guarantees and likely have 20 percent risk weighting. It is estimated that every 5 trillion yuan swapped from bank loans to local government bonds could boost banks' capital adequacy ratio by 0.6-0.7 percent.
Second, while the existing local government debts are loans and trust loans, new local government bonds are securities that can be more easily transacted at the market.
Furthermore, as bonds are considered investments and not included in the loan-to-deposit (LDR) ratio, unlike loans, holding bonds rather than loans will effectively lower banks' LDR, freeing more liquidity for lending. It is estimated that every 5 trillion yuan swapped could cut banking system LDR by around 4 percentage points.
Last but not least, as debt swap will increase local government debt sustainability, it will also reduce credit risk and the pace of NPL formation, improving overall asset quality of the banking system. This will be taken positively by investors who have been predominantly concerned about banks' asset quality and tail risk rather than their earnings.
In sum, local government debt swap can not only reduce local financing pressure and make lower local government debt more sustainable, but also benefit the banking system through multiple channels. Therefore, such debt swaps may be carried out in greater scale than the currently announced 1 trillion yuan, and to avoid pushing up yields, may be carried out through direct placement in negotiation with current debt holders such as banks.
The author Wang Tao is chief economist at UBS. The views do not necessarily reflect those of China Daily.
