So a couple of people that I know and some that I don’t know zeroed in, in my last post, on a couple of monetary issues. They raised some important questions and so I think it is important answer them as best I can based upon what I think we observe in China.
The basic idea that is being objected to is that bank recapitalizations can be monetary neutral. Before we even discuss the mechanics of bank recapitalizations, it is important that everyone knows what we mean by monetary neutral. Assume country A has a fixed exchange rate and decides to recapitalize their banks. If they increase the base money supply by a non-trivial amount that could cause pressure and ultimately some form of a devaluation/depreciation.
Now it is very important to note that a bank recapitalization can be monetary neutral but can also violate the concept of monetary neutrality. So in other words, it is entirely possible that they are right that a bank recapitalization could be monetary neutral, but it could also be false.
Let me give you two very simple examples to illustrate the difference. Assume a bank needs to increase its capital base, for any number of reasons, and does a secondary rights offering selling shares to the market to meet capital adequacy ratios. If they offer the shares to the market and the market buys the shares, there has been no increase in the money supply. Investors with existing capital chose between different investment options. This simple example could be expanded to cover a pre-emptive, hypothetical, type of recapitalization where the Chinese Banking Regulatory Commission (CBRC) orders all banks in China to sell shares to the market to ensure high capital levels. In these instances, there has been no increase in the Chinese money supply. We have not violated the principle of monetary neutrality.
However, it is also very easy to violate the principle of monetary neutrality. Assume now that a bank has made a bad loan but the government wants to ensure continued lending and investment growth. The government does not want the market to buy the shares because that would divert capital used for other investment purposes and it would dilute the governments shareholding. To solve this problem the central bank prints money to buy assets of some kind from the bank to give them capital continue lending. This results in a tangible and could be material increase to the money supply.
To make this example tangible, assume the bank has $1,000 in loans, $900 in deposits, and $100 in capital (I am being very very simple here). If the bank has a shock with NPL’s rising to 10%, assuming depositors lose nothing, the banks capital of $100 is wiped out. However, the central bank prints money and offers to buy the bad loan at face value of $100. The bank gets $100, returns its NPL ratio to 0%, and can resume lending. The money supply has gone up but the objectives of continuing to lend with functioning banks has been achieved.
Let’s briefly consider similar but very importantly not identical situations. Both the Bank of Japan and the Federal Reserve have engaged in quantitative easing whereby they print money to buy sovereign debt issued by their respective governments. The European Central Bank has engaged in a similar strategy buying a variety of sovereign and high credit quality corporate debt. Absolutely no one disputes these actions are not monetary neutral. They are in fact quantitative easing. If the PBOC is printing money engaging in balance sheet expansion to fund monetary easing, even if it is purchasing assets from banks or engaging in quasi lending to banks, this will count as monetary easing violating monetary neutrality.
Forecasting into the future is always difficult and it is entirely possible that if there were some type of “event” where these mechanisms would be discussed, it is possible that China could choose a mechanism that did not violate monetary neutrality. However, if we look at recent Chinese behavior, we have a very good example that clearly violates monetary neutrality.
In what I believe is one of the most overlooked events in recent Chinese history and will likely in time occupy a more central focus of analysis, Beijing conducted a full fledged bailout of local governments and the bad debts Chinese banks held. The banks who held vast sums of debt, with even much of it now unlikely to be repaid, were ordered to convert short term high interest loans into 10 year low interest bonds. As a simple example, a 1 year 7% loan became a 10 year 3% bond. If these debts blew up, this would have had an enormous negative impact on bank capital levels and restricted their ability to lend but also the bailout plan would have restricted their ability to lend.
Beijing came up with a solution when the bankers resisted. Local government bonds could be sold to the PBOC for money that would then be used to make new loans. This solution effectively wiped out local government debts and “recapitalized” banks by relieving them of bad debts allowing them to speed up new lending. It should come as absolutely no surprise that lending in China really surged roughly 6-9 months after this plan was first announced.
However, and very important to return to our earlier discussion, it completely violated the principle of monetary neutrality. The PBOC was printing money to buy assets from the banks. How do we know this? Chinese data tells us this is exactly what is happening.
In January 2015, prior to any discussion of a local government bailout, PBOC claims on other depository corporations stood at 2.6 trillion RMB but by April 2017 that stood at 8.45 trillion. That is an increase of 5.9 trillion RMB or $852 billion. In other words, the PBOC has spent the last two years buying large amounts of assets from Chinese banks and importantly exactly as it said it would. This was announced and agreed to by Chinese banks to sell the PBOC bad debts. This is not a shock.
