A little over a month ago we suggested [9] that QE in China may take the form of local government debt purchases by the PBoC. As a reminder, China is allowing local governments to refinance a portion of their ~17 trillion yuan debt pile by swapping it for lower yielding bonds. As a percentage of GDP, local government debt has grown to 35% and because a sizeable amount was accumulated off balance sheet via shadow banking channels, it carries relatively high interest rates.
The pilot program will allow for the refinancing of around 1 trillion of that debt, a move which could save local governments some 50 billion yuan in interest payments. As a reminder, here’s what the local government debt picture looks like in China:
[10]
The problem with the scheme however, is that the banks who purchase the newly issued local government bonds will have that much less cash to lend at a time when the central bank is keen to keep liquidity flowing and as we’ve seen over the past several months, several factors are conspiring to undercut or otherwise limit the effectiveness of interest rate and RRR cuts. Essentially, China is caught between [11] a peg to the strong dollar, decelerating economic growth, and capital outflows, meaning that devaluation to bolster flagging exports risks aggravating capital flight while not devaluing gets more costly by the quarter. It’s this currency conundrum that has led us to predict that in the end, China will resort to QE.
Given the new refinancing progam, it seemed logical to suggest that if China wanted to integrate QE into its current efforts to assist local governments with their debt load, the central bank could simply buy the local government debt. Here’s what we said last month: “It seems as though one way to address the issue would be for the PBoC to simply purchase a portion of the local debt pile and we wonder if indeed this will ultimately be the form that QE will take in China.” As the WSJ [12] reports, China may do just that, although the program, should it become a reality, will still be one step away from outright QE:
China’s central bank is considering taking a page from Europe’s financial-crisis handbook to free up more credit as growth in the world’s second-largest economy slows.
The proposed strategy would allow Chinese banks to swap local-government bailout bonds for cash as a way to bolster liquidity and boost lending, said people familiar with the People’s Bank of China talks.
Adopting the strategy would mark a major shift in the central bank’s money-supply policy and underscore the leadership’s deep concern about missing already lowered growth expectations...
The central bank is concerned about one issue in particular, according to Chinese officials and advisers to the PBOC: preventing a stranglehold on liquidity in the financial system at a time when local governments are about to begin a debt-for-bond replacement program to try to alleviate their repayment burdens.
The debt-restructuring program, announced by China’s finance ministry last month, seeks to reduce localities’ financing costs and stretch out the time they have to pay off debts. But it risks choking off funds available for lending, and could drive up interest rates at a time when many economists say more and cheaper credit is needed.
To stave off the undesirable consequences of the debt plan, the PBOC first tried freeing up more funds for banks to make loans. But officials at the central bank are weighing other ways to help mitigate the potential downsides, according to people with direct knowledge of the discussions.
One option involves giving banks access to long-term loans with the aim of improving lending to sectors that leaders see as crucial for China’s prosperity, such as farming, affordable housing and small and private businesses. To obtain the loans, Chinese banks would use bonds issued by local governments as collateral…
Borrowing by China’s various levels of government is a big reason the country’s debt load is expanding...
Under the debt-for-bond program, localities are allowed to sell 1 trillion yuan of “special” local bonds to replace their existing debts. The program, which likely will be expanded this year, could save China’s local governments a total of up to 50 billion yuan in interest payments a year, the finance ministry estimates.
China’s commercial banks, long the main providers of credit to local governments and a key investor in Chinese bonds, are expected to be the major buyer of those local bonds once they are issued, as the banks would essentially replace the higher-risk loans on their books with bonds with explicit government guarantee.
However, if banks use funds that could otherwise have been used for lending to purchase those bonds, overall money supply would tighten. Meanwhile, given the limited size of China’s bond market, a large-scale bond sale by local governments also risks pushing up market rates just as the authorities are struggling to drive down borrowing costs...
Under the LTRO-like strategy, commercial banks would be permitted to use local-government bonds they purchase as collateral to take out low-interest-rate, three-year loans from the central bank. By doing so, officials at the PBOC would try to direct the banks to lend to small and private businesses, among other sectors favored by the government.
Put simply, local governments refinance their debt by issuing new bonds which are purchased by commercial banks which in turn pledge the bonds to the central bank for cash loans.
So there you have it: China's QE trial balloon and it may take precisely the form we suggested it would last month. One interesting thing to note here is that it's widely expected that China will expand the scope of the local government debt refinancing operation later this year. 1 trillion yuan is actually not that large in comparison to the total amount of local government debt outstanding which means the PBoC could effectively launch multiple iterations of Chinese LTROs (contingent on any caps the PBoC puts on loans to commercial banks) simply by expanding the local debt refi operation.
We suspect it's just a matter of time before someone at the Ministry of Finance is paraded out to remind the world that "there's no such thing as Chinese QE."
