City investment bonds, issued by city investment companies set up by local governments, serve as a major financing tool for local governments in their public projects. [Photo / Provided to China Daily]

China's local authorities should allow regional defaults on their city investment bonds to cool down the enthusiasm of investors and ease the mounting risks, an expert with a top government think-tank said.

City investment bonds, issued by city investment companies set up by local governments, serve as a major financing tool for local governments in their public projects.

According to the latest survey by the National Audit Office of 36 local governments, city investment companies are responsible for 45 percent of the debt payment of local governments.

Ever since the first of its kind was issued in 1992, there has been no technical default reported in the city investment bond market.

"But the apparent security has hindered the healthy development of the debt market," said Liu Dongmin, a researcher with the Institute of World Economics and Politics at the Chinese Academy of Social Sciences.

In fact, there were two cases in Yunnan and Shandong provinces in 2011 in which city investment companies were unable to make payments when the debt was due. Default was avoided when local authorities lent a helping hand.

Liu said alongside the "no default" record was a worsening credit level among the issuers of city investment debt.

In 2006, only 7 percent of the debt issuers had a credit rating below AA. The figure rose to nearly 25 percent in 2012. In the meantime, city investment debt without a warranty was up from zero to nearly 80 percent.

Zhang Ke, chairman of Shinewing Certified Public Accountants, said his firm would no longer vouch for bond issuance by local governments.

Yet city investment bonds are popular among Chinese investors, most of whom are institutions, mainly because of the expectations that such bonds will not default because they are guaranteed by the government.

"Such expectations will lead to irrational investment," Liu said, adding that most of these bonds are for public projects from which revenues could not meet payments because of the low return rate.

"The regional default of city investment bonds should be allowed. A financial market without any risk is not a market at all," he added.

Liu compared China's local government debt with the United States' municipal bonds, which are issued by a state, municipality or county to finance their capital expenditure on public projects.

US municipal bonds are recognized as the second most secure assets, only after Treasury Securities issued by the Federal Reserve. Yet such a relatively secure investment has had 91 default cases a year on average since 1970.

By the end of 2012, the average maturity period for US municipal bonds was 16.5 years, while that of Chinese city investment debts was only 5.7 years - 35 percent of its US counterparts - leaving little time for the projects to generate enough revenue to make payments and leading to an increase in rollover activity.

According to a recent report by Ma Jun, chief economist for Deutsche Bank Greater China, and Bai Chongen, vice-director of the Economic Management School at Tsinghua University, local governments need to raise 5 trillion yuan ($815 billion) a year to meet the financing needs for urbanization and social welfare spending.

Given the strong fiscal revenue growth over the past two years, the overall debt burden, as measured by debt to revenue, has declined, said a report by the Moody's Investors Service.

But there are still regional risks, as the National Audit Office survey shows, that some local governments' debt burdens are high compared with those of their international peers. For example, the debt-to-revenue ratio of nine provincial capital cities was more than 100 percent, according to the report.

"The central government should prevent local governments from adopting any rescue measures in the case of defaults on fixed income investment in the future," Liu said.

In the meantime, "local government itself, instead of city investment companies, should be issuing the bonds to strengthen their liabilities and credit management level", he said.