Abstract: So far, China's first consideration should be the regular issuance of additional treasury bonds and open market operations, and at the same time, it should also be ideologically and technically prepared for the introduction of Chinese-style quantitative easing if necessary
Text: Yu Yongding, Zhang Yi
Recently, the discussion on the PBOC's direct purchase of government bonds in the primary market has once again become a hot topic in the market and academic circles. Such a discussion is necessary. As long as there is no preconceived notion and an open mind to listen to different opinions that do not please the ear, both sides of the debate should be able to reach an agreement on the basis of logic and facts.
There are three main reasons for opposing the PBOC's direct purchase of treasury bonds in the primary market: First, under the existing legal framework, the PBOC cannot purchase treasury bonds in the primary market to finance the fiscal deficit, which is the bottom line; second, the essence of the PBOC's direct purchase of treasury bonds in the primary market is "monetization of the fiscal deficit." Once the opening is opened, it is difficult to guarantee that the fiscal authorities will not indulge in borrowing money directly from the central bank in the future. "Monetization of fiscal deficits" will damage government credit and eventually lead to runaway inflation; third, China's macroeconomy has not yet reached the point where it requires the central bank to buy government bonds directly in the primary market. China's savings rate is high, and public demand for government bonds remains strong, and the issuance of government bonds by conventional means can finance fiscal deficits without crowding out them.
The argument in favor of the PBOC's direct purchase of government bonds in the primary market is mainly based on two points: first, the current economic pressure is relatively high, and it is necessary to attach great importance to the impact of the economic downturn, because the amount of government bonds that need to be issued is huge (and may even exceed the original plan), conventional government bond financing is very likely to have a crowding out effect, inhibiting private investment, and is not conducive to economic growth; second, in the context of insufficient aggregate demand, as long as the fiscal deficit can be exited in time, the monetization of the fiscal deficit will not lead to runaway inflation.
It is not the intention of this article to be a comprehensive review of the discussion of fiscal deficit financing, as some of these ideas go beyond economics, while others are hypothetical questions that can only be answered by practice. This article only scratches the surface of the possibilities and pros and cons of different financing methods in China.
Three ways to finance deficits
Deficit financing can be divided into three ways: one is treasury bond financing, in which the Ministry of Finance issues treasury bonds to the public through primary market dealers (mainly commercial banks in China), the other is monetary financing (commonly known as "fiscal deficit monetization"), in which the Ministry of Finance borrows money directly from the central bank, and the third is the current hotly discussed method in the market: the Ministry of Finance issues treasury bonds to the public through primary market dealers, and the central bank simultaneously purchases the same amount of treasury bonds from the public through open market operations. The third method is what some scholars call "Chinese-style Quantitative Breadth (QE)". This article will analyze the different impacts of government bond financing and monetary financing on the money supply, and explain that QE is essentially monetary financing, but it is not the same as monetary financing. For the sake of analysis, it is assumed that the government issues 100 units of treasury bonds,
Scenario 1: Treasury bond financing
The Ministry of Finance issues treasury bonds to the public through commercial banks. The Ministry of Finance increased its liabilities (treasury bonds) by 100 units at the same time as 100 units of assets (cash or/demand deposits, hereinafter referred to as "central bank deposits"). Under treasury bond financing, the increase in central bank deposits in the central bank's liabilities (the Ministry of Finance will first deposit the funds in a special account opened with the central bank - the treasury account) is offset by the decrease in the currency in circulation or reserves. The central bank's balance sheet will not expand.
If a commercial bank buys treasury bonds with its own funds. There should be two main possibilities. First, commercial banks reduced their holdings of other assets by 100 units (cash in hand in the simplest case) and increased their holdings of treasury bonds by 100 units. The asset structure of commercial banks has changed, but the scale of assets has not changed. The reduction of other assets by commercial banks means that commercial banks withdraw 100 units of currency from circulation and then re-inject 100 units of currency into circulation through the purchase of treasury bonds (first of all, it becomes a deposit with the central bank of the Ministry of Finance). There was no change in monetary aggregates during the above process.
