What if, circa 2007, the Fed had figured out what was going on and wanted to take some concentrated steps to save the day? Well, that is the position China is in today, and they are acting fairly decisively:
China is imposing a $160bn municipal bonds for debt swap on banks in an effort to shift some of the financing costs of cash-strapped local governments back to lenders…
Banks are supposed to swap out higher-yielding business loans in return for more municipal bonds, noting that banks owned about 63 percent of the outstanding municipal bonds to begin with. As a form of compensation, the central bank will accept these municipal securities as collateral for some of its special lending facilities. The policy is a mix of jawboning and inducement, in which exact proportions we shall see; there is further coverage here.
You can think of it as “we may expect you banks to share in some of the losses on this paper, but if push comes to shove we’ll just monetize the municipal debt and bail you out too.”
Rating agency Standard & Poor’s late last year estimated that half of all Chinese provinces would merit junk ratings…
These (non-transparent) municipal debts may exceed $3 trillion. And Christopher Balding, in his excellent post on all this, makes a very good point:
Especially with land revenue falling by more than 30% annually when it typically constitutes more than 50% of government revenue, the provinces’ ability to repay is highly suspect.
Some goals of the bailout are to keep the local governments up and running, and also building infrastructure, so that urbanization does not slow down. This is all being done in conjunction with a series of interest rate cuts, and there is likely yet more to come.
Balding adds this as well:
…the banks, after getting cash for the bonds as collateral from the PBOC, are being encouraged to lend out this cash to firms in favored industries. Given the drop in risk weighted capital from holding government as an additional benefit, this means that banks will have significant new capital to lend. The rapid rise in Chinese debt, which has even officially surpassed most developed countries, seems bound to rise even more. I can’t [help but] think that this seems like trying to sober up an alcoholic by buying him a beer.
…Here is hoping that deposit insurance will never be needed.
It will be very interesting to see how this goes, and so far these events remain a dramatically undercovered story. My net takeaway, to date, is that the finances of the provincial governments must be worse than most observers had thought.