China took one of its biggest steps yet to push local governments away from using opaque financing vehicles to raise money as policy makers seek to reduce leverage and develop a more transparent municipal bond market.

The nation’s clearing agency for exchanges said it won’t allow bonds rated below AAA or sold by issuers graded lower than AA to be used as collateral for short-term loans obtained through repurchase agreements. The new rules sparked a retreat in lower-rated bonds and contributed to shares in Shanghai tumbling as noteholders reassessed the appeal of owning such debt.

Policy makers in China have pledged to create a modern fiscal system by 2020 as local governments grapple with liabilities Fitch Ratings Ltd. estimates have climbed to about 30 percent of the nation’s gross domestic product. The new rules announced Monday make LGFVs a less viable option as China spurs development of its municipal bond market.

“Local governments may seek new channels to raise funds,” said Zhang Li, a bond analyst at Guotai Junan Securities Co., the nation’s third-biggest brokerage. “China may expand its municipal bond trial, allowing more local governments to issue debt on their own next year.”

The China Securities Depository and Clearing Corp. said it’s no longer taking application for repo agreements that use lower-rated bonds as collateral. The move means about 470 billion yuan ($75.8 billion) of outstanding debt can no longer be pledged, according to Haitong Securities Co.

LGFV Boom

LGFVs have boomed in China in recent years as an indirect method for provinces and cities to fund projects needed to sustain economic growth as the nation heads for its weakest annual expansion since 1990. A law initially passed in 1994 had banned local governments from selling bonds, forcing them to set up thousands of LGFVs. That law was revised in August, laying the legal framework to let regional authorities raise funds directly.

Premier Li Keqiang is allowing local governments to raise money themselves after the last state audit showed 17.9 trillion yuan of regional liabilities in June last year, up 67 percent from the end of 2010. China experienced the first default in its onshore bond market in March amid the slowest economic growth in 24 years.

The Ministry of Finance started to allow the cities of Shanghai and Shenzhen as well as Zhejiang and Guangdong provinces to sell municipal bonds in 2011 as part of a trial program. It added Shandong and Jiangsu provinces in 2013.

This year, the trial expanded to Jiangxi province, Ningxia region, and the cities of Beijing and Qingdao, as the ministry started to require disclosure of basic financial information and credit ratings. The development of China’s municipal bond market is vital in reducing risks from local government use of off-balance-sheet debt, Standard & Poor’s said in a May report.

Kashi Urban, Yongzhou City

The yield on Kashi Urban Construction Investment Group Co.’s 800 million yuan of debt due November 2019 climbed 75 basis points to 7.17 percent, the biggest jump since July, exchange data show. Kashi Urban Construction is an LGFV. The yield on Yongzhou City Construction Investment & Development Co.’s 1 billion yuan of 2021 notes jumped 94 basis points to 7.55 percent, the biggest increase since the debt was sold in December 2011.

“This new regulation will lift LGFV bond yields in the primary and secondary markets,” Guotai Junan’s Zhang said. “Everyone’s shunning LGFV bonds.”

Impact Considered

The CSDC’s move is also designed to help remove riskier debt from the repo market before China requires LGFVs to clarify which bonds are backed by the state, Zhang said.

The Finance Ministry has asked local governments to detail all outstanding borrowings by Jan. 5 as it extends its municipal bond market trial. Only debt identified by local governments by next month will be eligible for refinancing using municipal bonds and fiscal funds, according to a draft document circulated by the Ministry of Finance in October.

The CSDC said in a statement it fully considered the market’s ability to withstand the impact before issuing the collateral rule. New applications for repurchase agreements have been dropping over the past few weeks, and last week’s net increase amounted to only 5 billion yuan on the exchange market, it said. It also noted that the threshold for bonds that can be used as collateral has been raised in five separate actions, from May to November.

Sales Scrapped

State Grid Corp. of China postponed a 10 billion yuan bond offering originally scheduled for Dec. 10, according to a statement on Chinabond.com.cn, the Chinese govt bond clearing house’s website. Interest rates rose recently by a relatively large margin and State Grid intends to control financing costs, according to the statement.

Commercial Aircraft Corp. of China also delayed a bond sale because of market volatility.

“The regulation will damp investor demand for lower-rated corporate bonds,” said Yang Feng, a Beijing-based bond analyst at Citic Securities Co., the nation’s biggest brokerage. “That may result in higher borrowing costs for LGFVs.”

In China, credit scores of AA- or below are equivalent to non-investment grades globally, and many LGFV bonds fall into that basket, according to Haitong Securities.

The CSDC is the clearing house for bonds that are traded on China’s exchanges, which account for less than 10 percent of all outstanding notes in the country. There were 1.03 trillion yuan of outstanding corporate bonds regulated by the National Development & Reform Commission and traded on exchanges as of Oct. 31, CSDC figures show.

One-year interest-rate swaps, the fixed payment to receive the floating seven-day repurchase rate, rose 3 basis points to 3.345 percent as of 5:42 p.m. in Shanghai, according to data compiled by Bloomberg. They jumped as much as 29 basis points earlier to 3.67 percent, the highest since August.

The Hang Seng China Enterprises Index of mainland companies listed in Hong Kong closed down 4.6 percent. The Shanghai Stock Exchange Composite Index fell 5.4 percent.

The yuan dropped as much as 0.55 percent, the most on a closing basis since 2008. It was last 0.2 percent lower at 6.1855 per dollar.

“Negative headlines including the surge in China bond yields today triggered the sharp drop in the yuan,” said Ho Man Chun, a strategist at Bank of Communications Co.’s Hong Kong branch.

LGFVs sold 125.8 billion yuan of bonds in November, the least since January, Bloomberg-compiled data show. Issuance totals 1.5 trillion yuan this year versus 903.7 billion yuan in 2013, the most since Bloomberg started compiling the data in 1999.

“Because low-rated bonds can’t be used for repurchases on the exchange, this will force many financial institutions to deleverage,” Zhou Hao, a Shanghai-based economist at Australia & New Zealand Banking Group Ltd., said. “When there’s a liquidity issue, all bonds are sold off.”