Second, commercial banks use excess reserves to purchase 100 units of treasury bonds; the asset structure of commercial banks has changed, but the total amount has not changed. The change in the balance sheet of the Ministry of Finance is still as follows: liabilities increased by 100 units of treasury bonds, and assets increased by 100 units of central bank deposits. The structure of the Central Bank's liabilities changed: 100 units of excess reserves became 100 units of Treasury deposits. The base money in the central bank's liabilities remains unchanged. However, due to the difference in the liquidity of excess reserves and central bank deposits. The possibility that this form of Treasury financing would create inflationary pressures cannot be ruled out.
In fact, the vast majority of the assets of China's commercial banks are loans and advances, followed by financial investment, and then the central bank's reserves. Therefore, the Chinese government's main target for selling treasury bonds is the general public. Commercial banks act as primary dealers to purchase treasury bonds to a large extent as underwriters. According to the source of residents' funds, treasury bond financing can be divided into two situations: the first case, residents use cash to buy treasury bonds, and the cash held by residents is converted into deposits with the central bank of the Ministry of Finance. Commercial banks only receive commissions, and their balance sheets do not change. The total liabilities of the Central Bank remain the same, but the structure has changed: the cash held by the population has become the deposit of the Ministry of Finance. With the proximity of liquidity to cash and Treasury deposits, there should be no inflationary pressures.
In the second case, residents withdraw their deposits from commercial banks to purchase treasury bonds. In this case, the assets and liabilities of the commercial bank will be reduced by the same amount. But in other respects it is no different from the first case.
In summary, Treasury financing will not lead to an increase in the central bank's balance sheet, nor will it increase the base money, and thus will not lead to an increase in the money supply and inflationary pressures. However, Treasury financing could lead to an increase in Treasury yields and the overall economic yield curve, creating a "crowding out effect" on non-government investment.
Figure 1 Changes in the balance sheets of the Ministry of Finance and commercial banks under the operation of treasury bond financing
Source: Produced by the author
Note: For the sake of brevity, the two situations in which commercial banks purchase treasury bonds on behalf of the public are no longer tabulated.
Scenario 2: Monetary financing
The change in the balance sheet of the Ministry of Finance is the same as in Scenario 1. The assets of the Central Bank increased by 100 units of government bonds, and the liabilities increased by 100 units of Treasury deposits - the increase in the deposits of the Ministry of Finance with the Central Bank. The Treasury does not keep money in the central bank for long, and once the Treasury "spends it", other forms of money in circulation will increase accordingly. The biggest difference between monetary financing and treasury bond financing is that monetary financing leads to the expansion of the central bank's balance sheet (both assets and liabilities increase), while treasury financing does not lead to the expansion of the central bank's balance sheet. The result of monetary financing is an increase in the money supply in equal equal proportion to the fiscal deficit. Monetary financing will not have a crowding out effect, but it will most likely lead to inflation. In the process of monetary financing, in principle, there is no need for the intervention of commercial banks and the participation of the public.
Figure 2 Changes in the balance sheets of central banks and central banks under monetary financing operations
Source: Produced by the author
Note: The central bank deposit and the financial deposit are the same fund.
Scenario 3: Treasury bond financing + open market operation
The standard definition of open market operation is that the central bank buys and sells government bonds in the open market, and the open market operation itself is a monetary policy tool, and the central bank buys and sells government bonds through the open market to implement monetary policy. Even if the government does not issue new treasury bonds, the central bank must conduct open market operations at any time and buy and sell treasury bonds to achieve the monetary policy goals of maintaining growth and stabilizing prices. Under normal circumstances, open market operations buy and sell existing stock of government bonds rather than new flows of government bonds, and are therefore irrelevant to fiscal policy. However, open market operations can also be directly coordinated with the government's expansionary fiscal policy to widen the deficit.
It should be noted that the open market operations of the People's Bank of China are very different from those of the West in terms of objectives and instruments, and in particular, there have been a series of changes in the financial instruments bought and sold by the Central Bank of China's open market operations. For a considerable period of time, the central bank bills (central bank bills) were sold to hedge the impact of the increase in foreign exchange reserves on the base currency, and after 2015, the central bank mainly provided loans to commercial banks through reverse repo (commercial banks provided securities as collateral, which should also include treasury bonds). As the role of Chinese government bond trading in open market operations is relatively limited. Therefore, the following discussion of Treasury financing + open market operations is mainly based on the situation in the United States.
