Given the huge debt burden at commercial banks, the PBOC may have to keep pumping cash to expand the loan swap programme.
Just how much cash will the People's Bank of China need to hand out to get commercial banks into local government bonds? Some experts say it might have to finance the whole thing.
Industry watchers were surprised last month by media reports that local government bond sales in Jiangsu and Anhui provinces had been delayed due to a lack of demand.
After all, the mastermind of the one trillion yuan (HK$1.3 trillion) debt swap, the Ministry of Finance, is also the largest shareholder in many mainland banks, the dominant players in the government bond market.
The delays have led to talk of major monetary easing that would push banks into the debt-for-bond swap, a plan that it is hoped would reduce the credit risks surrounding opaque, unbridled local government borrowing since 2008.
It is also a clear sign that mainland banks are becoming more sensitive to the market - perhaps sooner than the Ministry of Finance would have liked - and requiring better conditions as their profits slow and balance sheets come under pressure.
On the surface, an opportunity to swap loans for bonds should be attractive to banks. The programme, announced by the ministry in March, would essentially allow banks to shift the asset class of debt from loans to bonds, which carry a lower risk weighting and could help boost earnings.
Provisioning on bad debt pulled down bank profits in the first quarter of the year as non-performing loans mounted. Downgrading the value of bonds would not be reflected directly in profits because they are classified as investments.
The return on assets for the bonds, at 1.6 per cent, was lower than for loans, but so was the risk, BNP Paribas analyst Judy Zhang said in a recent report, making the bonds a good buy for the banks.
But with returns close to the level of sovereign bonds, GaveKal Dragonomics analyst Chen Long said in a note that the bank regulator might need to lower the risk weighting of the bonds to the same level as central government bonds. The central bank could also change its rules and accept local government bonds as collateral, freeing up some liquidity.
Liquidity is still the big question for the local government bond market. By pumping more cash into the system, banks will need to find a place to put the cash that generates returns.
"That is one of the rationales for the PBOC to keep injecting liquidity into the banks," Daiwa Capital Markets analyst Leon Qi said. "Now that banks have more cash while the credit demand is still weak, they have to park some liquidity in interbank investments or bond investments."
How much liquidity the central bank needs to release is unclear.
Nomura analyst Sophie Jiang said in a report that the one trillion yuan debt swap could be increased to five trillion yuan over the next three years. To push that along, the central bank could use some unconventional monetary tools, namely short and medium-term cash injections, to generate the liquidity needed, she said.
Eventually, the government might end up providing all the cash. The central bank could add up to 20 trillion yuan over the next few years, Societe Generale China economist Yao Wei said. That is more liquidity than debt at present but the growing pressure on local governments might warrant such a response.
"Unconventional tools are called for in unconventional times," Yao said.
By the end of last year, direct debt liabilities for local governments had jumped to 16 trillion yuan, according to mainland media, a 47 per cent increase from 10.9 trillion yuan in just 18 months.
Mizuho China economist Shen Jianguang described the media reports in a note as "an indication of the scale of the debt burden, and the need for the debt-for-bond swap programme to expand in order to ease the pressure on local government debt repayment".
Local governments are losing some capacity to service the debt as land sales, a primary source of revenues, fall. Growth in land sales by regional and local governments slowed sharply to 3.1 per cent in 2014 from 45 per cent the year before, Moody's Investors Service said.
The total debt figures, which have not been confirmed by the Ministry of Finance, likely include on and off-balance-sheet lending to local governments. The estimated 12.6 trillion yuan in outstanding bank loans to local government financing vehicles at the end of last year constituted about 14 per cent of total outstanding loans, according to data from Goldman Sachs.
Source: http://www.scmp.com/business/banking-finance/article/1784970/local-bonds-no-easy-sell-chinas-banks’
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