China is in a tough spot and it’s starting to show up in what look like contradictory policy decisions. The problem — as discussed at length in “How China’s Banks Hide Trillions In Credit Risk” and in “China’s Shadow Banking Grinds To A Halt As Bad Debt Surges” — goes something like this. In the interest of curbing systemic risk and decreasing the percentage of TSF comprised of off-balance sheet financing, China has moved to rein in the shadow banking boom that helped fuel the country’s meteoric growth. The effort to deleverage a system laboring under some $28 trillion in debt is complicated by the fact that the export-driven economy is growing at the slowest pace in 6 years (and that’s if you believe the official numbers), a scenario which calls for some manner of stimulus. Unfortunately, the yuan’s dollar peg has served to further pressure China’s exports while rising capital outflows (plus an IMF SDR bid) make currency devaluation an undesirable tool for boosting the economy. Beijing has thus resorted to slashing policy rates, cutting the benchmark lending rate three times in six months and RRR twice this year (and they aren’t done yet). This of course flies in the face of attempts to deleverage the system. That is, lowering real interest rates encourages more leverage, not less, but Beijing has little choice. It must walk the tightrope, because at some point, the deceleration in economic growth will become so readily apparent that China will no longer be able to stick to the (likely) fabricated 7% output figure.
Consider the following graphics which do a good job of illustrating how China has too much leverage and not enough leverage at the same time. The first chart shows that credit creation in China far outstrips EM and G4 countries...
...while the second graphic shows that the ratio of TSF to new bank loans is near one, meaning almost all of new credit creation is in the form of traditional loans suggesting the shadow banking complex (the engine that has helped drive expansion) has indeed ground to a halt...
As we discussed on Thursday, the country’s local government debt dilemma is a microcosm of the challenges facing the broader economy. Local governments used shadow banking conduits to skirt borrowing limits, accumulating a massive pile of high-yield debt in the process. The total debt burden for these localities sums to around 35% of GDP and because a non-trivial portion carries yields that are much higher than traditional muni bonds, the debt servicing costs have become unbearable. To remedy the situation, Beijing is implementing a debt swap program which allows local governments to swap their high-yielding loans for long-term bonds with lower coupons. In order to create demand for the new issues, the PBoC is allowing banks that purchase the new bonds to post them as collateral for cash that can then be re-lent to the broader economy, presumably at a healthy spread. So while the program is designed to help local governments deleverage by cutting hundreds of billions from debt servicing costs, the PBoC’s move to allow the new LGBs to be pledged for cash by the purchasing banks, means that on net, the entire refi program will actually add leverage to the system as banks use the cash they receive from repoing their LGBs to make new loans.
In the end, it’s the same dilemma: China is attempting to deleverage and re-leverage at the same time.
Local government bond supply is expected to come in at around CNY1.6 trillion for the year (that includes CNY1 trillion of new bonds issued in connection with the debt swap program and another CNY600 billion to fill budget gaps). While that’s four times last year’s issuance, the increase in supply is tolerable because it’s supposedly for a good cause. That is, the lion’s share of new supply is part of the debt swap program and will thus go towards helping issuing local governments reduce their debt service burden and thus deleverage. Of course, as we said above, these bonds ultimately end up creating more leverage when they’re pledged by the purchasing banks for cash that’s then re-lent, but we’ll focus just on the effect the program has on local government finances for now and if we take that narrow view, the refi effort should help. Unless of course the PBoC does something stupid like lift the ban on local governments accumulating the same type of off-balance sheet debt that got them into their current predicament.
China is reversing course on a major effort to tackle its hefty local government debt problem, marking a setback for a priority reform aimed at getting its financial house in order.
The move could provide the economy with some short-term help. But it restores a backdoor way that enabled local governments to load up on debt in recent years, providing a drag on growth at a time when Beijing is looking for ways to rekindle it.
According to an announcement made Friday by the State Council, China’s cabinet, the authorities relaxed controls on the ability of local governments to raise money by allowing them to tap government-sponsored financing companies—the very entities that have been blamed for a rapid run-up in China’s local debt load over the past few years.
The move undermines an October policy intended to prevent those financing firms from taking on new debt.
It comes as China’s long push toward financial reform—part of its broader effort to make the economy rely less on big investments but more on consumer spending—increasingly bumps up against a more pressing national goal: boosting growth.
