On Thursday, to little fanfare, China's central bank announced its latest liquidity injection scheme, which many analysts saw as a quasi Quantitative Easing program and a potential precursor to full-blown QE.
Just like QE in the US, where financial system liquidity was boosted by the Fed injecting reserves into banks in exchange for sales of Treasurys and MBS, which fungible liquidity was then used for a variety of purposes including directly investing in risk assets as the JPM London Whale fiasco demonstrated, the PBOC announced that it will allow China's primary dealers to swap their holdings of perpetual bonds for central bank bills, and directly use those bonds as collateral to access certain PBOC liquidity operations.
By directly intermediating in the market, and effectively backstopping securities issued by local banks, this measure will increase the appeal of perpetual bonds to be issued by banks making them riskless for all intents and purposes, which can then be used to bolster capital cushions and thereby help relax a key current constraint on credit supply.
In other words, the PBOC just unveiled a roundabout way of injecting even more "risk-free" liquidity directly into the system, or as Rabobank's Michael Every (more below) writes "Chinese banks, desperate for cash to keep the Ponzi scheme afloat, can issue perpetuals that nobody in their right mind would want to hold; and the PBOC will swap them for its bills."
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First, some background: In December, China's financial authorities permitted banks to issue perpetual bonds as a way to bolster their capital base, and on Thursday Bank of China, the country's fourth largest lender, launched the first ever batch of perpetual bonds - which are the functional equivalent of preferred equity as they never have to be repaid - issued by Chinese banks, with an officially approved quota at 40 billion yuan and yielding 4.5%. These bonds count toward banks' (non-core) tier 1 capital, thereby boosting the bank's capital cushion and allowing the bank to issue more loans into China's increasingly cash-starved system.
Why did Beijing take this aggressive step? Because as Goldman explains, banks' increased consideration of their capital cushion had weighed on monetary policy transmission and loan extension. So, by adding to the banking system's capital buffer, the issuance of perpetual bonds should in turn help ease a main current constraint on credit supply.
But that wasn't enough, and just to make sure there is sufficient demand for "perpetual bonds" issued by banks, the PBOC launched the Central Bank Bill Swap (CBS), which just like QE, is an asset swap where the central bank injects high powered liquidity to backstop bank balance sheets, enabling them to pursue riskier credit transformation operations, in this particular case, issue more loans with the intention of reflating the system.
Below we summarize some of the key features of these Bill Swaps:
- The new tool works by giving primary dealers bills that can be used as high-quality collateral in exchange for perpetual bonds purchased from banks
- China Banking and Insurance Regulatory Commission will also allow Chinese insurance firms to invest in banks’ tier 2 capital debt and capital bonds without fixed terms
- Capital charges will be applied on perpetual bond holdings on Chinese banks’ balance sheet, even after they swap the securities for central bank bills using a new PBOC tool.
Regarding the PBOC's measures, the duration of the central bank bill swap was initially set at three years. While the swapped central bank bills cannot be directly converted into cash, and can only be used as collateral for borrowing from the PBOC (e.g., via OMOs) or other financial institutions, once said repo operation takes place, the proceeds from the CBS are effectively the equivalent of cash as banks face no further limitations on what to do with the funds received from the perpetual bonds issuance. There are some modest limitations on eligible collateral: the perpetual bonds that qualify for CBS need to be issued by banks that meet some minimum prudential requirements (such as CAR not lower than 8%) but generally this operation is meant to be inclusive and allow as many banks as possible to participate. As Goldman notes, more implementation details such as the risk weight of this new tool are still not released yet.
And just to make sure enough liquidity reaches the banks, the PBOC will also allow perpetual bonds that are rated AA or above to be used as collateral for MLF, TMLF, SLF, and relending monetary operations, i.e., once the bank issues the PBOC-backstopped perpetuals - which makes them the risk-equivalent of cash for downstream investors thanks to their central bank backstop - it can use the proceeds for pretty much anything.
Of course, this is not full-blown QE because the announced move are not monetary measures per se, in that they do not involve creation of money; they do however involve the central bank backstopping a bond-like instrument, which then has all the functional equivalents of money. Meanwhile, as Goldman also notes, the CBS "does not mean that the PBOC is indirectly providing capital to banks, as the CBS is of limited duration", which while true, does provide banks with virtually risk-free capital for a period of three years, so the "limited duration" argument in a world where investors only care about day to day liquidity is somewhat naive.
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Naturally, with China launching such a "novel" mechanism to boost liquidity in the system, there were quite a few analyst reactions, and courtesy of Bloomberg, we present some of these:
Ming Ming, head of fixed income research at CITIC Securities
- The new policies addressed two issues that had been major obstacles for the development of banks’ perpetual bonds: the poor liquidity of perpetual bonds and the need to include insurance firms, who are key investors for long-term bonds, as eligible perp buyers
- There could be three possible ways to boost bank perps liquidity:
- Investors who buy bank perps can sell the securities to primary dealers, who are able to swap the perps into central bank bills
- Primary dealers could use central bank bills as collateral for repurchase transactions with other institutions
- Primary dealers can borrow from PBOC against perpetual bonds or central bank bills
Li Qilin, chief economist at Lianxun Securities
- The introduction of Central Bank Bill Swap brings PBOC into the market as a buyer, boosting liquidity of perpetual bonds
- The ultimate goal of such a new tool is to expand credit supply. Perpetual bonds can replenish banks’ capital, therefore helping expand their loan books
- There are about 65 banks whose perpetual bonds can be eligible for central bank bill swap. The total loan size of the 65 banks makes up over 65% of that of all financial institutions
Ji Linghao, analyst at Huachuang Securities
- It makes primary dealers more willing to buy perpetual bonds and ensures successful issuance of such debt
- Allowing insurance firms to buy perpetual bonds helps diversify the investor base for such securities, making it easier to sell those notes
- Allowing primary dealers to swap perpetual bonds into central bank bills effectively means that PBOC throws itself behind such securities, easing market concern over risks of perpetual bonds
Liu Li Gang, at Citigroup
- The new Central Bank Bill Swap may make itself both a market player and a regulator, potentially leading to conflict of interests
- It may be better for the PBOC to "play just a facilitating role together with other market players"
- PBOC may have been "over reaching" in the market, and such interventions could make China’s monetary policy implementation extremely complex, monetary policy less transparent and policy transmission less effective
But the best, if also most cynical recap, of what quietly took place in China, comes from Rabobank's Michael Every, which we present below:
China just announced "US banks can start operating there in six months." I am sure useful-idiot headline-followers will say China is opening up. They probably won’t notice the PBOC also announced a Central Bank Bills Swap that will give primary dealers bills they can use as collateral in exchange for a flood of new perpetual bonds that Chinese banks are about to issue, following the lead of the Bank of China (which is offering CNy40bn at around 4.5% for people who never want to get their money back).
In other words, Chinese banks, desperate for cash to keep the Ponzi scheme afloat, can issue perpetuals that nobody in their right mind would want to hold; and the PBOC will swap them for its bills. Add that to MLF operations already underway and chatter of outright QE and one finds it hard to see where the real business model for Wall Street is in China, or to argue the part of Soros’ speech where he underlines how fragile China really is (which is why it needs that Wall Street cash-flow).
And, as Every hints, should the Bill Swap fail to boost credit creation and/or sentiment sufficiently, there is always good, old "outright QE" to fall back on...