First, treasury bond financing refers to the sale of treasury bonds by the Ministry of Finance to primary dealers (mainly commercial banks in China) in the primary market to finance fiscal deficits. The general public can purchase Treasury bonds from primary dealers in the secondary market. Treasury financing does not increase the money supply, but it can lead to an increase in interest rates. At the same time, the central bank conducts open market operations to buy government bonds in the open market (for the sake of simplifying the analysis, it is assumed that the central bank buys the same amount of government bonds as the new government bonds). As a result of treasury bond financing + open market operations, the total amount of treasury bonds in the assets of commercial banks has not changed: although commercial banks buy 100 units of "new" treasury bonds from the Ministry of Finance, 100 units of "old" treasury bonds are bought by the central bank. The 100 units of assets (other debts or own funds, etc.) that commercial banks have reduced when purchasing treasury bonds have been replaced by 100 units of reserves increased by the central bank. The central bank's new assets are 100 units of treasury bonds purchased from commercial banks, and the new liabilities are 100 units of reserves deposited by commercial banks with the central bank.
Under the mode of treasury bond financing + open market operation, the assets and liabilities of commercial banks change, but the total amount remains unchanged. The 100 units of new treasury bonds issued by the Ministry of Finance were eventually held by the central bank by the bypass commercial banks. The central bank's new assets are 100 units of treasury bonds, and the new liabilities are 100 units of reserves. The central bank has expanded its balance sheet and the base money has increased. The pressure on the Treasury to raise interest rates from treasury bond financing was offset by open market operations. Since we assume that central banks operate in the open market because of illiquidity in the money market, commercial banks do not have large excess reserves. Therefore, the assets of commercial banks in Table 3 do not include excess reserves.
Figure 3 Changes in the balance sheet of each institution under treasury bond financing + open market operations
Source: Produced by the author
Note: The central bank deposit and the financial deposit are the same fund.
Scenario 2 monetary financing and scenario 3 "Treasury financing + open market operations" are, according to Bernanke, essentially the same. In his famous 2002 speech on helicopter money, he made it clear that "financing tax cuts through money creation is equivalent to Treasury financing plus the Fed's open market operations in the bond market." But the author believes that there are still certain differences between the two. Monetary financing increases fiscal deposits on central banks' balance sheets. The Ministry of Finance will "spend the money" in the shortest possible time, and the liquidity of fiscal deposits is very strong, which belongs to M0 or M1. However, as a result of "treasury bond financing + open market operations", the central bank's increased liabilities are reserves and base money. Reserves cannot be used directly for the purchase of goods and services. An increase in reserves means an increase in the lending capacity of commercial banks. However, in the absence of effective demand or deflation, the increase in reserves does not necessarily lead to an increase in broad money immediately and does not necessarily immediately create inflationary pressures because banks are reluctant to lend, and households and enterprises are reluctant to borrow.
It can be seen that quantitative easing, which is linked to deficit financing, is not the same thing as open market operations as a purely monetary policy tool, and it cannot be said that quantitative easing is nothing more than large-scale open market operations.
The experience and lessons of quantitative easing in the United States
After the subprime mortgage crisis, the US Federal Reserve not only bought Treasuries, but also private financial assets such as MBS (mortgage-backed loans). In the initial stage, the main purpose of quantitative easing was to stabilize the prices of financial assets such as MBS and prevent the collapse of financial asset prices that would lead to the bankruptcy of a large number of "systemic" financial institutions. Another important purpose of implementing quantitative easing is to lower the yield of government bonds, "drive" funds from the government bond market to the stock market, raise stock prices, and stimulate consumption and investment through the wealth effect generated by rising stock prices, thereby stabilizing economic growth. Quantitative easing as a means of fiscal financing occurred a little later in the subprime mortgage crisis. After financial markets stabilized substantially, the U.S. government's main policy objective shifted to stimulating economic growth and preventing a recession. The U.S. fiscal deficit rose to $1.4 trillion in 2009, up from $459 billion in 2008. At the same time that the US government is engaged in a large fiscal deficit and is issuing new Treasury bonds, the Federal Reserve has purchased a large number of Treasury bonds (including a considerable amount of existing Treasury bonds) from the open market, which has effectively curbed the rise in Treasury bond yields and eliminated the crowding out effect.
