China Engages in 'Backdoor QE' as Monetary Policy Shifts, Says Jefferies
Blink and you might have missed it: The People's Bank of China's (PBOC) expansion of its lending facilities — aimed at injecting banking-sector liquidity and lowering borrowing costs for companies — is shoring up bank-demand for government bonds, a development analysts at Jefferies Group LLC have dubbed a form of backdoor quantitative easing (QE).
Chinese authorities have embarked on a bumper monetary-easing program that boosts Beijing's fiscal firepower to both juice the economy and redress bad debts that are clogging the financial system and depressing private-sector investment.
In a research report published on Monday, equity analysts at Jefferies, led by Sean Darby, say markets have overlooked one key monetary development: the PBOC has essentially launched QE through the backdoor in recent months, thanks to the expansion of lending facilities aimed at controlling the domestic monetary base.
The analysts say the PBOC has increased lending to state-owned banks, with the latter subsequently snapping up Chinese government bonds aided, in part, by the central bank's liquidity infusions.
In order to offset the contraction of the PBOC’s balance sheet due to capital outflows and dollar repayments, the central bank engaged in a form of ‘backdoor QE’ in our view. Alongside the introduction of short-term monetary instruments such as Medium-term Lending Facility (MLF) and Standing Lending Facility (SLF), the PBOC has moved away from using conventional interest rate and RRR cuts.
Reserve requirement rate (RRR) cuts could fuel capital outflows, while a further loosening of the policy rate threatens to reflate the property bubble in first-tier cities. As a result, the PBOC has used new lending instruments to both manage banking-sector liquidity and to provide funds for targeted lending, the analysts say. This dynamic is boosting banks' firepower to buy government bonds and, thereby, helping to ease long-term borrowing costs in the real-economy.
The market expects rates on quantitative tools will be lowered and liquidity volumes increased in the coming months if the economy slows. In a report earlier this month, the PBOC expressed concerns lower rates would add too much liquidity into the financial system and feed expectations the yuan will depreciate.
The SLF is seen as the ceiling of an interest-rate corridor formed by the central bank, and the MLF is targeted for areas such as agriculture and small and medium-seized businesses. But a happy by-product for the government is that the aggregate increase in system-wide liquidity is fueling lender demand for government bonds, the analysts at the U.S. investment bank say.
The Jefferies' strategists add that this fiscal and monetary co-ordination in China can be seen as a prelude to oncoming stimulus efforts in advanced economies. Nevertheless, Western central banks have engaged in far-more aggressive efforts to expand the money supply since the crisis, through buying up a bevy of financial assets directly from commercial banks. And the PBOC doesn't call its liquidity operations a form of QE, even as it directly re-capitalized policy banks last year to finance government investment programs.
But the QE analogy is deployed to make an under-appreciated point: the PBOC has loosened monetary policy to a greater scale than implied when looking at conventional tools, such as the (RRR) and policy rates, while it has sought to increase the proportion of domestic assets, relative to foreign, on its balance sheet over the past year.
Wei Yao, China economist at Societe Generale SA, adds: "You might not want to call this QE as it's not a textbook definition, especially since reliance on these new and short-dated instruments, relative to the average-weighted maturity of Chinese government bonds, would expose banks to duration mis-matches." But she adds that the introduction of new lending instruments should be seen in a bigger context: "The PBOC is transforming its balance sheet to that of a Western central bank by increasing the weight allocated to domestic assets."
Given the weak private-sector credit cycle, PBOC will continue to keep liquidity loose using its bevy of lending facilities, the analysts conclude, citing the negative spill-over impact of further cuts to the policy rate and the RRR, as well as the central bank's desire to offset any contraction in its balance-sheet triggered by foreign outflows.
This dynamic, according to the Jefferies analysts, is a boon to Beijing's fiscal-easing efforts.
The QE analogy is, therefore, somewhat ironic. The PBOC has traditionally shaped domestic credit conditions by using tools to adjust the quantity of money, rather than its price (the interest rate), through open-market operations. However, in recent years, the PBOC has sought to establish an interest-rate corridor, and a de facto interbank rate-target similar to Western central banks. Now the economic cycle is forcing the PBOC to redouble its focus on quantitative targets.