China: To QE or not to QE?
Reports that China’s central bank is preparing to launch quantitative easing may give investors the i mpression that the People’s Bank of China is about to join the ranks of major central banks that have embraced unconventional monetary policies. This impression would be false. The PBOC is certainly in easing mode, but its methods have been, and will continue to be, entirely conventional.
With the benchmark deposit rate still at 2.5%, the central bank has plenty of room to cut interest rates before it approaches the zero bound at which other central banks instituted QE. We expect 50bps of rate cuts this year, as well as a sizable reduction in bank reserve requirements. And while the PBOC does look likely to take steps that may superficially resemble the liquidityenhancing measures of central banks elsewhere, any such steps will be aimed specifically at helping China’s local governments to restructure their debt. They will not mean the PBOC is resorting to unconventional policies.
To raise new funds and to refinance maturing debts, China’s local governments are planning to issue RMB1.6 trln in bonds this year, a program that would more than double the value of local government bonds outstanding. So far, however, the program has failed to lift off. Last month, two provinces were forced to delay bond issues after commercial banks, which will inevitably be the core investors in any successful local government bond program, refused to step up and buy into the proposed issues. To be fair, the banks’ reservations are legitimate. For one thing, local government issuers are offering only extremely low yields, almost as low as the yield on central government bonds. In addition, there are technical reasons why banks are reluctant to hold local government bonds: the market is illiquid; the risk weighting of local government bonds is higher than for central government or policy bank bonds; and the PBOC doesn’t accept local government bonds as collateral.
To smooth the difficulties, it is likely the PBOC will step in to facilitate the programme of bond issues. The technical objections are easily overcome. The PBOC can tweak its rules on acceptable collateral so that banks can pledge local government bonds as collateral for central bank funds. The China Banking Regulatory Commission can also lower the risk weighting of local government bond to the same level as central government bonds.
But the most obvious way the central bank could help would be to cut bank reserve requirement ratios more aggressively. Even following this month’s 100bp reduction, the RRR for large institutions still stands at 18.5%. This is surely the highest rate in the world, locking up a vast reservoir of liquidity in the central bank’s vaults. We have argued previously that China needs to cut the RRR by more than 200bps simply to counter the reversal of capital inflows. If the PBOC were to go a step or two further and cut the RRR by 500bps, it would have some of the effects of quantitative easing in other markets. Whereas attention has mostly focused on the impact QE has on the asset side of central bank balance sheets, the effect on the liability side is at least as important initially. Just as QE asset purchases elsewhere pushed up central bank liabilities by increasing commercial banks’ excess reserves on deposit at the central bank, so reducing China’s RRR would also raise excess reserves. In effect this would release a wave of liquidity into the banking system, generating more than enough demand for high quality bonds to absorb the year’s entire local government issuance program.
In short, the PBOC has plenty of conventional tools it can deploy, both to continue to ease monetary policy, and to facilitate the reform of local government finances. It can cut interest rates, it can reduce the reserve requirement ratio in order to inject liquidity into the banking system and it can make technical changes that would have a big impact on the development of the local government bond market. As a result, contrary to what recent reports may have i mplied, direct asset purchases by China’s central bank are nowhere on the horizon.
Indeed, it is illegal for the PBOC to provide financing directly to the government, and just last week the central bank’s chief economist Ma Jun said in an interview that that the PBOC has no plans to purchase government bonds. There is currently no prospect of quantitative easing in China.