A worker works in the construction site of the residential buildings in Shanghai. Local governments have amassed large debts through off-balance sheet borrowing and, at more than 25 per cent of gross domestic product, these debts are seen as one of the big risks looming over the Chinese economy.ALY SONG
Shanghai became the first local government in China to issue bonds directly in nearly two decades, a reform that lies at the heart of attempts to clean up the troubled finances of Chinese cities and provinces.
Local governments have amassed large debts through off-balance sheet borrowing and, at more than 25 per cent of gross domestic product, these debts are seen as one of the big risks looming over the Chinese economy.
By allowing bond sales, the hope is that the market will impose discipline and transparency on local governments, ensuring that their borrowing remains under control.
The first local bond auction drew strong demand that would be the envy of many European governments.
Shanghai on Tuesday sold 3.6 billion yuan ($560-billion) of three-year bonds at a yield of 3.1 per cent and 3.5 billion yuan of five-year bonds at 3.3 per cent. They were both more than three times oversubscribed, according to the official Xinhua news agency.
Analysts cautioned that the sale amounted to a tiny step in the right direction and that far more was needed to reform the structure of government financing in China.
"I don't think they've solved the fundamental problem and the fundamental problem is a lack of local revenue generation capacity," said Stephen Green, head of China research with Standard Chartered.
Cities and provinces remain excessively reliant on land sales and fiscal transfers from Beijing and there was a lack of supervision over their spending, he said.
Largely prohibited from borrowing from banks and selling bonds, local governments in China have created thousands of financing companies in recent years to get around these restrictions.
Beijing has struggled to get a clear picture of how much these semi-official companies owe and where they have spent their funds. National auditors estimated earlier this year that they had racked up more than 10,000 billion yuan in debt.
Recognizing that bond sales would be a much more direct way for local governments to finance themselves, Beijing has tentatively moved to open that door.
Over the past three years, the finance ministry has issued 200 billion yuan each year in bonds whose proceeds were earmarked for local spending.
Then, to much fanfare last month, Beijing said that it would permit Shanghai, Shenzhen, Guangdong and Zhejiang -- four of the wealthiest, best-run jurisdictions in China -- to go a step further by directly selling bonds.
Local governments had not issued bonds since 1994, when Beijing banned them from doing so because of concerns that they were accumulating unpayable debts. Guangdong province is next, with its auction scheduled for Friday, and will be followed on Monday by Zhejiang province.
But there is less than meets the eye to these bond sales.
The central government dictated how much the local governments could issue, placing a low cap on them. Shanghai's bonds equate to just about 2 per cent of its planned expenditures this year.
China's national finance ministry will in fact pay both the interest and the principal on the bonds. Local authorities will be responsible for transferring corresponding funds to Beijing but analysts say the arrangement amounts to an explicit central government guarantee for the bonds.
"It is just the beginning of the beginning," said Zhu Ning, deputy director of the Shanghai Advanced Institute of Finance, a business school.
"The current situation is such that local governments do not have the resources to pay the principal and the interest."