Confusion Reigns At PBoC As Multi-Trillion Yuan Bailout Threatens To Undermine Rate Cuts

A few months back, we began to ask ourselves what QE in China might look like.

In early March it became apparent that Beijing was caught between accelerating capital outflows and a decelerating, export-driven economy. This presented China with the following rather unpalatable choice: risk exacerbating capital outflows by devaluing to stabilize economic growth or stand firm on the currency front in an effort to stem the outflows and hope the economy doesn’t deteriorate further in the meantime. 

Policy rate cuts had proven largely ineffective (as they have since) in terms of boosting the economy and so, we predicted that Beijing would ultimately join the rest of the world in the Keynesian twilight zone where ZIRP, NIRP, and perpetual debt monetization run roughshod over common sense.

Sure enough, the market soon began to debate the merits of a massive refi program designed to help China’s local governments crawl from beneath a debt pile that, thanks to off balance sheet LGFV financing, had grown to 35% of GDP. We suggested that one way or another, the PBoC would end up using the refi effort to implement some manner of backdoor QE. 

China set the refi quota at CNY1 trillion initially which meant that the country’s provincial governments would be allowed to swap up to 1 trillion yuan of their LGFV debt for lower-yielding, longer term muni bonds. This was, essentially, a pilot program designed to gauge demand.

As it turns out, banks were not eager to swap higher yielding assets for lower yielding assets and after a few local governments pulled their offerings, the PBoC decided to create demand by doing two things: 1) compelling the banks to participate in the debt swap using  the same tactics the party uses to compel banks to do a lot of other things, and 2) allowing the banks to pledge the new bonds for central bank cash which can then be re-lent into the real economy, effectively transforming the entire refi effort into a Chinese version of ECB LTROs. In other words, China went “unconventional” and was, at that point, just one step away from outright QE. 

Here’s Morgan Stanley with a summary of the program to date:

Local Government Financing Vehicles (LGFVs) LGFVs came into the spotlight in 2011/12 after China’s US$20 trillion debt stimulus efforts to kick-start the economy following the global financial crisis. The central government wanted local governments to borrow money, but local governments were not allowed to borrow directly from the financial markets because of the Budget Law. Hence, we witnessed the rise in LGFVs, which serve as a platform for off-balance sheet lending of local governments to pursue mainly infrastructure projects. Details of the LGFV Debt Swap Program In mid-May this year, the MOF announced a RMB 1 trillion debt swap of LGFV loans into local government bonds. Another RMB 1 trillion was added in early June, bringing the total quota to RMB 2 trillion. Chinese banks are required to underwrite the local government bonds, at least for the same amount as the LGFV loans that will be repaid by the swap. The local government bonds would have a tenor of 1-10 years and coupon of 1-1.3x of the treasury yields.

 

Of course, the entire effort is nothing more than an attempt to kick the can further down the road and indeed, when the PBoC reversed course on the continuation of LGFV financing, it effectively undermined the program’s stated goal by allowing local governments to accumulate still more high cost debt just as they began to refinance their legacy loans.

But the program isn’t just a bailout for China’s provinces. It also amounts to a bank bailout because ultaimtely, it wasn’t clear how many local governments would have been able to service their loans going forward given the size of their debt load. WSJ has more:

China is bailing out the nation’s heavily indebted local governments, relying on trusted methods to keep its financial system stable despite promises to allow market forces to play a greater role.

 

Beijing is permitting provinces to issue at least 2.6 trillion yuan ($419 billion) in bonds in 2015, the first local-government issuances in more than 20 years, to stave off a debt crunch. Local administrations have accumulated some 18 trillion yuan in bank loans and bonds to fund risky land and property deals—equivalent to a third of China’s economy. As the real-estate market slows, state-owned banks that did much of the lending are on the hook.

 

The municipal bonds are aimed at allowing local governments to refinance short-term bank loans, which carry high interest rates of 7%. The move won plaudits from economists and investors as a market-based solution to the debt problem.

