Why China’s big muni bond market move matters
China’s economy is undoubtedly large, complex and opaque. What confuses many as well is trying to view it through the prism of traditional Western economies where central banks play their role through fairly free financial markets.
For all of its economic clout, China’s financial markets have long been hard fixed by the central bank/government and in many ways are still new: the booming and oft-mocked stock market is still a mere 25 years old, and deposit rates are only just being freed up. So understanding these complexities is doubly hard because things are just, well, different. I was lucky to spend the few years I did in Hong Kong and do stints as temporary Shanghai bureau chief for Reuters to learn more about what was going on just after the global crisis.
Understanding China’s economic management is especially hard. I say economic management rather than monetary policy because that’s really what it is. China operates within a set of constraints of its own choosing — a mostly closed capital account and highly managed exchange rate for starters. The central bank is far from independent as well: monetary policy decisions are ultimately approved, if not mandated, by the State Council overseen by the president and premier. For all the prosperity and buzz that you see in China, its economic management is still very much a command-style top-down affair.
The challenges China faces now are also of its own making. The 2009 stimulus to counter the hit from the global financial crisis ultimately saddled local governments with a huge debt burden through fiscal spending that was mostly well spent, despite the obvious examples of bad behavior.
Traditional monetary policy — interest rates, bank reserve requirements, the exchange rate — is in a tricky spot right now because 1) China is not a terribly interest rate sensitive economy with rates so low/fixed for so long and not tied to credit risk 2) capital outflows mean that cutting bank RRRs is as much a response to such outflows as a measure to pump banks with liquidity to lend 3) said outflows are weakening the currency naturally, and China has little interest in encouraging further outflows by weakening the currency beyond the politics of its CNY management (plus it’s quite happy to see some outflows/FX reserve reduction, $4 trillion being a lot to manage) 4) banks really want to be grown-ups now on the international stage and not just do the bidding of the state (though sometimes they have little choice). Plus the State Council has showed little interest in doing another 2009-style stimulus that could create bad debts, bad behaviors (corruption, pollution) and more problems now being addressed. But at the same time, it needs to lean on local governments because they are the ultimate fiscal agents in China’s economic set-up.
There’s a reason why the muni bond market development is important and huge. In essence, a brand new market is being created from almost scratch and a gigantic debt transformation is taking place. Local governments are converting their debt, mainly in the form of loans from banks that also became an important part of the shadow banking system (itself an outcome of low, fixed deposit rates) into longer-term bonds with lower yields than the loans and likely with maturities of at least 10 years, if not longer.
Who will buy these bonds? Two buyers: 1) the banks who gave local governments the loans in the first place, even though they may not like it and 2) China’s big policy banks. The former have been formally bullied into buying by making those bonds usable in PBOC repo operations. The latter are becoming much more important agents of the state because the banks want to become proper international institutions behaving properly.
This is basically a huge debt transformation for an economy that has the state means to pull it off because this debt (unlike some of the corporate debt, which can still be dealt with domestically) is not financed internationally. What many who have long predicted a Minsky Moment for China (see this) miss is that most of its debt is in CNY, and China is putting in place mechanisms for bottling it up and, perhaps, eventually letting it die a natural death through potential absorption by the state — which being in its own currency, it has multiple means of doing.
Yes, that implies something of a debt monetization. Technically, it may be illegal under the PBOC’s rules. But that won’t stop it from happening. The frenetic pace of work on the local government/muni bond market shows this is a major priority right now, and basically a monetary one, because local governments are the ultimate fiscal agents and the prime channel for monetary/fiscal transmission.
China’s slowdown has been driven in part by cracking down on those agents, especially local government officials, that used the previous stimulus to be profligate at the people’s expense. We are far enough into the resulting corruption crackdown for the central government to change tack, even while reminding its states that they are being watched.
So this debt transformation achieves multiple goals: creating a new market for muni bonds and, eventually, and proper pricing of credit risk even while launching mechanisms for wiping away some of the bad debt via the state policy banks and, perhaps quietly, even the central bank. And also moving a huge pile of debt away from the shadow banking system — itself a reflection of how the still very fixed deposit rates have forced the country’s savings into unsavory avenues to find returns — into something more in the open, again eventually with proper pricing (credit risk).
Calling this a Chinese QE masks the fact that China’s monetary policy has always had a fiscal element that has been quantitative in nature. That’s why the focus is on new CNY lending and China’s self-created Total Social Financing that brings together all the capital market activity happening and creating new lending. Muni bonds are a way of taking it off bank balance sheets, sort of, making it part of TSF and actually creating a proper market for credit risk over time while giving Beijing the leeway to wipe some of it away at its own discretion. There are always multiple goals involved in these big projects that still manage to combine reform with cleaning up for past sins.
What’s fascinating about the above is how China has managed to crack down on the shadow banking (see how banker acceptance bills have disappeared), while the regular bank lending remains relatively healthy. All part of the debt transformation.
Let’s keep in mind the most important aspect of China’s opening up to the world is less what it does internally than its not-too-distant opening up of its capital account that means a massive investment overseas. Watch out.