Last week, the first province to participate in China’s local government debt swap program delayed a $10.5 billion bond sale. As a reminder, local governments in China are laboring under [17] some 18 trillion yuan in high interest loans. That figure amounts to around 40% of GDP and has doubled since 2007. The rates are unfavorable because the debt was raised via banks and shadow banks through off-balance sheet vehicles which allowed the country’s local governments to skirt official restrictions on borrowing. Here’s a look at the situation:
[18]
In order to help alleviate the problem, China is allowing local governments to swap a portion of that debt (the pilot program is set at 1 trillion yuan) for new, government guaranteed bonds that carry lower rates. The initial debt swap should save local governments some 50 billion yuan in interest payments per year. While that sounds like a good idea, it only works if there are buyers for the new bonds and that is where Jiangsu province ran into problems last Thursday. Here’s Bloomberg [19]:
China’s Jiangsu province postponed a local government bond sale scheduled for Thursday, raising concern that there isn’t adequate demand for municipal debt with issuance set to quadruple this year…
On April 14, Jiangsu said it had hired underwriters and would issue 64.8 billion yuan of general bonds on April 23 to swap for debt maturing this year. The sale date was missing from the onlinestatement when Bloomberg checked April 17 and 24.
And more from WSJ [20]:
China’s flagship effort to resuscitate the finances of heavily indebted local governments suffered an early setback as the first province set to issue bonds to restructure old debt postponed the sale.
An official of the eastern province of Jiangsu said on Friday that the proposed sale of 64.8 billion yuan ($10.5 billion) in debt, scheduled for the day before, has been postponed. He declined to offer a reason or a new date…
The government of Jiangsu, China’s second-largest provincial economy, was supposed to be the first to offer debt under the plan. The province’s quota would allow it to issue 81 billion yuan of debt this year.
But the market response has been lukewarm to the new local government debt—at least at the initially proposed interest rates.
It isn’t clear what interest rate the provincial government hoped to pay. Local media have quoted provincial officials as saying the interest cost would drop to about 5% from the 6% to 7% charged on bank loans.
“Banks will want to buy local government bonds,” said Zhao Yang, an economist at Nomura International (Hong Kong) Ltd., though he added they may insist on higher interest rates.
Needless to say, just about the last thing you need if you are China and you intend to assist in what could be a rather painful deleveraging process among local governments is for the entire program to fail before it gets off the ground. Furthermore, local governments are now banned from issuing debt through the off-balance sheet vehicles which previously helped finance growth but which also created the current unsustainable situation. This makes creating a robust market for new municipal security issuance all the more critical. Here’s Bloomberg again:
“It’s very important to have a good beginning.” said Huang Wentao, a Beijing-based analyst at China Securities Co. “It’s certain there will be a jump in issuance, and we expect the central bank to buy some of the notes. If it doesn’t, borrowing costs will rise and go against the initial intention to lower the debt service burden.”
“The market thinks the PBOC needs to intervene in some way, including direct or indirect buying of such notes, or injecting liquidity to create an environment appropriate for issuance,” said Sun Binbin, a Shanghai-based bond analyst at China Merchants Securities, an affiliate of China Merchants Bank Co.
So unpacking those quotes, what the two analysts are saying is that if demand is tepid — which it clearly is or Jiangsu wouldn’t have canceled its first offering — the PBoC will either have to conduct an LTRO-like program (which we previewed here [21]) or buy the new bonds outright (which we discussed here [22]). The latter option amounts to QE.
Given all of this, it comes as no surprise that rumors have swirled over the past week that China is set to either allow banks who purchase local government bonds to swap them for long-term loans or instruct the PBoC to simply step in and buy local debt directly, and while China is apparently out denying yesterday’s rumor that outright QE is under discussion, WSJ reports that LTROs are now a reality.
Via WSJ:
Under the plan, which could be put in place in the next couple of months, the People’s Bank of China will allow Chinese banks to swap local-government bailout bonds for loans as a way to bolster liquidity and boost lending, the officials said…
Adopting the strategy would mark a major shift in the policies of the Chinese central bank, which has traditionally relied on interest rates and banks’ reserve requirements to regulate money supply…
Driving the new program is Beijing’s struggle to solve the country’s mounting local-government debt problems. The latest official data show that borrowing by city halls and towns across China jumped nearly 50% from June 2013—the last time such data were available—to about 16 trillion yuan ($2.6 trillion). Such debt is responsible for a quarter of the buildup in China’s overall domestic debt since 2008, with the International Monetary Fund warning that China’s debt level is growing more rapidly than debt in Japan, South Korea and the U.S. did before those countries tumbled into recession.
To help localities alleviate their debt-repayment burdens, China’s Finance Ministry recently said it would allow heavily indebted local governments to sell new bonds with explicit government guarantees to replace their existing debts...
But China’s commercial banks have balked at buying the new local bonds as they view the yields on offer as too low. At the same time, banks are worried that purchasing those bonds could choke off funds available for lending. As a result, a number of provinces, including Jiangsu, Anhui and Ningxia, have either delayed or plan to put off their bond offerings.
In a statement Tuesday, the Finance Ministry urged local governments to “speed up debt issuance and scheduling, rationally set debt-issuance times and urgently complete the work of issuing bonds”...
Under the planned LTRO-like strategy, China’s commercial banks will 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 will try to direct the banks to lend to small and private businesses, among other sectors favored by the government.
So in short, Beijing pushed local governments to begin the process of swapping their high interest loans for municipal securities with lower rates as soon as possible and when it became apparent that banks’ appetite for the new bonds wasn’t sufficient to support what could eventually become an extraordinarily ambitious program, Beijing moved quickly to grease the wheels.
The PBoC will try the Chinese version of LTROs initially, but if that proves inadequate, don’t write off outright local debt purchases by the central bank (i.e. Chinese QE), because the alternative — lackluster demand for the new bonds drives up rates rendering the entire refi effort pointless — is simply not an option. Stay tuned.
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More from UBS:
Many of you might have seen media reports about China considering "QE", with PBC directly purchasing commercial banks' loan assets.
We think such reports are largely varied and delayed interpretations of what we wrote about last Monday. As we have written, the government has announced that the central bank will provide PSL (onlending collateralized with China Development Bank loan or loan-turned-into-local bonds) through CDB, to help finance infrastructure investment, but also release base money liquidity. We have also written that we think the government should and is planning to launch large scale local government debt swap with banks. In this context, banks may be able to use the swapped bonds as collateral to receive PBC on lending.
We have expected such measures to help lower debt service burden in the economy and have called for further monetary easing to prevent passive tightening of monetary conditions.
It is worth noting that PBC has always relied heavily on quantitative measures to regulate base money and broad money supply. Will the latest measure constitute major monetary expansion or mere counter balance to capital outflow-related tightening?
Today PBoC chief economist Jun Ma said in an interview that media report on China's QE is ungrounded. Ma said that the central bank has enough tools to manage liquidity and base money supply with current tools at hand, and there was no need for the central bank to purchase local government bonds to supply base money. In addition, the central bank law specifically prohibits central bank to provide direct financing to the government. Ma also said that at the moment the PBoC has not considered allowing LGFV loans to be used as collateral for central bank onlending.
