“Bond risk for China’s biggest bank fell to a three-month low as Standard and Poor’s and Moody’s Investors Service said a 1 trillion yuan ($161 billion) debt swap plan will help curb regional-government delinquencies,” Bloomberg News reported this morning. Industrial Commercial Bank of China’s 5-year credit default swaps were trading at LIBOR +132, vs. more than LIBOR +170 in March. Moody’s analyst Qiang Liao was quoted saying, “It is a strong credit enhancement for banks’ holdings of Local Government Financing Vehicle debt because provincial governments have to budget for the repayments, which means the process is better documented and more transparent.”

In a March 12 report on the local government debt swap, Hong-Kong based Reorient Group wrote:

Local governments now finance large part of their infrastructure spending through both LGFVs and land sales. In terms of underlying economics, this is the close equivalent of taxation. In the US, local governments obtain a large portion of their revenue through taxes levied on privately-owned land; in China, where the government has owned most of the land, local governments sell or pledge land as a collateral to obtain loans instead. A recent International Monetary Fund study claiming that land sales were the equivalent of deficit financing is plain wrong.

But there is an enormous difference in market efficiency between the present system, where local governments borrow through a large number of special-purpose vehicles, and the emerging municipal bond market. That is the diversification of revenue sources. For the same reason that full-faith-and-credit bonds of large US states offer much lower yields than one-off industrial development bonds, most of China’s provinces have populations the size of European countries. Issuance of debt backed by provincial revenue streams, moreover, affords far less room for abuse than LGFV’s.

De-risking what might become China’s largest fixed income market will have a salutary portfolio effect: Chinese institutional investors as well as households will have access to a liquid market in low-risk bonds across the maturity spectrum. That will allow them to shift other parts of their portfolios toward risk, and support the growth of the corporate bond market.

ICBC’s Hong Kong-listed shares are trading at a P/E of 5.4, according to Bloomberg’s BEST estimate. Total return to the bank’s shares including reinvested dividends was 29% over the past year.

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