In the US experience, price growth has been significantly below the 2% inflation target over the past decade because the banking system is reluctant to lend and the money supply has not increased with the increase in reserves. When the economy was in a state of deflation, the Fed's balance sheet expansion and surge in reserves due to quantitative easing did not lead to inflation.
Overall, the Fed's quantitative easing policy has been very successful. However, any policy must be implemented at the right time and in a measured manner. In March 2020, due to the outbreak of the epidemic and the collapse of the stock market, the Fed expanded its balance sheet "frantically", and in a few months, the Fed's assets rose sharply from about $4 trillion to more than $8 trillion. At the same time, the U.S. government has dramatically widened its fiscal deficit. The U.S. fiscal deficit to GDP ratio rose to 15% in 2020 from 4.6% in 2019, leading Summers to denounce the U.S. government's unprecedented irresponsible fiscal policy.
Since 2021, U.S. inflation has been on the rise, reaching as high as 9.1% in June 2022, although to a large extent (especially before 2022) U.S. inflation was caused by supply-side shocks such as supply chain disruptions caused by the pandemic. But the Fed is also to blame for over-expanding its balance sheet. After more than 10 years of implementation, how to withdraw from quantitative easing is still a problem.
China's choice of the moment
In the previous section of this article, we have repeatedly tried to make it clear that monetary financing is not an impossibly impossible red line, and fiscal deficits are not absolutely impossible to monetize. We should not place too much trust in textbook rhetoric out of theoretical purity.
Similarly, we cannot argue that China should do the same just because the United States and other developed countries have engaged in monetary financing and monetization of fiscal deficits. Everything should be based on China's actual situation. All policy considerations should be based on the principle of "not only the top, not the book, but the truth".
As mentioned earlier, the Chinese government and academics have two main concerns about monetary financing: the loss of fiscal discipline after the monetization of deficits, which will eventually lead to the loss of credit of the government and the central bank, and the second concern that monetary financing may lead to increased inflationary pressures and further inflation of asset price bubbles.
These fears are justified. When the economy is operating normally, abiding by fiscal discipline is conducive to maintaining the credibility of the government and the central bank, and maintaining the public's confidence in fiat currency. However, in the period of economic contraction, if the failure to adopt countercyclical adjustment policies to curb the rapid economic downturn, the credibility of the government and the central bank will not be able to be discussed. At present, "insufficient aggregate demand is a prominent contradiction facing the current economic operation". Although the consumer price index (CPI) turned positive in February year-on-year, it is still necessary for the government to adopt expansionary fiscal and monetary policies to stimulate growth without worrying too much about rising inflation in the future.
According to the government work report, in 2024, the budget deficit will be 4.06 trillion yuan, and the broad fiscal deficit will be 11.1 trillion yuan. The central government has planned to issue 4.06 trillion yuan of general treasury bonds and 1 trillion yuan of ultra-long-term special treasury bonds, while local governments plan to issue 3.9 trillion yuan of special bonds. For a fiscal deficit of this magnitude, debt financing should be the first consideration. In fact, judging from the current situation, the public is still quite enthusiastic about buying government bonds, and it seems that there will be no problem of having to raise the interest rate of government bonds (or push up the yield of government bonds) in order to issue government bonds. However, according to our preliminary estimates, unless the government lowers its 5% growth target, the government will have to significantly increase support for infrastructure investment if consumption growth is not satisfactory, real estate investment growth continues to fall sharply, and net export growth is unlikely to provide significant support for growth. Under such circumstances, the government needs to significantly increase the issuance of government bonds, and the Ministry of Finance and the central bank need to strengthen cooperation and try to implement Chinese-style quantitative easing.
The main objective of fiscal policy is to make up for the shortfall in effective demand through an increase in government spending. The main direction of fiscal spending should be infrastructure investment. Second, fiscal spending can also be used to improve and increase the provision of public services and promote household consumption.
While fiscal policy takes the lead, the central bank must also increase the expansion of monetary policy. Expansionary monetary policy means cutting interest rates and increasing credit to businesses and households. By cutting interest rates and issuing additional credit, monetary authorities can directly stimulate consumption and investment demand. In this way, the pressure on the Ministry of Finance to increase the scale of treasury bond issuance in order to achieve the 5% growth rate target has been reduced.
