After the credit binge of the last decade, China’s banks are suffering from a bad case of indigestion. They are over-leveraged, under-capitalized, and so stuffed with non-performing loans that they are struggling to lend. Now, the People’s Bank of China (PBC) has decided to sort them out. Welcome to the Great Chinese Bank Bailout.

In a masterly exhibition of fudge, the PBC managed to announce the bailout on January 25 without revealing that it was, in fact, a bailout. The press release headline said “PBC Launches Central Bank Bills Swap to Support Liquidity of Banks’ Perpetual Bonds.” Ah yes, liquidity. Saying that you are providing “liquidity support” when you are in fact recapitalizing is the oldest trick in the book. And the full text of the press release shows that this is exactly what the PBC is up to (my emphasis):

To improve the liquidity of banks’ perpetual bonds (including capital bonds without fixed terms) and to encourage banks to replenish capital through perpetual bond issuance, the People’s Bank of China (PBC) decides to launch Central Bank Bills Swap (CBS). Primary dealers of open market operations can trade their perpetual bonds issued by qualified banks for central bank bills with the PBC. And banks’ perpetual bonds with ratings at no lower than AA will be included as qualified collateral for medium-term lending facility (MLF), targeted medium-term lending facility (TMLF), standing lending facility (SLF) and central bank lending.

Yes, this is about recapitalizing banks, not just providing liquidity support. It’s a bailout.

The reason why this is a bailout, not simply “encouraging” banks to recapitalize, is hidden in the dense central bank speak of the remaining sentences of the press release. Fortunately, a helpful official at the PBC has paraphrased it for us in a press Q&A:

Banks need to have adequate capital to guarantee sustainable financial support for the real economy, and an important way of replenishing their Tier 1 capital is to issue perpetual bonds. The Central Bank Bills Swap (CBS) allows financial institutions holding banks’ perpetual bonds to have more collateral of high quality, improves market liquidity of such bonds, and increases market desire to buy them, thereby encouraging banks to replenish capital via perpetual bond issuance and creating favorable conditions for stepping up financial support for the real economy.

Well, ok, this isn’t exactly clear either. So let me explain. Because perpetual bonds don’t have to be repaid, they are treated more like equity on bank balance sheets. Like preference shares and contingent convertible (“Co-Co”) bonds, they can form part of additional Tier 1 or Tier 2 capital. So, one way for banks to recapitalize is to issue perpetual bonds. The PBC wants ailing Chinese banks to build up their capital by issuing perpetuals, which they haven’t previously done.

But although Chinese banks seem keen to issue perpetual bonds, investors are cautious. So the PBC is providing a backstop. It is doing so in two ways:

  • Banks and financial institutions can exchange holdings of perpetual bonds for highly liquid PBC bills, which they can then use as collateral to obtain funding
  • Banks can pledge holdings of perpetual bonds (of sufficient quality) to the PBC in exchange for funding.

Of course, these would only be existing holdings of perpetuals. Banks would still have to find buyers for new perpetual bond issues. By a remarkable coincidence, on the same day that the PBC announced its scheme, the China Banking and Insurance Regulatory Commission (CBIRC) said it would allow insurance companies to invest in perpetual bonds issued by banks. This completes the loop. Banks can issue perpetual bonds and insurance companies can buy them, knowing that they will be able to exchange them at the PBC for safe liquid bills. What’s not to like?

On the face of it, this looks remarkably like other schemes devised by central banks to get banks lending. For example, the PBC’s reserve-neutral exchange of perpetuals for bills is much like the Bank of England’s Funding for Lending scheme. And  the ECB’s “Long-Term Repo Operations” (LTROs) encouraged governments to issue debt for banks to buy then pledge at the ECB for cheap funding, just as the PBC’s backstop encourages banks to issue perpetuals for other banks to buy then pledge for cheap funding.

But the purpose of this scheme is recapitalization, not just funding. And one way or another, lots of the perpetual bonds will end up on the PBC’s books. So, in effect, the PBC is recapitalizing banks at arm’s length. That’s why I say this is a bailout.

The reason for the Great Chinese Bank Bailout is clear. China’s economy is weakening, and its banks are in no shape to support it. As the PBC official says, recapitalizing banks should free them up to lend more to the real economy – provided the demand is there. China’s authorities have demonstrated repeatedly over the last few years that they have ways of persuading people and businesses to borrow. Recapitalizing the banks could be a prelude to yet more government-initiated investment projects funded by debt.