China local governments tap $29bn in special bonds to fund smaller banks

Issuances accelerate as smaller lenders face greater trouble generating profits

Chinese local authorities have stepped up bond sales to assist small and midsize banks in supplementing capital to mitigate risks to the financial system as narrowing margins squeeze lenders.

Local governments of 16 provinces and regions had issued 19 special-purpose bonds designed to inject liquidity into banks as of Dec. 11, worth a total of 208.3 billion yuan ($29 billion), according to data from bond market database ChinaBond.

The value of the issuances has reached a record high since the special bond was rolled out in 2020 and is more than triple the total amount issued in 2022.

In a latest bond sale last week, Shandong province in eastern China issued 25 billion yuan in special bonds for primary capital replenishment of four city commercial banks and 80 rural commercial banks, including 2.2 billion yuan to be injected into Dongying Bank and 1.7 billion yuan for Jinan Rural Commercial Bank. The local government will use the proceeds of the bond sales to purchase convertible negotiated deposits of the banks — an innovative capital tool to replenish bank capital, according to ChinaBond.

The 10-year notes, with coupon rate of 2.92%, started trading on the Shenzhen Stock Exchange on Wednesday. Shandong’s issuance is the second-biggest one of a local government this year, only after a 28.2 billion yuan bond sale by the central province of Henan in late November. Henan planned to use the proceeds to support 26 small and midsize local lenders.

Chinese local authorities previously have issued special-purpose bonds mainly to finance infrastructure construction and other public welfare projects that are commercially viable. The borrowings are generally repaid from income generated by the projects they fund. Unlike general-purpose bonds, they are not usually allowed to be repaid from government fiscal revenue.

In 2020, the State Council allowed the use of such bonds to recapitalize small and midsize lenders, as many banks suffered narrower profit margins and bad loan surges during the economic slowdown and the COVID pandemic.

The issuance of special bonds to refinance banks has accelerated this year because smaller lenders have faced greater difficulties generating profits as their net interest margins continue to narrow, said Ming Ming, chief economist at Citic Securities.

By the end of September, the average net interest margin of city commercial banks had plunged to 1.6%, a record low, according to Citic Securities. China’s central bank has cut interest rates several times over the past few years to bolster the economy, weighing on bank earnings amid a government push for lenders to provide cheap loans to small businesses and homebuyers. Since 2022, a number of banks have lowered interest rates paid on deposits to cut costs.

Compared with large state banks, small and midsize local lenders are under greater pressure, as they lack the financial strength to tap new capital from the bond or stock markets.

According to the central bank, the total issuance of special-purpose bonds meant to recapitalize small and midsize lenders has reached 481.3 billion yuan since 2020, about 88% of the total quota allocated. This means that there is still 68.7 billion yuan of the quota left untapped.

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