Last week, China moved to increase the quota for issuance under the country’s local government debt swap program to CNY3.2 trillion. The program, designed to help the country’s local governments crawl out from under a debt burden that amounts to more than 30% of GDP, allows provincial governments to issue bonds with yields that approximate the yield on central government debt and swap the new bonds for outstanding LGFV loans which generally carry higher interest rates. Generally speaking, the debt swap will save local governments somewhere in the neighborhood of 300 to 400 bps.
Of course, as we’ve detailed exhaustively, these types of deleveraging initiatives come at a cost for China. That is, with the economy slowing, there’s a certain degree to which China needs to re-leverage by attempting to boost credit growth and juice aggregate demand. That reality, plus the fact that the banks which made the initial loans to local governments weren’t keen to swap those high yielding assets for the new, lower yielding bonds, prompted the PBoC to implement what amounts to Chinese LTROs [9] which allow the banks to pledge the new local government bonds for central bank cash which can then be re-lent to the real economy. So, in a nutshell, local governments issue new bonds, the bank swaps existing loans for those bonds, then the PBoC allows the bonds to be pledged as collateral for new cash. Ideally, this would be a win-win; that is, local government save billions in debt servicing costs and banks have fresh cash to make new loans.
The only problem is this: what happens when local governments need to borrow more money to finance things like infrastructure projects? That question prompted the PBoC to relax rules on LGVF financing, a move which hilariously negated the entire refi effort by encouraging local governments to turn to the very same high interest loans that got them into trouble and necessitated the debt swap program in the first place.
There’s some (or maybe we should say "a lot") of ambiguity here regarding how much of local governments’ new financing needs can be met by issuing on-balance sheet bonds (i.e. the same type of traditional, low yielding munis that are part and parcel of the debt swap program only issuance is aimed at raising cash, not at refinancing old LGFV loans) and how much is new, off-balance sheet LGVF borrowing, and sorting that out is an exercise in futility (trust us), but whatever the case, China has now moved to cap local government debt issuance at CNY16 trillion for 2015. Here’s Xinhua with the story [10]:
China's top legislature on Saturday imposed a ceiling of 16 trillion yuan (2.51 trillion U.S. dollars) for local government debt in 2015.
The decision was adopted at the close of the National People's Congress (NPC) Standing Committee bi-monthly session.
The 16-trillion-yuan debt consists of two parts, 15.4 trillion yuan of debt balance owned by local governments by the end of 2014, and 0.6 trillion as the maximum size of debt local governments are allowed to run up in 2015.
The 2014 debt balance surged over 40 percent from the end of 2013 H1, and valued 1.2 times of the final accounting of 2014 public budget, according to the statistics.
According to the Budget Law which took effect this year, and a State Council regulation, China should cap local government debt balance, and the size of local government debt should be submitted by the State Council to the NPC for approval.
Wang Dehua, researcher at Chinese Academy of Social Sciences, said the fast expansion of local debt was a result of former inaccurate statistics and the recent proactive fiscal policy as well as major infrastructure projects.
"The move will rein local government debt with law," said Ma Haitao, a professor at Central University of Finance and Economics.
Yes, "rein local government debt with law," but because this is China, and because one initiative designed to curtail leverage must everywhere and always be met with an initiative to expand credit growth lest Beijing, in an effort to get control of the situation should inadvertently end up choking off what little demand for credit still exists outside of CSF plunge protection borrowing [11], China has also decided to remove the 75% loan-to-deposit cap. Here’s WSJ [12]:
China will remove a 75% cap on banks’ loan-to-deposit ratios on Oct. 1 following the adoption of a legal amendment by the national parliament on Saturday, according to state news agency Xinhua.
The ratio will instead be regarded as a liquidity monitoring indicator, according to the amendment passed by the Standing Committee of the legislature, known as the National People’s Congress, Xinhua said.
The 75% cap has been in place since its inclusion in a commercial banking law enacted in 1995, Xinhua said. China’s State Council, or cabinet, said in June that the ceiling would be scrapped in a draft amendment to the law.