Due to the problem of the incentive mechanism, commercial banks have a strong incentive to absorb deposits, and it may be difficult to further reduce the deposit interest rate. At present, the net interest margin of banks has fallen to about 1.7% under the breakeven level, coupled with the uncertainty of the Fed's interest rate cuts, although it is necessary for China to further cut interest rates, or even cut interest rates significantly, but due to various constraints at home and abroad, the central bank has been compressed to further reduce the policy interest rate. At the same time, due to the lack of high-quality loan projects, commercial banks still have the problem of difficulty in obtaining loans. Due to the lack of confidence, companies are reluctant to borrow rashly, even if the interest rate on loans is further reduced. For example, despite several RRR cuts, the excess reserves of Chinese commercial banks with the central bank remain at a high level. These phenomena show that in the case of quasi-deflation and liquidity traps, it is difficult for monetary policy to play the important role of stimulating effective demand and promoting economic growth alone.
In order to achieve the 5% GDP growth target, further expansion of fiscal policy and the issuance of additional government bonds to finance larger fiscal deficits may become the only option later this year.
Whether the issuance of up to 9 trillion yuan of treasury bonds and special bonds that have been included in the plan will lead to an increase in the yield of treasury bonds deserves great attention. Households are likely to maintain high savings rates due to concerns about the income outlook, and government bonds should be the safest vehicle for household savings. Medium- and long-term government bonds should be sold first and foremost to the general public. If the mainland central bank can actively cooperate with the issuance of treasury bonds, and at the same time or in advance lower the benchmark interest rate, lower the reserve ratio, and change the incentive mechanism for banks to "pull deposits", the strong demand for government bonds can keep the yield of government bonds low enough, and the government does not need to worry too much about the sustainability of government bonds. Due to the interest rate cut, the RMB exchange rate may come under depreciation pressure. As for the depreciation of the renminbi, it seems that the monetary authorities should not be too worried. Depreciation is a double-edged sword, and in a period of recession and low inflation, depreciation should do more good than harm to the overall economy.
It should be noted that even if we do not talk about supporting the expansionary fiscal policy of the Ministry of Finance, the central bank should further reduce the benchmark interest rate and reserve ratio, and further expand the issuance of credit. The expansionary monetary policy not only encourages residents to increase consumption and enterprises to increase investment, but also helps to prevent the liquidity of the real estate market from turning into a debt crisis, and prevents the partial debt crisis of real estate developers from turning into a full-scale debt crisis, and helps to reduce the debt burden of local governments.
In the past, due to the different structure of its assets and liabilities, the PBOC's open market operations were not primarily about buying and selling (or buying or outselling) government bonds, as the Fed did. For a considerable period of time, the PBOC mainly bought and sold central bank bills to hedge against changes in foreign exchange reserves, and after 2015, it mainly conducted open market operations through reverse repo, rediscounting, credit lending, and the provision of structured loans to regulate the liquidity of the money market, or carried out cash buyouts or buyouts for one-time injection and contraction of the base currency. It is worth noting that, although generally speaking, large state-owned commercial banks have abundant funds of their own, but the number of treasury bonds held is not large, and the proportion of treasury bonds and local government bonds in the total assets of banks is about 20%. On the one hand, China's commercial banks hold relatively few government bonds, and on the other hand, the central bank's claims on the central government (long-term special government bonds) are very limited. If China needs quantitative easing, the way the PBOC operates in the open market will inevitably be different from that of the United States, and it will inevitably have a different approach to monetary and capital markets. If China needs to implement quantitative easing, many technical details need to be studied.
If the issuance of government bonds is too large and there are signs of oversupply, the government should encourage commercial banks to buy and hold government bonds. Under normal circumstances, after satisfying the needs of credit business, commercial banks will allocate funds according to the net rate of return. Bonds held by banks include corporate bonds, general financial bonds, policy financial bonds, local government bonds and government bonds. Compared to other bonds, Treasury bonds do not yield well, but they are liquid and can be used as collateral to inject short-term funds from the central bank at any time. Commercial banks are motivated to hold a certain amount of government bonds, but that's about it.
