Deleveraging: China’s Mission Impossible Made Possible

（中文摘要：中國去槓桿化勢必進行，問題是如何實行而已。在這巨大的體系存在嚴重扭曲操作的前提下，下重藥推行去槓桿化，可能會引發意想不到的負面效應。然而，我們可從三個方面出發，觀察所謂「去槓桿化」是否仍只是紙上談兵……）

 

The question about China’s deleveraging is not whether it will do it, but how?  Given the significant distortion in such a large system, drastic measures could entail unintended adverse consequences.  Official data from the People’s Bank of China (PBoC) shows that the country’s stock of aggregate financing (also known as total social financing, or TSF) reached RMB123 trillion, or 193% of GDP, at the end of 2014.  Indeed, annual TSF growth has outpaced nominal GDP growth by an average of 5.6 percentage points since 2006, and by 6.4 percentage points in 2014 (Chart 1).

 

 

If China’s nominal GDP were to grow at the same 7.9% rate as it was in 2014, which is what the market is expecting, and if Beijing wants to deleverage the economy at this nominal GDP growth rate, TSF growth would have to decelerate by more than 6.4 percentage points from last year.  This would mean monetary policy tightening.  But this would be unlikely at this point of the economic cycle when excess capacity, weak exports, structural reforms and property market contraction are inflicting a deflationary drag on growth.  The downside risk of growth will dominate Beijing’s credit policy so that it will err on an easing bias until growth stabilises.

 

So in the short-term, China’s credit-to-GDP ratio may rise even further, albeit at a slower rate.  A continued credit expansion, however worrying, may be more prudent in the current growth environment than an abrupt tightening because liquidity support for reasonable growth is needed for structural reforms to go through while maintain systemic stability.  Given China’s very small external debt, strong household balance sheet and a closed capital account that acts to shield the domestic banking system from external shocks, the scope for a debt-currency crisis is limited in the medium-term.

 

Though China’s headline leverage ratio may still rise in the short-term, Beijing has started to pare the country’s debt burden by reducing local governments’ debt-servicing cost.  Since March 2015, the Ministry of Finance (MoF) has approved a 2 trillion renminbi debt swap scheme to replace a similar amount of local government financing vehicle (LGFV) debt maturing this year by longer-term bonds issued by local governments and the MoF.  The scheme aims at restructuring the LGFV debt through ownership changes (from LGFV to local governments or the MoF) and duration extension.

 

For investors (mostly domestic banks and insurance companies) holding these debts, the scheme improves their asset quality in one stroke by replacing LGFVs with local governments and the MoF which have stronger credit standing.  From a system perspective, Beijing is not moving money from the right pocket to the left.  Through the bond swap, it is effectively redirecting local government borrowing from the opaque and poorly-regulated shadow banking market to the relatively transparent and better regulated capital market.

 

The scheme will eventually be enlarged to replace the whole local government (include LGFV) debt stock, which the National Audit Office estimated at RMB17.9 trillion as of June 2013.  This means that issuance of local government bonds is expected to rise in the coming years.  Since most of the LGFVs have borrowed from the shadow banking market, which drove the bulk of China’s liquidity growth between 2009 and 2013 (Chart 2), the bond swap scheme will improve the risk profile of the system and cut the local government’s debt-servicing cost.  Local government bond yields are closer to Chinese Treasury bond yield (10-year at about 3.4% at the time of writing) than LGFV bond yields, which are significantly higher and closer to the shadow banking market yields (at 6.0% or higher).

 

The expected increase in local government bond supply will help create a municipal bond market in China, which is a step forward in capital market reform and is what the market has been longing for.  Granted, the increasing supply could also drive up local government bond yields, but they are still going to be lower than the LGFV bond yields.  The PBoC’s monetary easing will also help ease the upward pressure on yields.

 

 

In a nutshell, the public sector can use the saved borrowing costs to fund government-led infrastructure investment, an act that is budget-neutral but a better way to stabilise GDP growth than throwing good money after bad as in the old practice.  The bond swap scheme should alleviate local government debt risk and reduce China’s bond market’s risk premium.  The expansion of local government bond issuance should help create a municipal bond market with higher quality issues than LGFV bonds, establish benchmark yields, and improve risk-pricing and capital allocation efficiency.

