* Government wants bonds to be main source of municipal funding
* Move could create US$1.5trn market, world's second largest
* Muni bonds will reduce strain on banks
By Lianting Tu
SINGAPORE, May 21 (IFR) - China's state council this week took a major step toward allowing local governments to sell debt publicly, in a move that could create the second-largest municipal bond market in the world.
The decision by the National Development and Reform Commission could pave the way for a US$1.5trn muni market, which would be bigger than Japan's and second only to that of the United States.
Authorities hope that, in addition to cutting funding costs and reducing banking risks, the move will increase transparency by making bonds the main form of local government borrowing.
Banks and trust companies accounted for more than 56% of the total Rmb17.9tln (US$2.9tln) of China's local government debt outstanding at the end of June 2013, according to a recent Deutsche Bank report.
But current annual costs can easily exceed 10% on bank or trust funding - via local government funding vehicles used to circumvent a former ban on direct borrowing.
Five-year municipal bonds issued under a pilot programme are currently yielding around 4.5%, only about 50bp higher than central government paper with similar maturity.
The very low yield of these few bonds, though, may be partly attributed to implicit government guarantees.
Rolled out in 2011, the pilot programme allowed a few municipalities to sell bonds directly.
While they sought their own underwriters and conducted auctions, the finance ministry was still making the payments on the bonds on behalf of the local governments.
Under the new plan, local governments will pay coupons directly, which could mean that investors could demand higher yields.
Even if yields rise however, the average funding costs should be lower than what local governments currently pay, according to Robert Zhang, an analyst with Standard & Poor's.
The development of a municipal bond market will also help Beijing shed light on what has become an increasingly murky market.
Municipal bonds are currently the most transparent type of local government debt in China, as financial information and use of proceeds have to be detailed and disclosed publicly, the Deutsche Bank report said.
The new plan is expected to require even more comprehensive financial statements from local governments, including additional details on assets and liabilities.
"The has been working on those financial statements for the last two years," Zhang said.
"But at this stage, it is still unclear exactly how much information will need to be disclosed."
Shifting local government borrowing to the bond market is also expected to reduce the strain on the banking system.
It is "good for the economy, because banks are able to better allocate their assets in the longer term as they lend less to the local governments", Zhang said.
Full rollout of the new scheme will not happen right away and, for now at least, Beijing is expected to increase the bond quota for local governments to grow the market.
That quota had already been raised to Rmb400bn this year from Rmb350bn in 2013.
"In order to have a healthy municipal bond market, the Chinese government needs to offer more ways for local governments to raise revenue - such as collecting property tax - in addition to land sales," said Taimur Baig, chief economist for Asia at Deutsche Bank.
"Also, the central government needs to offer healthy incentives to the local governments, such as a lower target growth rate and more autonomy."
China will also need to enforce discipline among local governments - and reassure the market by offering some guidance on what happens in case of default.
"Chinese municipal bond markets will be different from the US, because China is a unitary state and the central government will balance the reputation of government and the need to discipline the local governments," Zhang said. (Reporting by Lianting Tu; Editing by Christopher Langner, Marc Carnegie)