 

What is transpiring, however, is more akin to the public bailout of China’s state-owned banks in the 1990s. Back then, the government pumped billions of dollars in fresh capital into the banks and carved out bad loans from the lenders. Only around a fifth of the soured debt was ever recovered.

 

Beijing mandated last month that state-owned lenders buy the bonds, effectively swapping them for higher-interest loans. As in the past, the approach seems more like shifting around state resources, analysts said.

 

“Banks will remain the biggest buyers of local government bonds, which means the risk will stay in the system. It’s the same accounting treatment that Beijing used in the 1990s,” said Terry Gao, a senior analyst at Fitch Ratings.

 

Beijing allowed governments to negotiate directly with banks to swap maturing loans for bonds. As an enticement, the government is allowing banks, which face a squeeze on income because of the lower interest rates they are getting, to use the bonds as collateral for low-cost loans from the central bank.

 

“The debt swap is effectively a debt restructuring for banks,” said Zhu Haibin, J.P. Morgan Chase & Co.’s chief China economist.

For reference, here’s a look at debt by province, revenue growth by region, and the dramatic effect the program will have on WAM and funding costs:

While there's probably a degree to which the program does represent a government-assisted bank bailout, it's not entirely clear that the 200bps+ hit the banks are taking doesn't negate the refi benefit. In other words, banks reduce credit risk and improve their capital position (lower risk weight for munis than for LGVF loans) but lose interest income that, once the first CNY2 trillion of bonds are swapped, could amount to around 2% of industry earnings. Additionally, to the extent the banks use PBoC cash obtained via LTROs to make loans to individuals and corporations, it's not entirely clear that overall credit risk will improve either. Meanwhile, the extra supply is serving to undercut the PBoC's efforts to keep rates low, in yet another example of China's multiple easing efforts tripping over each other. Here's Reuters:

Support for China's economy from the central bank has been put at risk by a surge in municipal bond issuance that has driven up yields, undermining its efforts to cut borrowing costs.

 

Heavily indebted local governments seeking to refinance expensive debt have issued more than 600 billion yuan ($96.7 billion) of municipal bonds in the past month - more than in all of 2014.

 

Traders are betting government bond yields will rise rather than fall in coming months on the back of more debt sales, producing a tug-of-war between a People's Bank of China (PBOC) determined to prop up flagging economic activity and a bond market awash with supply.

 

"The sudden fall in government bond futures really runs against the overall monetary easing trend," said a senior trader at a major Chinese bank.

 

"It reflects market sentiment that investors are supplied with too much new debt of late, including local government bonds." Five-year September 2015 government bond futures suffered their worst trading day of the year on May 26.

 

Driving the huge new issuance of municipal bonds is an estimated 22.6 trillion yuan of high interest local government debt, which provinces are struggling to refinance more cheaply.

 

This also serves to underscore what we said last month: because the central government is ultimately responsible for guaranteeing local government debt, and because yields on the new muni bonds are so close to those on treasurys, the newly issued local government bonds are really just treasury bonds, meaning that, in essence, the supply of Chinese government bonds is set to jump by CNY2 trillion in the coming months. If all of the local government debt ends up being refinanced, the end result will be the equivalent on CNY20 trillion in additional treasury supply. 

The takeaway here is that while China is rather proud of the fact that it hasn't yet implemented outright QE, Beijing has now put in place a bewildering hodge-podge of hastily construed easing measures that can't seem to get out of their own way. For instance, successive RRR cuts have served to undermine efforts to ramp up ABS issuance (who needs balance sheet relief when the PBoC is slashing RRR?). And now we see excessive muni supply driving up yields even as the PBoC has cut the benchmark lending rate three times since November. Only time will tell whether the PBoC's efforts will succeed in mitigating China's economic slowdown, but in interim it's worth noting that throwing things at the wall until something sticks is usually not a particularly effective strategy.