Historical Lesson: Debt Conversion Impacts Bond Market

In recent discussions about China's financial market, the term "debt conversion" has emerged as a significant point of interest and debate. The government's proposal aims to boost the local government debt limit by approximately 60 trillion yuan, which will be implemented in three annual tranches of 20 trillion yuan each between 2024 and 2026. This aligns with the expectations of market analysts, reflecting a well-calibrated approach to address the pressing issue of hidden debt burdens faced by local authorities.

To further substantiate this initiative, the Minister of Finance has introduced two additional measures designed to alleviate debt pressures. The comprehensive strategy, which aggregates three key policy interventions, aims to reduce the total hidden debts that local governments need to manage from a staggering 14.3 trillion yuan to a more manageable 2.3 trillion yuan by 2028. This means that the annual debt resolution efforts will significantly decline, from an average of 2.86 trillion yuan to just 460 billion yuan, a reduction to less than one-sixth of the previous burden.

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Put simply, debt conversion is the process of transforming local governments' short-term, high-cost, and opaque “hidden” debts into long-term, low-cost, and transparent “visible” debts. The essence of this approach lies in “borrowing time to gain space,” which effectively helps in managing and mitigating debt risks. It recognizes the urgency of ensuring a sustainable financial environment while minimizing potential disruptions to the economic system.

The history of debt conversion in China has seen several noteworthy phases, according to research by CITIC Securities. A significant instance began in 2015 with a broad debt swap initiative, which involved approximately 12 trillion yuan worth of debt being restructured. The immediate impact of this measure included a reduction in overall financing costs across society, the alleviation of debt stress, and enhanced control over financial risks. These developments contributed to a climate that favored both stock and bond markets, leading to a notable bullish trend.

Another memorable phase began in 2019, introducing a multi-layered approach to debt resolution. This method was more diversified compared to its predecessor and adhered strictly to accountability principles. It effectively mitigated local debt pressures by introducing various mechanisms tailored to the specific contexts of different regions.

However, a major debt conversion process can lead to immediate increases in the bond market supply, which may theoretically generate some supply-side pressure in the short term. When analyzing the aftermath of the 2015 debt conversion, it is essential to scrutinize how it impacted bond markets.

The 2015 debt swap can be understood in three distinct stages:

The first phase, from early March to mid-May 2015, witnessed a prevailing concern for supply. Worries about market supply dominated discussions, leading to considerable volatility in interest rates.

The second phase began in mid-May when the initial debt swaps commenced. During this period, the market experienced a combined impact of new supply and liquidity fears, leading to a rise in interest rates.

By the third phase, which began in mid-June 2015, regular issuance of the converted bonds had become the norm, resulting in a downward trend in interest rates as the market adjusted to the new supply landscape.

Given this historical context, one might question why the extensive debt conversion in 2015 did not impose lasting pressure on the bond market. According to Tianfeng Securities, this was due to three primary factors:

From a macroeconomic perspective, the debt swap did not increase overall societal credit. This was compounded by an ongoing weak economic environment alongside an accommodative monetary policy.

On an institutional level, the implementation of the debt swap led to increased operational pressures for banks and encouraged a shift towards bond market transactions, as financial institutions sought to adapt to the changing landscape.

Additionally, from a policy viewpoint, coordinated efforts involving the government and selective underwriting by financial institutions created a conducive environment that encouraged bank participation in these debt issues. Although the central bank's role was less direct, its sustained relaxation of monetary policy provided implicit support throughout the year.

In summary, the overall context of loose policy measures meant that macroeconomic demand largely dictated the direction of interest rates during this period.

Returning to the contemporary scenario, the impending debt conversion policies anticipated for 2024, coupled with the expected net financing of government bonds amounting to around 2.4 trillion yuan in November and December, feature a financial landscape shaped by the issuance of an additional 2 trillion yuan in funding measures. Overall, the government bond issuance is projected to remain at a level similar to that of 2023, reaching approximately 3.4 trillion yuan.

In the current cycle concerning the domestic bond market, the added supply generally aligns with what market participants were anticipating. Despite uncertainties regarding the impact of government bond issuance within the year, it is expected to remain manageable and unlikely to exert severe pressure on the bond market. This prognosis is justified for several reasons:

Firstly, the issuance of special refinancing bonds will indeed increase overall government bond supply. However, it is crucial to recognize that this increment does not equate to merely raising new bond levels. Instead, it represents a transition from high-cost liabilities to lower-cost alternatives. Despite rising supply, it is anticipated that this strategy would not disrupt social financing on a significant scale.

Secondly, the central bank is expected to actively cooperate with the government's bond issuance to alleviate any liquidity pressure that may arise. Through the introduction of new mechanisms that involve a synergy between fiscal measures and central bank responses, such as open market operations or reserve requirement ratio adjustments, the aim is to smoothen any potential liquidity shocks resulting from increased government bond issuances. This carefully crafted policy will contribute to stabilizing market liquidity and preventing drastic fluctuations in interest rates, ensuring that the tight funding scenario faced in late October of the previous year is not repeated.