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Confusion Reigns At PBoC As Multi-Trillion Yuan Bailout Threatens To Undermine Rate Cuts
A few months back, we began to ask ourselves what QE in China might look like.
In early March it became apparent that Beijing was caught between accelerating capital outflows and a decelerating, export-driven economy. This presented China with the following rather unpalatable choice: risk exacerbating capital outflows by devaluing to stabilize economic growth or stand firm on the currency front in an effort to stem the outflows and hope the economy doesn’t deteriorate further in the meantime.
Policy rate cuts had proven largely ineffective (as they have since) in terms of boosting the economy and so, we predicted that Beijing would ultimately join the rest of the world in the Keynesian twilight zone where ZIRP, NIRP, and perpetual debt monetization run roughshod over common sense.
Sure enough, the market soon began to debate the merits of a massive refi program designed to help China’s local governments crawl from beneath a debt pile that, thanks to off balance sheet LGFV financing, had grown to 35% of GDP. We suggested that one way or another, the PBoC would end up using the refi effort to implement some manner of backdoor QE.
China set the refi quota at CNY1 trillion initially which meant that the country’s provincial governments would be allowed to swap up to 1 trillion yuan of their LGFV debt for lower-yielding, longer term muni bonds. This was, essentially, a pilot program designed to gauge demand.
As it turns out, banks were not eager to swap higher yielding assets for lower yielding assets and after a few local governments pulled their offerings, the PBoC decided to create demand by doing two things: 1) compelling the banks to participate in the debt swap using the same tactics the party uses to compel banks to do a lot of other things, and 2) allowing the banks to pledge the new bonds for central bank cash which can then be re-lent into the real economy, effectively transforming the entire refi effort into a Chinese version of ECB LTROs. In other words, China went “unconventional” and was, at that point, just one step away from outright QE.
Here’s Morgan Stanley with a summary of the program to date:
Local Government Financing Vehicles (LGFVs) LGFVs came into the spotlight in 2011/12 after China’s US$20 trillion debt stimulus efforts to kick-start the economy following the global financial crisis. The central government wanted local governments to borrow money, but local governments were not allowed to borrow directly from the financial markets because of the Budget Law. Hence, we witnessed the rise in LGFVs, which serve as a platform for off-balance sheet lending of local governments to pursue mainly infrastructure projects. Details of the LGFV Debt Swap Program In mid-May this year, the MOF announced a RMB 1 trillion debt swap of LGFV loans into local government bonds. Another RMB 1 trillion was added in early June, bringing the total quota to RMB 2 trillion. Chinese banks are required to underwrite the local government bonds, at least for the same amount as the LGFV loans that will be repaid by the swap. The local government bonds would have a tenor of 1-10 years and coupon of 1-1.3x of the treasury yields.
Of course, the entire effort is nothing more than an attempt to kick the can further down the road and indeed, when the PBoC reversed course on the continuation of LGFV financing, it effectively undermined the program’s stated goal by allowing local governments to accumulate still more high cost debt just as they began to refinance their legacy loans.
But the program isn’t just a bailout for China’s provinces. It also amounts to a bank bailout because ultaimtely, it wasn’t clear how many local governments would have been able to service their loans going forward given the size of their debt load. WSJ has more:
China is bailing out the nation’s heavily indebted local governments, relying on trusted methods to keep its financial system stable despite promises to allow market forces to play a greater role.
Beijing is permitting provinces to issue at least 2.6 trillion yuan ($419 billion) in bonds in 2015, the first local-government issuances in more than 20 years, to stave off a debt crunch. Local administrations have accumulated some 18 trillion yuan in bank loans and bonds to fund risky land and property deals—equivalent to a third of China’s economy. As the real-estate market slows, state-owned banks that did much of the lending are on the hook.
The municipal bonds are aimed at allowing local governments to refinance short-term bank loans, which carry high interest rates of 7%. The move won plaudits from economists and investors as a market-based solution to the debt problem.
What is transpiring, however, is more akin to the public bailout of China’s state-owned banks in the 1990s. Back then, the government pumped billions of dollars in fresh capital into the banks and carved out bad loans from the lenders. Only around a fifth of the soured debt was ever recovered.
Beijing mandated last month that state-owned lenders buy the bonds, effectively swapping them for higher-interest loans. As in the past, the approach seems more like shifting around state resources, analysts said.
“Banks will remain the biggest buyers of local government bonds, which means the risk will stay in the system. It’s the same accounting treatment that Beijing used in the 1990s,” said Terry Gao, a senior analyst at Fitch Ratings.