Let me put this number in a little perspective for you in a variety of ways. This 5.9 trillion RMB is equal to 21% of the growth in total loans during this time frame. This is equal to 38% of net capital for the entire commercial banking industry in China. This is equal to 1,098% of the growth in M0 over this time frame. As a slight tangent here, I use M0 here rather than M2, or other potential measures, as the PBOC controls the printing presses to print RMB but they do not directly control for our purposes here broader money measures such as deposits which are also related to history and asset prices. These broader measures are outside the immediate and direct control of the PBOC. In short, as we can see the purchases of the PBOC are significant by any related financial measure.
Probably the biggest impact of this shadow “recapitalization” is that the banks did not have to declare bad loans reducing their capital base and lending growth. By selling via some form of a repurchase agreement, the banks were able to maintain that loan on their books as a standard loan. Just as other forms of asset purchases by central banks keep capital costs low and stimulate investment/public spending, so the PBOC purchases here are designed to do this using the banks as conduits.
Now I can already hear an understandable objection. This is not a recapitalization because the PBOC is just holding assets as a collateral they are not recapitalizing the banks. Possible (which I will return to in a moment) but in the short term, irrelevant for what we are discussing here. In the short run, the PBOC is clearly violating the principle of monetary neutrality. Just think of how big the drop in lending would have been, not even assuming second order/dynamic effects, from just backing out the PBOC purchases. Assuming a not insignificant numbers of these pledged assets are bad assets, think of what that does to bank capital. Banks are making loans with money that did not previously exist printed by the PBOC to further stimulate lending. We have violated monetary neutrality.
The question I briefly circle back to is whether the PBOC is actually recapitalizing. I would humbly submit a couple of points of importance here that violate the presumption of standard central bank lending that lead us to the conclusion this is a type of recapitalization. For starters, we cannot consider 228% growth in just over two years as standard and normal growth. This is clearly far outside the bounds of normal financial growth even by Chinese standards. Then, and though we cannot say for certain, given that the most likely scenario is that the PBOC is buying distressed, bad, or low quality loans, this absolutely has to count as non-normal lending practice.
However, probably the most important question is what is the nature of the capital here? By that I mean, does the PBOC seem likely to pull credit and the what happens when the underlying loan is either repaid or is defaulted on? On the first part, I believe it is extremely unlikely that the PBOC will pull the credit facility because this was the whole point of the local government bailout. Banks would only go along if they had a place to effectively dump these low yield junk/NPL bonds. More importantly is whether this is a “recapitalization” or just standard asset lending by central banks. Given that the PBOC is accepting, most likely, very low quality debt, this is not standard central bank lending.
The question then focuses on the capital supplied by the PBOC. If the underlying debt is repaid, then the PBOC is repaid and no “recapitalization” has taken place. So then what about the scenario if the underlying debtor defaults? In most every system I am aware of and I would assume the same for China, though I cannot say for sure, during a repo, which is likely the type of transaction taking place or a similar transaction when a lender pledges a fixed income security as collateral to borrow if the debtor of the fixed income security defaults while the security is used as collateral for borrowing, the original lender can be held liable for the bad debt. Put another way, if ICBC holds a bond of province X, ICBC takes that bond to the PBOC and sells that bond agreeing to repurchase it in say 5 years, if the province defaults during those 5 years, the PBOC can pursue ICBC to make good the bad debt portion. Here is what I think is important: assume province X defaults on the bond ICBC sold to the PBOC, I think the probability PBOC would pursue ICBC for damages to recoup losses as above zero but very very low. In this scenario, the PBOC has effectively recapitalized a bank absorbing the loss they should have suffered.
Circling back to our original questions, while I think it is possible that recapitalizations can be monetary neutral, in China this is clearly not the historical case and would I believe be unlikely in the future. Furthermore, while not all of the new money supply will be “recapital” into banks as some of the securities held by the PBOC sold to them by banks will be repaid, I would deem it highly unlikely that the PBOC would pursue bad debt claims against Chinese banks in the event of default. Banks would in this case receive a backdoor recapitalization by not suffering losses they should have suffered. It is quite likely, the PBOC is the new Superbad asset management company for China.