China: To QE or not to QE?

Financial Mirror (Cyprus) - - FRONT PAGE -

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.

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