Beijing allowed governments to negotiate directly with banks to swap maturing loans for bonds. As an enticement, the government is allowing banks, which face a squeeze on income because of the lower interest rates they are getting, to use the bonds as collateral for low-cost loans from the central bank.
“The debt swap is effectively a debt restructuring for banks,” said Zhu Haibin, J.P. Morgan Chase & Co.’s chief China economist.
For reference, here’s a look at debt by province, revenue growth by region, and the dramatic effect the program will have on WAM and funding costs:
While there's probably a degree to which the program does represent a government-assisted bank bailout, it's not entirely clear that the 200bps+ hit the banks are taking doesn't negate the refi benefit. In other words, banks reduce credit risk and improve their capital position (lower risk weight for munis than for LGVF loans) but lose interest income that, once the first CNY2 trillion of bonds are swapped, could amount to around 2% of industry earnings. Additionally, to the extent the banks use PBoC cash obtained via LTROs to make loans to individuals and corporations, it's not entirely clear that overall credit risk will improve either. Meanwhile, the extra supply is serving to undercut the PBoC's efforts to keep rates low, in yet another example of China's multiple easing efforts tripping over each other. Here's Reuters:
Support for China's economy from the central bank has been put at risk by a surge in municipal bond issuance that has driven up yields, undermining its efforts to cut borrowing costs.
Heavily indebted local governments seeking to refinance expensive debt have issued more than 600 billion yuan ($96.7 billion) of municipal bonds in the past month - more than in all of 2014.
Traders are betting government bond yields will rise rather than fall in coming months on the back of more debt sales, producing a tug-of-war between a People's Bank of China (PBOC) determined to prop up flagging economic activity and a bond market awash with supply.
"The sudden fall in government bond futures really runs against the overall monetary easing trend," said a senior trader at a major Chinese bank.
"It reflects market sentiment that investors are supplied with too much new debt of late, including local government bonds." Five-year September 2015 government bond futures suffered their worst trading day of the year on May 26.
Driving the huge new issuance of municipal bonds is an estimated 22.6 trillion yuan of high interest local government debt, which provinces are struggling to refinance more cheaply.
This also serves to underscore what we said last month: because the central government is ultimately responsible for guaranteeing local government debt, and because yields on the new muni bonds are so close to those on treasurys, the newly issued local government bonds are really just treasury bonds, meaning that, in essence, the supply of Chinese government bonds is set to jump by CNY2 trillion in the coming months. If all of the local government debt ends up being refinanced, the end result will be the equivalent on CNY20 trillion in additional treasury supply.
The takeaway here is that while China is rather proud of the fact that it hasn't yet implemented outright QE, Beijing has now put in place a bewildering hodge-podge of hastily construed easing measures that can't seem to get out of their own way. For instance, successive RRR cuts have served to undermine efforts to ramp up ABS issuance (who needs balance sheet relief when the PBoC is slashing RRR?). And now we see excessive muni supply driving up yields even as the PBoC has cut the benchmark lending rate three times since November. Only time will tell whether the PBoC's efforts will succeed in mitigating China's economic slowdown, but in interim it's worth noting that throwing things at the wall until something sticks is usually not a particularly effective strategy.

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Teflon walls everywhere...
The Chinese are only going through the motions waiting for the West to collapse.
Then Xi will unveil his 10,000 tonne golden-petro-Yuan.
Backed by the labour and military might of 1/5th of the worlds population.
For some strange reason, Westerners always want to ascribe the highest intelligence to Indians and Asians.
If they are so smart, why did the West rule the world - and to whatever critics contend - it still does.
I saw this with the Japanese decades ago when they were going to take over the world - and now look at them. Not too bright.
The Chinese are the same - they build warships, mobilize an army, have nukes - and somehow we are to stand in awe of their fake numbers, ghost cities, fraud, lies, and all the other things they've done to build an image of the brightest humans ever.
Stay tuned, you China-boosters; just like the Japanese, they are about to collapse under thier own lies, polllution, bubbles, and hard-core reality that are soon to be hitting them square between the eyes.
-30-
Prophetic and well said.
The Chinese are akin to the Japanese, but lacking in morals and zero dignity -- Homer Simpson without the round eyes!
The west has ruled the world by guns and intimidation like any power!
The west is bankrupt that's a fact and the only thing that could undermine them is if people have a choice like a gold backed currency.
