Two months ago we first explained why Chinese QE may be inevitable. The Cliff’s Notes version goes like this: Beijing needs to prop up its export-driven economy by devaluing the dollar-linked yuan but that’s a risky move primarily because the country has seen $300 billion in capital outflows over the past four quarters and also because China doesn’t want to be seen as a currency manipulator ahead of an IMF SDR bid.
Conveniently (if you’re a central bank looking to adopt unconventional monetary policy tools), China’s local governments are set to embark on a multi-trillion yuan refi effort aimed at bringing the servicing costs of their mountainous debt pile under control.
The idea is to swap the existing high-interest loans — which are a consequence of localities skirting debt issuance limits by tapping shadow banking conduits for cash — for standard muni bonds which will carry yields that are more inline with the supposed credit-worthiness of the issuer. This all sounded great on paper, but when the provincial early adopters tested the waters they discovered that bank demand for the new bonds was tepid, leaving the PBoC with two options: 1) buy the bonds outright, 2) create demand by allowing banks who purchases the bonds to pledge them for long-term cash loans. Option number one would simply constitute Chinese QE, while option number two is akin to ECB LTROs and in either case, it gives the PBoC an excuse to implement a large-scale easing program and in the case of the latter option, the hope is that banks will use the cash to lend to the broader economy thus kickstarting growth. Here’s a bit of color via SocGen (note the projected size of the program):
The PBoC can do something similar to the ECB's LTRO or TLTRO, accepting LGBs as collaterals for lending to commercial banks. The PBoC has introduced a tool of such design: Pledged Supplementary Lending (PSL). This structure will provide incentives for commercial banks to load up on LGBs. The mechanism looks like this: commercial banks retire their loans to local government financing vehicles (LGFVs) that earns 6%, buy LGBs with 3-4% yield, go to the central bank and ask for long term credit at 2-3%, and then lend out to corporates at 6%. Hence, banks can earn 1-2ppt more with such a programme than otherwise.
If we are right about PBoC’s intention of helping local government debt restructuring, the total size of this programme may match the total size of local government’s debt stock at the moment. Considering that issuance for the fiscal spending in the coming years may also need some help on attracting demand, we would not be surprised by an eventual size of CNY20tn.
It could take five years or more, depending on the development of the bond market. The hope is that over time more investors will be interested in LGBs for asset allocation or other reasons. Some foreign institutional investors may already be interested if they have access. The idea is for the PBoC to give a jump-start to the LGB market, instead of dominating the market. Therefore, we do not think that the PBoC will commit itself to a targeted size or a fixed pace, unlike the Feb or the ECB. At best, it may announce a maximum volume year by year, and this year it is likely to be CNY2tn – somewhat bigger than the planned amount of new LGB issuance of CNY1.5tn.
The impact of this program shouldn’t be underestimated. Between the initial CNY1 trillion in new local government bonds issued as part of the bond swap initiative and another CNY600 billion in new supply needed to fund budget deficits, local government debt issuance is set to quadruple in 2015 compared to last year, meaning, as SocGen notes above, the PBoC will need to help create demand. Here's a look at past issuance which should provide a bit of perspective on the relative size of 2015 supply:
As of Monday, this program became official, meaning that LTROs (which can perhaps be described as a QE trial balloon) are now a reality in China.
China is launching a broad stimulus to help local governments restructure trillions of dollars in debts while prodding banks to lend more, as fresh data add to signs of a worsening slowdown in the world’s second-largest economy.
In a directive marked “extra urgent,” China’s Finance Ministry, central bank and top banking regulator laid out a package of measures to jump-start one of the government’s most-important economic-rescue initiatives: a debt-for-bond swap program aimed at giving provinces and cities some breathing room in repaying debts.
Central to the directive, which was issued earlier this week to governments across the country and reviewed by The Wall Street Journal, is a plan by the People’s Bank of China that will let commercial banks use local-government bailout bonds they purchase as collateral for low-cost loans from the central bank. The goal is to provide Chinese banks with more funds to make new loans.
In response to the new directive, the prosperous eastern province of Jiangsu this week relaunched a sale of bonds that package the debt of its local governments but that it delayed last month because banks hesitated to buy them…
“The central bank is using this opportunity to provide cheap funding to commercial banks and guide down interest rates,” said China economist Zhu Chaoping at UOB Kay Hian Holdings Ltd., a Singapore-based investment bank. “This will have similar effects as quantitative easing,” Mr. Zhu said, referring to the bond-buying programs used by the U.S. and European central banks to spur economic growth.
Helping the country’s struggling local governments crawl out from under a debt burden that totals 35% GDP and jumpstarting the economy via stepped up lending aren't the only reasons the program is necessary. Beijing’s currency conundrum has caused the PBoC to rely increasingly on policy rates to stimulate the economy and with two RRR cuts and two benchmark lending rate cuts already in the books and at least three more cuts expected this year, it was becoming quite clear that something else was needed given that economic growth is still decelerating and real interest rates are still elevated:
Here’s WSJ again:
Officials at the central bank have in recent days denied the need to resort to unconventional monetary tools, saying, for example, that interest rates can be further cut, as they were Sunday for the third time in six months. But signs abound that the economy is behaving more sluggishly than the government and economists have expected and that officials are casting about for solutions.
Data released Wednesday show investment in factories, buildings and other fixed assetsrose 12% in the first four months this year from a year earlier, the slowest pace since December 2000. The bigger-than-expected drop was driven by anemic investment in property, which has been a drag on the economy. Meanwhile, factory output and retail sales in April also came in below expectations.
The steeper slowdown is forcing policy makers to devise more aggressive measures to prop up growth, if Beijing is going to reach its already-lowered annual growth target—set at 7% for this year, the lowest level in a quarter century.
With that, China has officially entered the realm of "unconventional" monetary policy, joining the Fed, the ECB, the BoJ, and a whole host of other global central banks in an attempt to bring the supposedly all-mighty printing press and the unlimited balance sheet that goes with it to bear on subpar economic growth. We suspect the results will be characteristically underwhelming (at least in terms of lowering real interest rates, although in terms of boosting risk assets, the results may be outstanding) meaning it's likely only a matter of time before LTRO becomes QE in China just as it did in Europe.