Under current rules, Chinese banks must keep their loan-to-deposit ratios below 75%. For every dollar a bank collects in deposits, it can lend only 75 cents.
Analysts say the move could modestly boost lending, while also making banks safer as the ceiling encouraged many of them to disguise loans as investments or move them off their balance sheets.
Of course it’s not at all clear here how much of this decision is truly aimed at reducing risk and how much is simply a desperate attempt to encourage banks to lend. After all, the fact that Chinese banks disguise loans as investments and hold as much as 40% of credit risk off balance sheet isn’t exactly a secret, and in fact, it’s a critical piece of the puzzle [13] when it comes to what is essentially a state-sponsored effort to keep NPLs artificially low (another part of the effort involves forcing banks to roll bad loans).
And speaking of artificially suppressed NPLs, even the fake numbers official NPL ratios are rising. Here’s FT with a bit of color [14] on H1 performance for China’s big four:
The country’s big four state-controlled banks — Agricultural Bank of China, ICBC, Bank of China and China Construction Bank — reported only marginal gains in net profit for the first half of the year, while official measures of non-performing loans surged.
While the central bank eased policy last week, cutting the benchmark interest rate and lowering the reserve ratio requirement for banks, analysts expect China’s lenders to remain under increasing pressure as they grapple with the most difficult market conditions they have faced in recent years.
“It’s definitely going to get tougher before we see any turnround,” said Patricia Cheng, head of China financial research at CLSA in Hong Kong. “This is the usual trick of kicking the can down the road, adding new liquidity and hoping it goes to more productive businesses so companies can generate better returns and pay off debt,” she said. “But for the last few years, it hasn’t come true.”
Analysts at Moody’s, the credit rating agency, estimate that the move to cut the RRR — the amount of reserves that banks must keep with the central bank — by 50 basis points to 18 per cent will free up Rmb600bn-Rmb700bn ($94bn-$110bn) of liquidity in the banking system.
Andrew Collier, managing director of Orient Capital, an independent research house in Hong Kong, reckons the People’s Bank of China will continue to reduce the RRR in an attempt to support the banks and the real economy.
But he doubts that will be effective in tackling the main challenge of rising bad debts.
“There are trillions available in banks that the government is slowly releasing like air being let out of a basketball,” he said. “It will help banks’ profitability but it won’t help them overcome the real problem.”
No, it most certainly will not and in fact, one could plausibly argue that flooding banks with liquidity and forcing them to lend into a weakening economy where household and corporate balance sheets are feeling the heat from a stock market collapse and generally poor economic conditions, respectively, is a recipe for disaster in terms of NPLs. Here’s a bit more from FT:
[ICBC’s] NPL ratio rose to 1.4 per cent as of end-June, from 1.29 per cent at the end of March, while Bank of China’s rose to 1.4 per cent from 1.33 per cent and Agricultural Bank of China’s hit 1.83 per cent from 1.65 per cent. The ratio for CCB rose to 1.42 per cent from 1.19 per cent at the end of last year.
Not to put too fine a point on it, but China no longer has any idea what it's doing. On the one hand, NPLs are rising and there's every reason to think that creditworthy borrowers are becoming fewer and farther between as the economic deceleration gathers pace. Meanwhile, demand for credit has fallen off a cliff as evidenced by the fact that in July, lending to the real economy (i.e. not to the plunge protection team) cratered 55%. But China simply cannot afford to let the system adjust and rebalance, especially not when daily FX interventions are sapping liquidity and tightening money markets. So Beijing has resorted to forcing the issue by flooding banks with liquidty, an effort which, again thanks to currency management, has to be orders of magnitude larger than it would otherwise be which is why you're seeing RRR cuts, LTROs, hundreds of billions in reverse repos, and a mishmash of short- and medium-term lending ops.
So where, ultimately, does this leave China? Well, it's almost impossible to say. What the above demonstrates is the extent to which Beijing is continually forced to implement conflicting policy initiatives in a desperate attempt to deleverage and re-leverage simultaneously. At the risk of using an overly colloquial metaphor, this is just a giant game of whack-a-mole. The question is where and how it all ends.
