China's local and regional governments (LRGs) recorded an overall 9.4% yoy growth in 2015 operating revenue, but the fiscal performance of individual regions vary greatly indicating rising polarisation of the LRGs.

Coastal areas including Shenzhen, Guangdong and Shanghai posted a yoy growth of 10-30%. These regions demonstrate a more resilient fiscal position owing to its consumption-led economy and a diversified tax base, despite China's economic slowdown.

In contrast, some local governments in the northeast suffer from a widening fiscal deficit and recorded a yoy decline in growth in 2015. Shrinking demand in industrial sectors, commodity over-supply and a subdued real estate market push their tax revenue to a record low. These governments' fiscal strength is aggravated because a bigger commitment in education and social security in these regions increases their operating expenditure.

However, the identical coupons of domestic bonds issued by these LRGs do not reflect the widening difference in individual provinces' financial strength. After the ban on provincial local governments from issuing bonds was lifted, most of China's muni bonds have been priced only 10 to 30 bps above the treasury for public auction deals and around 50 bps above for private placement.

The central government's initiative allowing provinces to issue muni bonds on their own credit intends to adopt a market-based approach to regulate the sub-nationals' leverage management so that an LRG with higher leverage needs to pay a premium than those with a better credit profile. The identical coupons at present indicate that goal has not been fully achieved.

However, Fitch has observed positive signs demonstrating the investors are paying more attention to the fundamentals of each local government. For example, the yield spread of muni bonds under public auction has widened from 0-10 bps at the inception of this programme in May 2015 to 40-50 bps in December 2015.

Fitch believes that the establishment of a market-driven muni bond market in China cannot be achieved in one go. The Chinese government has taken a series of substantial steps in reforming the debt-laden local and regional public sector in 2015 by launching the CNY3.2trn local government debt swap programme, implementing a more sophisticated principle of debt prudence, shifting from cash-based to accrual-based government accounting standards and continuously streamlining local government-owned public sector enterprises.

These reforms mark a fundamental change in the management of LRG financing, providing a much more transparent framework for future debt issuance.