The past couple of weeks Chinese financial markets have been driven by the stock market boom, bust, and then boom coupled with the massive government debt restructure/bailout. Why the two are correlated seems to only speak to the rationale of what investors believes drives the Chinese stock market. The deal went roughly like this: banks would be forced to trade high interest short term government debt in the form of bank loans for long term low interest bonds that would then hand over to the PBOC as collateral they would then lend back out to favored industries. The unilateral debt restructuring (provincial bailout) is a bad deal for the banks but it could have been worse. The PBOC accepting the provincial bonds as collateral, with likely no recourse back to the banks if the debtor defaulted, took a lot of the sting out of the deal.

It just got worse for the banks. Reuters is reporting that trading in the bonds is thin due to lack of demand and prices are dropping rapidly to entice those willing to shoulder the risk of an excessively indebted Chinese provincial government with no legal ability to enforce a claim as even debt contracts will be unilaterally rewritten. This is bad news for the banks.

This is quite surprising and has numerous interesting implications if this continues. If this is true, this is imposing significant capital losses on Chinese banks already struggling with rising (even very generously defined) non-performing loan rates. While Chinese banks and regulators adhere strictly to the international “mark it at whatever we feel like today even if they haven’t paid us for a year” accounting standard rather than GAP or IAS, even by their own standards bonds available for trade should be marked to market. Banks may not be trading the newly issued bonds due simply to the fact that this would require them to recognize significant losses that are at the moment not explicit but would become explicit if the bonds are traded or available for trading. Furthermore, given their funding costs, this essentially gives the banks a near zero margin on government debt straining their resources when they can least manage it.

Another possibility is that there is some short term delay in using the loans as collateral with the PBOC as promised. Given what was announced about the overall debt restructure and the time lag, it is distinctly possible that final details of the PBOC collateralization have yet to be finalized and debt essentially moved onto the PBOC balance sheet. Due to the lack of trading and drop in price, it seems likely that banks will hold on to the debt for sometime or wait for the PBOC to open the promised lending facilities required to redeem the provincial bonds.

There is one more worrying and counterintuitive possibility here. It is possible that after the banks swapped the short term high interest debt for the long term low interest debt, with the promise of redemption at the PBOC, the PBOC has decided to opt out and not accept the bonds as collateral. I assumed based upon the PBOC accepting the new provincial bonds as collateral that banks would receive the bonds turn right around and give them to the PBOC. Given the fact that this appears to not be happening raises the very real specter that the PBOC is getting cold feet.

If the PBOC is not having the printing presses running late to monetize the dubious debt on offer, this itself raises a couple of issues. First, given the history of enormous money creation by the PBOC, this seems like an odd time to turn the printers off. Both textbook economics and the shrinking money supply in China from a variety of factors like capital outflows indicate this would be a time to pump money into the system which the PBOC is appearing increasingly reluctant to advocate. Second, the PBOC as prudent bankers seeing what the bankers see may be just as reluctant to act as a bad debt repository. The PBOC may execute their political orders like good soldiers, but they are also smart economics and finance guys who see the risks they are being told to incur. It is quite possible they are dragging their feet or refusing to uphold their side of the bargain in accepting this bad debt as collateral. Third, if the PBOC is dragging their feet or backing out of the deal to accept provincial debt as collateral, this sets a bad precedent for all the debt that Chinese banks are going to be asked to swap. If the bankers were in near open revolt over the forced debt restructure when they at least could hand it off to the PBOC, think of what will happen when they realize they are getting suckered. While everyone knows (or should know) that Chinese banks are little more than public slush funds even if they are listed, this simply confirms it.

I am going to hold a verdict in reserve until more information comes out about what the PBOC is going to do. Neither the thin trading or drop in prices should come as a major surprise as everyone knew the banks were not receiving a yield commensurate with the risk. However, this was all predicated on the PBOC promise. Your move PBOC.