When China's northwestern Xinjiang Autonomous Region issues 3 billion yuan (439.88 million U.S. dollars) in local government bonds next Monday, with the Ministry of Finance as the legal debtor, it will be taking part in a financial experiment.

Xinjiang's bonds are part of a 200-billion-yuan program of bond issues by the central government on behalf of localities. The program is a compromise reached during the annual legislative session earlier this month, between provincial and municipal governments that want to issue bonds on their own and a central government that is watching local finances carefully.

Lawmakers, mainly from the more-developed regions such as the city of Shanghai and the provinces of Guangdong and Liaoning, strongly urged the National People's Congress to allow local borrowing. What resulted was an agreement by the legislature to allow the central government to issue the bonds on behalf of all local governments, the wealthier areas as well as less-developed ones whose fiscal positions aren't so strong.

The debt will help finance the central government's 4-trillion-yuan economic stimulus package, announced in late 2008. The central government will provide 1.18 trillion yuan, with the remainder to be contributed by local governments and corporate investors.

According to Zhang Ping, head of the National Development and Reform Commission (NDRC), the local governments' part of the funding could be raised in three ways: the 200-billion-yuan bond program, undertaken by the Ministry of Finance on behalf of local governments, policy loans and more local corporate bonds.

Gray regulatory zone

Some economists, however, warn that a rush of local corporate bonds could trigger demand for more local debt issues, which are still in a "gray" zone of regulatory barriers.

Under a 1995 budget law, China's local governments are banned from issuing bonds directly or running budget deficits. The law was intended to prevent excessive borrowing because most local governments, those from less-developed regions in particular, are still financially weak and heavily dependent on central government funds.

Most of their fiscal expenditure is covered by transfer payments from the central government, while most of their fiscal revenues are required to go into the central coffer.

Proceeds from the centrally sponsored bonds will be incorporated into provincial budgets, with special approval by the State Council (cabinet). Chinese officials believe that the central government's involvement will increase the creditworthiness of the local government bonds.

The money raised will go mostly into projects designed by the central government, such as low-income housing, infrastructure construction, projects to improve rural living standards, environmental protection, post-earthquake reconstruction in the southwest and similar projects.

The Ministry of Finance will pay the principal and interest on the bonds and local governments will repay the ministry. The payments are secured, in the sense that the central government will deduct any unpaid amounts from transfer payments it owes to the local governments, according to the ministry.

Economists warned that the central government might end up footing the bill for some poorer regions, which might not be able to repay the Finance Ministry. But, they said, the central government could not undertake all risks for any possible debt issues that local governments might want to make to pay for their portion of the stimulus package.