If further Treasury bond issuance is needed, a rise in Treasury yields may be more inevitable. If, despite the easing of monetary policy, commercial banks are reluctant to buy more new and incremental government bonds, the yield curve will inevitably move upwards and have a restraining effect on economic growth. At this time, the Ministry of Finance may consider "targeted issuance" or other methods to sell treasury bonds to commercial banks. At the same time, the central bank has bought the treasury bonds that have completed the "one-day tour" in commercial banks through open market operations. The implementation of Chinese-style quantitative easing is actually the central bank assisting the Ministry of Finance in marketing government bonds. Open market operations at this point may not be directly related to monetary policy. The basic principle of treasury bond financing + open market operation is to keep the yield of treasury bonds as low as possible while issuing additional treasury bonds, so as to ensure that the yield of treasury bonds is lower than the nominal interest rate.
Some people may worry that the essentially fiscal deficit (monetary financing) financing method of government bond financing + open market operations will create asset price bubbles. The problem is that what we need to worry about at the moment is a double dip in the real estate market. If monetary financing can bring about an improvement in market sentiment, provide necessary liquidity for real estate companies, curb the over-fall of asset prices of real estate enterprises and enrich the capital of real estate enterprises, then monetary financing is the least bad choice. In order to avoid the transformation of real estate enterprises from a liquidity crisis into a debt crisis, which will lead to a systemic financial crisis, as a series of recent policies have guided, the government does need to exert efforts in the three directions of assets, liabilities and capital of real estate enterprises. The same is true for local government debt. These crisis prevention and mitigation measures require financial support. In this case, Chinese-style quantitative easing may become an option that should not be avoided. Needless to say, the role of quantitative easing in supporting the stock market is not to be repeated.
In short, in extraordinary times, the countercyclical adjustment of macroeconomic policy can consider adopting some unconventional policies, including monetary financing in the form of quantitative easing. At the same time, it should be noted that monetary financing is not without cost. This is evidenced by the worsening inflation in the United States after March 2021. Quankuan is more of a helplessness than a panacea. So far, China's first consideration should be the regular issuance of additional government bonds and open market operations aimed at increasing money market liquidity and lowering interest rates, but it should also be mentally and technically prepared to introduce Chinese-style quantitative easing if needed. Since we have no experience in implementing quantitative easing in the past, these preparations are now necessary.
Since the beginning of this year, after several RRR cuts and adjustments to money market interest rates, the short-term interest rate level of the market has dropped significantly, but the long-end interest rate has fallen relatively little, and has remained stable in the range of about 2.3%. Based on the previous monetary policy operation practice, it is difficult for short-term liquidity easing to quickly reduce the yield level of long-end bonds if the policy rate is not adjusted. If the PBOC implements Chinese-style quantitative easing and buys long-term treasury bonds in the secondary market, it can lower long-term yields and effectively reduce the financing cost of the real economy.
The implementation of quantitative easing, the purchase of treasury bonds and even other assets from commercial banks, will increase the excess reserves on the central bank's balance sheet and expand the scale of the base currency. However, as previously analyzed, in the case of increasing downward pressure on the economy, it is difficult to transmit the effect of the increase in base money to the real economy for a while. Therefore, we do not need to worry too much about increasing inflationary pressures for the time being. Of course, you should also be prepared to withdraw from the quantitative allowance at any time.
Chart 4 Treasury yields by maturity (%)
Source: Wind database
Due to a number of characteristics of China's economy, such as the fact that China's household savings rate is still quite high and the public demand for government bonds is still relatively strong, China may not be at the point where it needs to implement monetary financing or monetization of fiscal deficits. But we should not rule out the possibility of extraordinary measures in extraordinary times from the outset. "Development is the last word". Only by grasping economic growth as the core objective, formulating economic policies based on China's realities, and not being bound by all kinds of traditional concepts and dogmas, will we certainly be able to embark on a path of maintaining sustained economic growth in China and resolving various contradictions and problems in the process of growth.
(The author Yu Yongding is a member of the Faculty of the Chinese Academy of Social Sciences, and Zhang Yi is the general manager of the Research and Development Department of Hengtai Securities; editor: Zhang Wei)