The latest move comes as the world’s second-largest economy endures slower-than-expected growth. A barrage of monetary-easing measures since last year has proved insufficient to counter a real-estate downturn and flagging factory output…
Beijing heavily restricts the ability of local governments to borrow. In response, local officials around China have created thousands of finance companies called local-government financing vehicles that can borrow on their behalf. Such borrowing—which totals about $4 trillion by some estimates—is responsible for one-quarter of the buildup in China’s overall domestic debt since 2008, according to analysts. The International
Monetary Fund says China’s debt is growing more rapidly than debt in Japan, South Korea and the U.S. did before they tumbled into recessions.
Under the rule issued in October, those local financing vehicles were barred from borrowing additional funds starting this year, as the government sought to close what it dubbed “the back door” for localities to borrow.
Instead, all borrowing would be done by the local governments themselves and be appropriately disclosed and reflected in their budget plans. The purpose was to rein in runaway local-debt growth and make local borrowings more transparent.
According to the latest directive, local financing firms can continue to get loans from banks to fund ongoing projects. If the local firms have trouble repaying their bank debts, the rule says, their loan contracts should be “renegotiated and extended.”
Here’s Deutsche Bank with more color:
The Ministry of Finance (MoF), the PBoC, and CBRC issued a policy guideline on May 11 and loosened control on the financing of local government financing vehicles (LGFV). This policy guideline has been made public today. We take this as a significant policy easing signal. The growth slowdown in Q1 was partly due to a crackdown on LGFV financing by MoF and the State Council who issued the "document 43" guideline in late 2014. The new guideline will likely make "document 43" less effective. This development is in line with our expectation, and it is consistent with the pickup of fiscal spending in April (see our note China: April fiscal data show first sign of stimulus on May 15). It reinforces our view that growth may rebound slightly in H2.
The guideline released on May 11 focuses on the financing of ongoing LGFV projects. It specifies several issues, including: 1: Banks should not stop lending to ongoing projects which started before end of 2014. If the ongoing projects have trouble repaying banks, the loan contracts may be renegotiated and extended. (ZH: we discussed forced roll overs just yesterday; this is NPL 'management') 2: Encourage new financing through fund raising from private sources. For projects where financing is not sufficient, new financing should be included into local government budget and financed through government bonds. 3. Encourage spending in rural water projects, public housing, urban transportation projects. 4. Local governments now have more authority to spend fiscal funds flexibly before local government bonds are issued.
Note what China has done. They justified the implementation of LTROs by pointing to the need to jumpstart the refinancing program for local government debt accumulated off-balance sheet. The LTRO program will have the effect of creating more leverage, as purchased LGBs are pledged for PBoC cash that's then re-lent. The net increase in leverage could be justified by the hundreds of billions local governments will save on interest expense. Meanwhile, local governments would not be allowed to use LGFVs to take on more debt because after all, taking out off-balance sheet loans was what got them into trouble in the first place, so tapping those channels again while simultaneously participating in the debt swap program would render the entire refi effort useless. Now, Beijing has done a complete 180 and will not only allow, but encourage local governments to accumulate more of the very same type of debt they are now swapping, meaning that even as the newly-issued debt-swap bonds decrease local governments' debt servicing costs, new financing via LGFVs will invariably carry higher rates just as it did before, meaning the whole program is a wash.
Actually it's worse than that. Because as we noted above, inserting an LTRO program into the equation means that every new debt-swap bond ultimately ends up creating a new loan for the broader economy and now that local governments are free to go right back to accumulating the same high interest loans which necessitated the creation of the debt swap program in the first place, the end result is simply the original scenario (i.e. local governments gorging themselves on off-balance sheet financing) only with the addition of an LTRO program.
Better (or worse) still, one is certainly left to wonder what stops Beijing from allowing newly-acquired off-balance sheet debt to be swapped for still more newly issued muni bonds. In other words, the current plan seems to be to segregate legacy high-yield loans from new LGFV financing, with the former eligible for the debt swap program and the latter ineligible. While the policy guidelines call for new LGFV loans to be rolled over by lenders in the event local governments get into trouble, it's not clear what stops Beijing from simply saying that these loans are also eligible for the debt swap.
Should that happen, local governments would be free to borrow cash from whoever will lend it, at whatever interest rate the lender wishes to charge, because they know that ultimately, these loans can be swapped for low yielding muni bonds which will then be pledged by banks for cash that is in turn used to make loans to individuals and businesses.
And that, ladies and gentlemen, is how you create a perpetual leverage machine disguised as a deleveraging program.