PBOC 'poised to pull QE trigger' as economy stalls

Central bank may buy local government bonds as a way to get more money into the markets, reports Zheng Yangpeng.

Financial markets on the Chinese mainland are abuzz with speculation that the central bank will inject more liquidity into the economy by unconventional means that could amount to a version of "quantitative easing".

The People's Bank of China may adopt new policies that could include direct purchases of local government bonds from the market, a report by Market News International said on Monday. The Wall Street Journal also reported that the government may let banks use these notes as collateral for loans from the central bank.

Economic growth in China has been slowing, but unlike Europe and the United States, there is abundant scope in China to counter the downward pressure by conventional means as reducing interest rates and cutting banks' reserve requirement ratios, both of which have been done in recent months.

So it seems strange, to say the least, to be talking about QE. However, a closer look suggests that the idea is not so irrational, and an aggressive asset-purchasing program with Chinese characteristics can be expected.

To understand why, it is important to put several recent moves by the PBOC into context.

First, on April 19, the central bank pumped anywhere from 1.2 trillion yuan ($196 billion) to 1.5 trillion yuan into the market by reducing the RRR, which is the fixed portion of deposits that banks must park at the PBOC.

The cut was a full percentage point, twice the scale of the previous reduction on Feb 4. Most analysts were quick to call it a stimulus move, but others hesitated. Ma Jun, chief economist at the central bank's research bureau, argued that the primary reason for the move was that with capital inflows ebbing, the PBOC's traditional means to deliver base money have to be replaced by new methods, such as RRR cut.

Previously, the PBOC acquired inbound funds, and they were added to China's foreign exchange reserves. Because the bank was issuing yuan to buy foreign currencies, base money kept growing.

Base money is currency in circulation plus banks' deposits of required reserves at the PBOC. The latter category is illiquid, because it cannot be used for lending to companies or consumers, although the PBOC can use it to sterilize incoming foreign currencies.

But if less money is coming into China, or if money is even flowing out, the PBOC requires other tools to conduct its operations and put money into the economy. One option is cutting the RRR.

"To put it in another way, a cut in the RRR is 'defensive' rather than 'offensive'," Ma said.

Second, there have been targeted capital infusions into policy banks. Soon after the latest RRR cut, media reports said the PBOC had injected huge sums into policy banks: the equivalent of $32 billion into the China Development Bank and $30 billion into the Export-Import Bank of China. The stated goal was to boost the banks' lending to the targeted sectors such as farming, subsidized housing and small and private businesses.

In July, the CDB received a 1 trillion yuan, three-year loan from the PBOC. Known as "pledged supplementary lending", the facility allowed the CDB to use loans as collateral to get funds, which were invested in subsidized housing projects.

This time around, the CDB could use its newfound capital to buy bonds from local governments and then use those securities as collateral to get funds from the PBOC. That looks a lot like QE.

Despite two cuts each in interest rates and RRRs, policymakers are wary of an across-the-board easing, fearing the new liquidity would flow to "undesirable" areas such as property and industries plagued by overcapacity. The latest worry is that the additional credit would flow into the soaring stock market.

Analysts said that further interest rate and RRR cuts are still possible, and the PBOC would not hesitate to use them if the economy weakens further. But unconventional methods seem to be on the table.

The third issue is local government debt. An official with the Ministry of Finance said over the weekend that local governments have reported aggregate direct debt of 16 trillion yuan, up 46.8 percent in just about 18 months. Knowing the severity of the matter, the ministry in March announced a 1 trillion yuan debt-for-bonds swap plan that would save local governments a total of up to 50 billion yuan in interest payments a year.

Commercial banks, long the main providers of credit to local governments, are expected to be the major buyers of those low-yield bonds once they are issued. However, the fear now is that the gigantic supply of these bonds will drain the markets of liquidity and push up borrowing costs, just the opposite of what the government intends.

Last week, Jiangsu province delayed a bond issue of 64.8 billion yuan after failing to agree with banks on the terms of the issue. This scenario could be repeated in other parts of China, because banks stand to lose money on low-yielding government debt.

All this strengthens the case for QE－with Chinese characteristics. Designating these bonds as acceptable collateral would give banks more reason to buy them. Policy banks could play a major role, which explains in hindsight why the PBOC may have injected capital into them.

"As long as the central bank provides capital for bond purchases, directly or indirectly, it could be seen as 'monetization' of local debt ... the operations on the one hand alleviate local governments' repayment pressure, while on the other they deliver base money as foreign exchange-related liquidity declines," said Li Miaoxian, an analyst with Bank of Communications International Holdings Co.

"Local governments could be viewed as a sector 'too big to fail'. Supporting them means supporting the overall economy," Li said. Do not be surprised if the PBOC resorts to a new monetary weapon.