In China as it is the custom elsewhere, major policy changes are first leaked through the media. So a few weeks ago we first heard rumors of a possible quantitative easing program in China.
The economy has deteriorated so far that the move is merely seen as a logical extension of other easing moves by the central bank, such as interest rate cuts.
What wasn’t clear, however, is what form the quantitative easing would take. In America, the Fed has bought Treasury bonds from banks outright and in turn increased the balance of their reserve account at the Fed.
This kind of easing depends on new issuance from the central government, which the United States Federal government gladly supplied. The increase in the balance sheet of the Fed is indefinite and the transaction doesn’t involve collateral because it is an outright sale.
According to the newest leaks, however, China will use the European approach to take credit risk out of the market.
Local governments have been the worst offenders when it comes to bad debt and it is clear they won’t be able to repay many loans for futile building projects. Over the years, they have borrowed $2.8 trillion
Those loans are on the books of the big state-owned Chinese banks, who are increasingly unwilling to lend, given the risk they already carry on their balance sheets.
In comes the PBOC. It could buy the bad local government debt outright, like the Fed did with the U.S. Treasurys. However, the risk profile of U.S. government debt is slightly better than that of Chinese local governments. As a result, not even the PBOC is going to buy their debt outright.
In fact, Chinese local government debt has a similar risk profile than let’s say Greek government debt—always on the brink of default.
So the PBOC will do what the European Central Bank did and still is doing: Take the bad debt as collateral for loans to banks instead of buying it outright and do it over a limited time horizon.
According to the Wall Street Journal, which has reviewed documents to that effect, the PBOC will accept local government debt as collateral for central bank reserves as part of regular refinancing operations.
This way, the banks can exchange bad debt for good reserves, while the PBOC doesn’t have to carry the bad loans on their balance sheet either. In a way, the toxic assets just vanish in the cracks of central bank accounting. If all goes well, it doesn’t matter if they reappear again. If it doesn’t, the PBOC will have other things to worry about.
