OREANDA-NEWS. Draft legislation submitted by China's State Council to set limits on local government borrowing would be positive for local government creditworthiness, says Fitch Ratings. That said, the process for determining the limits have yet to be defined. To be most effective, the limits would be based on a transparent and consistently enforced formula - as opposed to being determined on an ad hoc basis.

The proposed legislation was submitted to the National People's Congress on 24 August, and signals a commitment by the authorities to bolster the borrowing framework for local government as part of a broader debt reform initiative. The intention is to develop a local government debt market where sub-national authorities are able to issue bonds directly and swap debt from off-balance-sheet local government financing vehicles.

The recent initiative follows the passage of a new budget law in 2014 which formalised plans to enable local governments to issue debt directly, as well as establishing a broader regulatory framework for the market (see "China Local Gov't Bond Law to Improve Budget Transparency" 4 September 2014 on www.fitchratings.com).

Details of how the new borrowing limit will be defined have yet to be made public. The initial level will be set according to the existing debt as of end-2014 in conjunction with the additional borrowing quota which was approved by the National People's Congress in March 2015.

Fitch believes it likely that the limit will be set according to a pre-set nationwide formula based on economic and fiscal variables and legislated at the central government level. Having a pre-set formula to define annual borrowing limits would enhance local government borrowing supervision, and enable the central government to manage potential systemic local government debt risk more efficiently. As part of the broader strategic reform agenda for better monitoring and control of local government borrowing, it also would help to put local government financing on a more sustainable path.

There is a risk that the debt limit will not be formula-based, or that the formula will not be sufficient to restrict unsustainable borrowing. But Fitch believes this risk is limited - based on the legislation and reforms that have been submitted so far as part of the local government debt market plan.