What is the “special debt” China is using to boost its economy?

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China’s government is financially strapped with Covid-19, tax breaks and a real estate downturn cutting revenues while spending continues to surge to pay for economic stimulus and contain virus outbreaks. One option Beijing has to bridge the gap is to sell special government bonds, a rarely used financing tool last dusted off in 2020, in a bid to boost the economy without inflating the budget deficit. Before that, they were employed during the Asian financial crisis of the 1990s and the founding of China’s sovereign wealth fund in 2007.

1. What are special government bonds?

Unlike regular government bonds, special bonds raise money for a specific policy or to solve a specific problem. They are not part of China’s official budget and are therefore not included in deficit calculations. The State Council, China’s cabinet, can propose the sale of such bonds, which then only requires the approval of a standing committee of the National People’s Congress, which usually meets every two months, rather than the entire legislature, which meets only once a year. This means they can be issued more flexibly than regular bonds, which have to be budgeted and approved by the NPC’s annual meeting.

2. Why use this tool now?

China has a target for gross domestic product growth of around 5.5% this year, but amid Covid lockdowns and a housing slump, the government is far from achieving it, according to economists. One way President Xi Jinping hopes to spur a faster recovery is by spending trillions of yuan on infrastructure projects. However, with tax revenues plummeting this year, funding this type of stimulus from the budget will be a challenge. Some of the funding will come from China’s state-owned development banks, such as the China Development Bank and the Agricultural Development Bank of China, which have received an additional 800 billion yuan ($120 billion) line of credit to provide loans for infrastructure investments. Dedicated government bonds could be an additional source as some of these have been used for this purpose in 2020. Wang Yiming, an adviser to the central bank’s monetary policy committee, highlighted special national bonds as an option. According to Betty Wang and Xing Zhaopeng, analysts at Australia & New Zealand Banking Group Ltd., the bonds could more likely be used to close the fiscal gap and fund the stimulus measures the government announced in May.

3. How were these bonds used in the past?

In 2020, at the start of the pandemic, about 1 trillion yuan worth of banknotes were sold. For once, the all-powerful Communist Party Politburo decided to sell the bonds, and the NPC gave the official go-ahead at its May plenary session. Around 700 billion yuan from this sale has been transferred to local governments to support their Covid-fighting efforts and infrastructure investments, according to a report by the Ministry of Finance. The remainder was put into the central government’s general public budget to subsidize local spending on the outbreak, it shows. Before:

• In 2007, 1.55 trillion yuan of special government bonds were issued to capitalize China Investment Corp., the sovereign wealth fund. The bond proceeds were used to purchase currency reserves from the People’s Bank of China, and these funds then went to CIC. Some of the bonds, worth around 950 billion yuan, will mature in the second half of this year, data compiled by Bloomberg shows.

• During the Asian financial crisis, China sold 270 billion yuan in special government bonds – then the country’s largest bond issue – to raise capital for its major state banks and help absorb losses on distressed assets.

4. How could the bonds affect the financial markets?

An increase in bond supply would drive security prices down and yields up. The mid-2020 issuance helped lift China’s 10-year government bond yield by more than 20 basis points to near a six-month high in about three weeks. At the time, liquidity conditions were tight due to a glut of local government bonds before the special bonds hit the market and the central bank’s cautious approach to monetary easing, in part to avoid fueling asset bubbles. The situation is different now. Rate cuts and other easing measures by central banks mean the country’s banks are awash with cash with which to absorb any additional bond offerings. Also, local governments – which issue their own special bonds used mainly for infrastructure investments – were ordered to sell almost all of this year’s 3.65 trillion yuan quota of debt by the end of June. This should leave room for the market to add new debt in the second half of 2022.

5. How much do we talk?

Jia Kang, a former head of a Treasury Ministry research institute, said the 1 trillion yuan sold in 2020 could serve as a “reference” for policymakers when deciding how much to spend this year. Others think there could be more. Larry Hu, head of China Economics at Macquarie Group Ltd., estimates that the Covid outbreaks have likely left China with a budget deficit of 1 trillion to 2 trillion yuan this year. A sale of this size could add 1-2 percentage points to gross domestic product growth given the additional financial boost it will give to local governments, he estimated, adding that the impact on the financial market is expected to be “limited”.

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