Quantitative Easing with a Chinese Face

There’s no lack of invention in finance. In fact, while accounting is a library’s worth of rules for writing down what happened yesterday, finance is by definition an exercise in creating what will happen tomorrow. Imagination in accounting is called “fraud”. Imagination in finance is either called entrepreneurial genius or monumental stupidity, depending -- in perfect 20/20 hindsight, of course -- upon whether creative finance ultimately results in success or failure.

The completely insane idea that individuals could be given an open line of credit -- an idea we now call a “credit card” -- a form of credit only massive corporations had 50 years ago, is of course “genius”.  Because it worked. The idea that people with sketchy credit could become trusted, successful home buyers -- an idea we now call a “sub-prime mortgage” -- is now universally deemed “stupid”. Because it failed.

The paradox is that if financial creativity is killed in the cradle by overzealous and risk averse regulation, economies suffocate and wither. Killing all things new and fresh equates to killing every baby in the crib. Not to overstate things, but the only true stasis in nature is death, and financial stasis creates economic zombies.

The latest brainstorm in creative finance is being run by central banks. It goes by a variety of terms -- LTRO, exchange rate management, protection for exporters -- but the most common is “quantitative easing” or QE. In the common tongue, it’s called “printing money”. The U.S. Fed invented it in its current form. The central tenet is that one can print one’s way out of a soggy economy; that by printing money one can prosper and grow.  Results have been mixed in the U.S. and elsewhere.

As an aside: the QE the U.S. Federal Reserve ran in 2009, in the teeth of 2008 mess, prevented a catastrophe -- a general collapse too horrendous to contemplate, really -- and was therefore in my judgment a success. The subsequent U.S. Fed QEs have been, however, all but worthless, doing as much harm as good. To their credit, the Fed governors realized this and ended the last QE abruptly. 

That said, the Japanese Central Bank is running amok with QE. The European Central Bank just initiated it. A couple dozen smaller CB’s have recently engaged in QE as well. The Wall Street Journal reports that the Chinese have just announced they will join the parade, but as usual in a particularly Chinese fashion.

The bulk of sovereign debt in China is not at the national level but is created and owed by local governments. In China, most of the public spending on infrastructure and development is local. Quite rationally, most of the debt underlying that public spending is local, too. And like national governments in the West, these local Chinese governments are vastly over their heads in debt, particularly with the economy softening, the housing market in free fall (sound familiar?) and a recession looming.

Beijing is coming to the rescue by creating a flood of printed money to essentially bail out the locals. Here’s how it will work -- or how it will fail, a judgment that will in time be made with perfect 20/20 hindsight.

The Chinese Central Bank will make an unspecified amount -- local governments owe an estimated ¥4 trillion -- of new money available in loans to China’s local banks on very sweet terms. Those CB loans to the local banks can be -- and everyone will understand must be -- collateralized by local government bonds. Local banks will of course be highly motivated to loan the money to local governments, taking local government bonds in return.

The money going to local governments will be used to pay off existing bonds that are coming due, bonds they could not repay or refund without this QE. Government defaults in China, as in Europe with Greece’s pending failure, are a no-no, at all costs. Money will be created by the central bank, passed through the local banks, into the hands of local governments and used to refund bonds at risk of default.

Some of that new money will go to new local spending, this also being Beijing’s desire in order to forestall the recession that is brewing. The money in China’s local banks not used to salvage local government will be retargeted to loans to small, privately-owned businesses that are being crowded out of the credit market, this also being in the interest of deflecting a recession.

Will this Chinese iteration of QE work any better than have the largely fruitless efforts at economic stimulation and inflation-igniting in the U.S., Japan, Europe and other countries of the West? Is this QE with a Chinese face clever? Or just tangled and all the more flimsy? The jury is out.

Michael Booth, often posting and commenting as Cato, lectured in finance and economics at the Univ. of Texas, and worked for 20 years as an independent contractor and managerial trainer on financial topics in the technology industry.