DO NOT BANK ON CHINA QE TO REFUEL STOCKS / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

June 29, 2015 5:11 am

 

Do not bank on China QE to refuel stocks

 

Diana Choyleva

 

Beijing’s local government debt swap does not create new money

 

©AFP

 

There are several reasons not to write off Chinese equities just yet, despite this month’s sharp correction and a structural economic downturn. But banking on Beijing’s Rmb2tn local government debt swap to work monetary magic is not one of them.

 

The swap is a sensible piece of financial engineering. By transforming expensive short-term loans into cheaper bonds with longer maturities, China is reducing the threat that its rapid accumulation of debt poses to financial stability and the economy. By Lombard Street Research estimates, China’s non-financial debt had jumped to 240 per cent of GDP by 2014 from around 150 per cent in 2008.

 

But the idea in some quarters that the operation is akin to the quantitative easing programmes pursued by other central banks is wide of the mark. Anyone lured by the talk of QE into expecting the debt restructuring to provide a fillip to growth will be sorely disappointed.

 

This is far from a monetary policy boost. QE is money creation by the state, be it the government or central bank, when it buys assets from banks or non-banks. But swapping loans to local governments for bonds simply changes the composition of the asset side of the banks’ balance sheet. It does not entail asset purchases and so does not create new money.

True, the debt swaps do have second-round monetary effects. Because the bonds carry a lower risk weighting than the loans they replace, the swap frees up capital so, in theory, banks can lend more. In practice, Chinese banks are wallowing in bad loans and may well be reluctant to lend, especially to smaller, privately owned firms. In addition, the corporate sector is already overextended, its debts estimated at 150 per cent of GDP due to the credit-fuelled investment binge ordered by Beijing to prop up the economy after the 2008 financial crisis.

The local government debt restructuring is just one part of a broader shake-up of the Chinese financial system that promises to be neutral to negative for overall monetary conditions. And remember that money growth is already extraordinarily weak. The growth of the broad money supply (as measured by M2) plumbed a record low of 10.1 per cent in the year to April (before rebounding modestly in May) even though, by our estimates, the economy last winter was nearly as weak as in 2008-09. We calculate that Chinese GDP shrank between the fourth quarter of 2014 and the first quarter of 2015 as domestic demand plunged.

Although Chinese banks have issued large volumes of preference shares and subordinated debt, they need fresh equity capital. As Basel III rules governing bank capital requirements come into effect and deposit rates are fully liberalised, it will be difficult for banks to replenish capital through profit growth alone.
 
Not many realise that recapitalising the banks could exacerbate the weakness of broad money. If Beijing sells shares to the domestic non-bank private sector, money growth will fall as deposits are drained to settle the transactions.

This background of a swooning economy and a weak monetary response is seemingly enough to explain the fall in Chinese stocks over the past two weeks. But it is important not to lose sight of some of the factors that fuelled the explosive rally in the first place.

 

Crucially, the cuts to interest rates and the required reserves ratio for banks this weekend confirm that the rally has had the blessing of the ruling Communist party. Of course, the authorities do not want a re-run of the market’s collapse in 2008 — hence the recent crackdown on margin trading. But they would rather see money pouring into shares than inflating a new property bubble that could burst with potentially more severe social consequences. Moreover, by making it easier to issue fresh equity, a rising market promotes China’s strategic shift away from an over-reliance on debt. And, not to be forgotten, it makes it cheaper to recapitalise the banks.

 

But lastly and most importantly, investors should remember that the market is not being propelled by an excessive injection of money into the economy, as happened after the financial crisis. Rather, this year’s rally has been driven by increased liquidity, or in other words, a decrease in the demand for money due to a greater appetite for risk-taking. This makes this bubbly market upswing more vulnerable to a change in investor sentiment, but resisting Beijing’s wishes can be a costly game.


Diana Choyleva is chief economist and head of research at Lombard Street Research