 

As and when China is freed from the cyclical constraints on its deleveraging effort, what signs should we be looking for to gauge whether this multi-year process will be serious or just paying lip-service?

 

The first clue is in the composition of the aggregate liquidity flows.  The types of credit delivered to the economy are as important as the absolute amount.  The former affects the structural foundation and risk profile of the system while the latter affects its cyclical fluctuation.  Since 2014, Beijing has started to improve the structure of the liquidity flows by restricting the growth of shadow banking credit, including entrusted loans, trust loans, bankers’ acceptance bills and curb-market lending (Chart 3).

 

 

In early 2015, shadow banking credit accounted for 12.4% of annual total social financing flows, down from a peak of 41% in early 2013.  During the same period, the share of bank credit flows rose to 77% from less than 50%, and capital market financing rose to more than 15% from less than 10, indicating Beijing’s effort to shift credit flows from the opaque shadow banking market to the better regulated banking and capital markets.  This is especially important for improving the credit-risk profile of the local governments and is a positive factor for developing the domestic municipal bond market.

 

The second clue comes from Beijing’s policy manoeuvre in the economic cycles.  If the authorities are worried about the downside risk of GDP growth and decide to ease monetary policy, how they choose to act is crucial to China’s deleveraging goal.  They should favour the usage of price-based measures, such as changes in interest rates and bank reserve requirements, to encourage the expansion of credit and kick the habit of quantity-based easing, notably by pumping credit through administrative measures.

 

This should help enable banks to price credit and allocate capital more appropriately and avoid any indiscriminate build-up of debt that eventually turns bad.  How fast China liberalises deposit rates will determine how fast the banks’ funding costs will be normalised to eliminate the implicit cost subsidy and to commercialise lending decisions to increase capital allocation efficiency.

 

The third clue is the trend for non-performing loans (NPL).  After the 2008-09 global financial crisis, Beijing flooded the domestic economy with a RMB4 trillion credit binge, funding a vast amount of unproductive investments.  However, banks’ NPL ratios remained below 1% until recently, due to administrative measures to suppress defaults and rollovers of bad loans.  Allowing uncompetitive firms to fail is a necessary creative destruction process to allow both deleveraging and the emergence of productive (mostly private) firms to drive the “new” economy.

 

The deleveraging process has already started, albeit slowly.  Since 2014, the number of defaults by small companies and banks’ NPL ratios has risen.  As discussed above, Beijing started to pare the system’s debt burden by introducing a debt swap scheme in March 2015 to reduce local governments’ borrowing costs.  The scheme replaces short-term (typically 1-3 year) high-risk LGFVs and other local government debt with longer-term (5-7 year) bonds issued directly by the Ministry of Finance and local governments through the relatively better regulated and transparent bond market.

 

Granted, this programme will not fully resolve the local government debt problem.  Other structural reforms are still needed to complement the debt swap scheme.  These will have to involve the private sector, such as the public-private partnership scheme and the disposal of local government assets, in order to have market discipline help resolve moral hazard in the system.

 

The bond swap programme should be seen in conjunction with the revision of the Budget Law in August 2014, which allows local governments to borrow in the capital market under strict conditions and introduces greater transparency in the local budgets.  The latter is of particular importance because it lays the ground for proper pricing of China’s credit risk premium.  Under the revision, local governments are required to publish their budgets and final accounts reports within 20 days after the legislature’s approval.  The public, including companies, investors and credit-rating agencies, can access this budget and audit information that underlies local government debt.

 

The implications of the Budget Law revision-cum-bond swap programme are positive.  It will help mitigate systemic risks, and thus reduce China’s credit risk premium.  This will bring down the local government yield curve, as high-risk LGFV debts are replaced by high-quality government bonds.  However, the expected increase in the supply of local government bonds under the swap programme may put some upward pressure on the long-end, and thus steepen the yield curve.

 

On this note, contrary to the perception in the financial market that China has a “debt bomb” that would explode and wreak havoc on its economy and financial system, China’s debt problem is within manageable limits and a deleveraging process is already underway.