China is never going to back its currency with gold. The Chinese debt overhang makes a few ten thousand tons of gold look like pocket change.
Good post. I can tell you from experience that Chinese mainlanders are largely uneducated and in no shape to drive a modern high-value-added economy that can break through the Middle-Income Trap toward competing with established players in Japan, Korea, and the West.
Maybe 40% of the Chinese even graduate highschool, 15% to to university, and the best of those emigrate. What's really left in the 90% of the country that is not Shanghai, Beijing and Shenzen are ignorant racist bumpkins brought up on a diet of jingoism, Han supremacy, and inducements to hate and distrust outsiders in order to legitimise an authoritarian state.
Needless to say, this bodes incredibly well for all the anti-western ZHers who want to accept China as their personal lords and saviours.
I don't want Chinese warlords any more than I want Corporate US and bankers enslaving our population.
They poison our food, water, air and feed us shit. and then charge us the most for health care and medications. They fucked the US with NAFTA and now all over the pacific with TTIP
We are plebs and surfs with ipads and iPhone.
So stop signing their papers.
Perfect soldiers these Han supremecists
Has anyone seen Ted Nugent?
I saw him.
He plays the hell out of a guitar.
And he likes to talk shit.
i have traveled (not toured) throughout various regions of China quite a few times since early 80s. My experience tells me the average Chinese whom i have met are far more intelligent and friendlier than your average Joe6Packs here, precisely because they may have less government forced schooling. Education today in the West is 100% indoctrination and job training and it has nothing to do with the root meaning of the word as it had in the past anymore. We are all born geniuses but many die idiots, as Charles Bukowski puts it. In general the more highly"educated" you are, the less you know.
LOL. Yeah what a bunch of commies! I'm anti-oppression and I just happen to live in the West, that doesn't make me anti-"West" and it certainly doesn't make me pro-China (whatever the hell that even means). the government and corrupt institutions drive things like the poisoning of their water and the relentless crushing of dissenters. But "China" is not some sub-human wasteland of unenlightened Neanderthals. It's that kind of old world pigeon-holing that keeps us in a perpetual state of bigotry and fear and panic and war readiness.
Exactly. You live in the West. That's what you know. All your squishy feelings about how everyone is just like you is exactly what a westerner really thinks.
Pretty much anyone in China can tell you the countryside is filled with surly peasants, and even the cities have their fenqing activists that like to cause shit and...
BEAT TO DEATH A FELLOW CHINAMAN SIMPLY BECAUSE HE DROVE A JAPANESE CAR.
Kiddo, you have no argument here. China is not your backyard picnic. You got a lot to learn about how the world is not entirely composed of reasonable, well-meaning humanistic sorts that value the same things as westerners. You got shit to say to me until I see you beating someone to death for driving the wrong car.
It will not be China alone that defeats the west- it will be Persia (Iran), along with its allies which will include China.
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What me worry?
Me Dictatah!
You Chop Suey!
Welcome to the Peking Buffet
"but in interim it's worth noting that throwing things at the wall until something sticks is usually not a particularly effective strategy."
It seems China has a long way to go to catch up to Japan, the US, and Europe in this regard. If anything, being late to the game must give them some confidence that the end it not as looming as MS infers.
Japan is well into its 3rd decade of throwing shit against the wall. The fact that nothing has stuck yet hasn't appeared to matter.
I beg to difer, the author is not saying that China is the only one "throwing things at a wall" but that it isn't a particularly effective strategy. Which, from what you just said about Japan, is absolutely true. So why then is China following in the Japanese footsteps by just trying things out without any coherent strategy?
I know you like to ciritize the west and see a lot of good in China but one has to admit that the central comittee seems to be as much at a loss on how to stimulate growth as western elites....
How do you convince workers to borrow money to buy stuff, that they don't really need?
That is the essence of economic stimulus.
we clearly need to buy chinese and then russian bonds in order to prevent ww3 and set up the great debt forgiveness of the 21'st century.
Chinese QE = + YINN
I have to wonder if there isn't a zero sum element to all this refinancing with regard to the Chinese economy.
SOMEBODY was making 7% on the money they loaned to the LGFVs.
Now that income stream has been cut by about 60%, which ought to be reflected in GDP.
Of course, the local jurisdictions are now free to issue more debt at the lower rate so it's possible that the gross interest payout may still be the same, or even higher.
But China is supposed to save us!
:)
Doh
This is a very impressive compilation and analysis. Thank you for putting this together. Really helpful!