PBOC QE ? Not So Fast

(from my colleague Dr. Win Thin)

Press reports suggest that the People’s Bank of China (PBOC) is considering unconventional monetary policies, including direct purchases of local government bonds and/or some sort of long-term refinancing operation (LTRO) using local government bonds as collateral.  While there is no universal definition of QE, we make the distinction that the former (direct bond purchases) are unconventional measures, while the latter (long-term liquidity injections) are along conventional lines.
 
For reasons stated below, we downplay the likelihood of QE in China given the typical reasoning seen in the developed markets.  But, we acknowledge that China policymakers may be tempted to use some form of unconventional measures to tackle problems that are unique to China.  If the PBOC were to go down this path, it would only be the third instance of unconventional policies by an EM central bank (following Israel and the Czech Republic).  We do note, however, that China officials have so far denied these reports.

Has China exhausted its conventional measures?

Like other forms of QE undertaken around the world, unconventional measures are meant to fight deflation and stimulate the economy when other more conventional measures have been exhausted.
Given that conventional measures are nowhere close to being exhausted, we are a bit skeptical about the prospect of unconventional measures from China in the near term.  The 1-year lending and deposit rates stand at 5.35% and 2.50%, respectively, while the Reserve Requirement Ratio (RRR) for commercial banks stands at 18.50%.  The RRR was just cut 100 bp this month, while the key rate were last cut by 25 bp each in February.  There is clearly room to ease conventional policy further.
That said, deflation is a potential threat in China.  China’s PPI is in deflationary territory, it has been there since March 2012.  That’s 37 straight months through March 2015.  CPI inflation is still falling, but talk of outright deflation in China seems premature given that it averaged 1.2% y/y in Q1.  The decisions to implement QE in the US, Japan, UK, and the eurozone were all made against a backdrop of deflationary risks and economic crisis. 

What would be the likely impact of unconventional PBOC policies?

If we assume that a Chinese QE-type program would fall more or less along the lines of those done in major economies, the PBOC will be looking to (1) reduce interest rates and the debt burden of financial institutions; (2) promote bank lending; and (3) boost the attractiveness of risky assets.  In the major developed countries, it seems as if objectives (1) and (3) were easily achieved, but not so much (2).  More liquidity injections did not always translate into increased lending in major markets.  Often, the added liquidity simply sat at the central bank in the form of excess commercial bank reserves.  Since China has a lot more control over its financial institutions, via state-owned lenders and “window guidance,” this will probably not be a big obstacle for China.

One possible concern for China is capital outflows.  This is especially the case if markets come to associate QE with a weaker currency, as they did in the case of the major central banks.  So counter-intuitively, the yuan may actually appreciate in the initial stages of QE.  We suspect the PBOC may guide the fixing stronger, just to make sure expectations for yuan depreciation don’t take hold.

Do current conditions justify QE in China?

At first blush, we don’t think so.  GDP growth is clearly slowing, though the data are hardly reliable.  Yet from what we can tell, the current growth trajectory doesn’t yet warrant what we view as a “nuclear option” of QE.  Liquidity is plentiful, with the key 7-day repo currently slipping further below 2.5% to multi-year lows.  The 10-year government bond yield is around 3.5%, also near multi-year lows.  Equity markets in China are already flying high, and investors hardly need any more reasons to buy.

Bank lending and money growth have slowed.  However, bank lending in China has never really been about market-based decisions, but rather largely directed by officials.  For instance, targeted RRR cuts for various sector banks (such as agriculture) is the typical Modus Operandi for policymakers in China.

We repeat the possibility that Chinese policymakers would use unconventional measures to tackle problems that are unique to China.  That is, the usual reasons for QE seen in the developed markets (deflation, economic crisis) may not be in China’s reaction function.  Instead, we will now discuss other potential factors that China may consider.

Why is China considering QE?

We think that the biggest potential motive for unconventional policy would be rising financial sector stresses.  China’s largest banks are so far reporting weak Q1 results and rising NPLs.  ICBC, for instance, reported the weakest Q1 since it first listed in 2006.  It reported NPLs climbing 17% in Q1 to CNY145.5 bln, and the bank set aside CNY20.8 bln in provisions against potential bad loans.   Similarly, the Agricultural Bank of China reported NPLs up 12% to CNY140 bln and saw a 51% rise in bad loan provisions to CNY20 bln. 

Other major China banks are still reporting Q1 results, but the weak showings so far is highlighting potential financial stresses ahead.  Perhaps a building debt problem is making Chinese policymakers think about contingency plans, though we are (hopefully) far from having to actually implement such plans.  At the same time, Chinese authorities appear to be encouraging companies to raise money via stock issuance instead of debt issuance. 

And this is just the official banking sector.  By definition, the state of the shadow banking sector is hard to quantify.  Yet efforts to pare back the shadow banking system appear to working so far.  Its share of aggregate financing (on a 12-month trailing average) has fallen to 25% through March, the lowest since October 2009.

Some sort of QE-type policy that moves toxic debt onto the PBOC balance sheet could be one goal of unconventional measures.  PBOC bond purchases of state and local debt would thus transfer risk from private sector balance sheets to the PBOC’s balance sheet (which is in effect the government).

If troubled bonds are held by the PBOC (and therefore the government), a negative credit event would likely have a more limited impact than if they were held by local financial institutions. 
There have also been press reports about the authorities trying to facilitate the development and depth of the municipal debt market.  It would seem that introducing government interference and potential distortions into this market via QE would defeat this purpose.

Is the PBOC signaling that it wants a weaker currency?

While this has never been a stated goal of QE in any country, most would agree that this is a major consequence.  We do not think China is trying to weaken its currency.  Premier Li said recently that a weak yuan would not be used to stimulate the economy.  Furthermore, foreign reserve data show a steady leakage over the past several quarters.  The fact that foreign reserves are no longer piling up at the PBOC negates a major liquidity-creating mechanism and perhaps helps explain the PBOC’s recent efforts to boost liquidity via domestic channels.

With the trade and current accounts in surplus, this means that capital outflows are the primary driver behind falling reserves.  We do not think policymakers want these outflows to continue, and are steering investors away from a self-fulfilling prophecy of a weaker currency feeding into even more outflows.

Indeed, the PBOC has fixed USD/CNY lower since the mid-March peak around 6.1617, fixing it at 6.117 (the lowest level since mid-December) on Wednesday.  In addition, we think policymakers favor a stable yuan policy ahead of a possible IMF decision to include it in its SDR basket. 

What should investors expect in the future?

We believe more conventional stimulus will be seen, both monetary and fiscal.  An LTRO-type program is also possible, but we do not think the PBOC will embark on a full-on QE program given current conditions and what we view as “typical” metrics for central banks.  The Chinese authorities have already taken several measures that are meant to encourage foreign investment inflows, and we expect this to continue.  We also expect the nominal exchange rate to remain fairly stable for the time being. 

We do acknowledge a very low probability of unconventional measures by the PBOC, but we do not think they would take the same form as we have seen in the developed markets.  Why?  Since these measures would most likely be aimed at problems that are unique to the mainland economy, we think they would be tweaked and targeted measures rather than full on balance sheet expansion.