connecting Central Banks to the market - MNI by xumiaomaio


Issue Number 51                                                      25th October 2011

…connecting Central Banks to the market

          See MNI Connect events schedule (by invitation only) – Page 2 (click here)
          For terms to subscribe to MNI Connect, contact:
          Kevin Woodfield +44 207 862 7400 or email for London
          Mike Connor +1 212 669 6400 or email for New York

         A mutli-dimensional chess game involving the Eurozone’s political leaders, the
         ECB, the IMF and the banks seems to be settling for a tougher burden share for
         bailing out Greece, from which it is hoped that other parts of the grand plan to
         avoid contagion risks among the debt-laden Eurozone peripheral members
         and the banks that service them will somehow fall into place via creative (but
         taxpayer-driven) financial architecture. Meantime the clock ticks and the
         costs rise inexorably, writers…
         Bernard Wolfson in Paris – Page 3 (click here)

         The BOE’s further tranche of QE may have surprised some with its timing and
         most with its larger size. But, coupled with the alarm bells clanging from
         Governor Mervyn King on down about a Eurozone-triggered return to
         financial-economic dislocation, watch out for an MPC pushing the deflation
         bogeyman to press still harder on the QE gas as it seeks to shore up UK-based
          banks, writes…
         David Thomas& David Robinson in London – Page 8 (click here)

          A majority on the FOMC remains firmly behind Ben Bernanke in emphasising
          the downside risks – even the deflationary threat – and that they are mandated
          to at least keep on trying to stimulate the economy. That mood is likely to point
          to more easing at some stage. The more immediate question is how to
          communicate a framework for Fed policymaking to make it clearer and, it is
         hoped, more effective, writes…
         Steve Beckner in Washington – Page 12 (click here)

         The BOJ’s policy board is set to downgrade its growth and inflation outlook
         through 2013 when it issues its next set of forecasts this week, and to stress
         downside risks at home and overseas. But indications that this could prompt
         yet more easing as the yen soars are confronted by doubts about the
         effectiveness of the central bank’s dwindling armoury, writes…
         Max Sato in Tokyo – Page 18 (click here)

         Beset by investor concerns about local government indebtedness and funding
         problems, Beijing has taken a modest step toward creating a municipal bond
         market. It’s only a pilot scheme, includes only a few areas and is subject to a
         centralised cap, but it is an important move, writes…
         David Wilder in Beijing – page 22 (click here)

                                                                Contact – Kevin Woodfield

    MNIConnect                                                             0207 862 7400
Page |2                                                    …connecting Central Banks to the market

   MNI Connect Policymaker Event Program: 2011

We are pleased to announce the current schedule of MNI Connect events for 2011. Attendance is by
personal invitation to MNI Connect subscribers (in EMEA for events in London; in North America for
events in New York); guests to be notified of precise venues:

Adam Posen, Bank of England Monetary Policy Committee member
Events:      MNI Connect Policymaker Luncheon
Date/Time:  12:30 pm to 2:00 pm, Wednesday, 2 November
Venue:       London

Christophe Frankel, CFO of the European Financial Stability Facility (EFSF)
Event:        MNI Connect Policymaker Brunch
Date/Time:    11:00 am to 12:30 pm, Thursday, 3 November
Venue:        London

José Manuel González-Páramo, Member of the Executive Board, European Central Bank
Event:      MNI Connect Policymaker Luncheon
Date/Time:  12:30 pm to 2:30pm, Friday, 25 November
Venue:      London

Bernard Wolfson, Chief ECB Correspondent, MNI
Event:       MNI Connect Customer Seminars on the ECB policy outlook
Date/Time:   November; precise dates to be confirmed
Venue:       MNI Connect subscriber offices in London

Giorgios Provopoulos, Bank of Greece Governor & ECB Governing Council member
Event:       MNI Connect Policymaker Luncheon
Date/Time:   21 October date postponed; new date to be confirmed
Venue:       London

Mike Connor                                               Kevin Woodfield
CEO                                                       European Managing Director
Market News International                                 Market News International

Tel.: +1 212 669 6400                                     Tel: +44 (0)20 7862 7400
Email:                             Email:
Page |3                                               …connecting Central Banks to the market

                             Paying the piper
By Bernard Wolfson, Chief ECB Correspondent

 There is one overriding question in this week of summit madness: will Europe's
 political class finally stand up and deliver, or will the sound and fury of recent
 days prove in the end to be merely July 21 redux?

The deal hammered out in July -- a new Greece bailout worth E109 billion, a 21% haircut
on privately held Greek bonds, and significant new powers for the Europe's bailout fund,
the EFSF -- was billed as a breakthrough that would finally tame the Eurozone debt crisis.
But the package unraveled in the days immediately following the July 21 EU summit and
then imploded spectacularly in August, as markets saw that governments and banks
were not implementing the promised measures, which were insufficient anyway.

Here we are three months later, caught in a dizzying flurry of summits and high level
financial meetings. Presidents, prime ministers and other senior officials are once again
promising the mother of all anti-crisis packages. The new big deal was supposed to be
sealed over the weekend, then the Eurozone's date with destiny was postponed until
Wednesday because agreements on key aspects of the plan proved elusive.Germany's
                                                    Chancellor Angela Merkel needed time
                                                    for the Bundestag's Budget
 ”Because of the political                          Committee to sign off on any
                                                    proposed changes to the EFSF, as
 dithering since July, the                          required by German law.

                                                     Because of the political dithering
 price tag for rescuing                              since July, the price tag for rescuing
                                                     Greece has mushroomed. A report
 Greece has mushroomed.”                             last week by Greece's international
                                                     creditors showed that a new EU-IMF
                                                     bailout for Athens would now require
public funds of E252 billion if the banks holding sovereign Greek bonds stick with the
original plan for a 21% haircut.

Conversely, it would take a haircut of between 50% and 60% to hold the line on public –
ie. taxpayer -- funding, the report said. Even with a haircut of 50%, which now appears
to be the focus of negotiations between banks and political officials, the public sector
bailout bill would still rise to about E138 billion from the E109 billion pledged in July, a
senior EU source told Market News International.


Eurozone leaders have been twisting the arms of bankers behind the scenes, and the EU
source said the banks now appear prepared to compromise around a figure of 50% --
two and a half times the writeoff that was envisioned in July. The arm twisting has been
hard, but it is not one-way. Banks want assurances in return, particularly on concrete
steps that will return Greece to economic growth.

The deal is far from concluded, since even once the outlines of a plan are agreed,
individual banks will presumably need to evaluate it and decide, on an individual basis,
whether to sign onto it. The reluctance of banks following the July 21 haircut agreement
Page |4                                              …connecting Central Banks to the market

became a major obstacle to implementation of that plan. And clearly, with the massive
increase in the magnitude of the losses banks are being asked to absorb this time
around, the stakes have risen considerably. Indeed, the optimism of the EU official cited
above may represent wishful thinking -- or else certainty that the governments will get
their 50% whether the private sector investors want it or not.

Despite official insistence that any private sector contribution must still be voluntary –
given fears of a credit event that could trigger heavy credit default swap losses -
Eurozone politicians seem willing to make the haircuts virtually mandatory if necessary.
Germany in particular, but also Finland and the Netherlands, have reached the political
limits of what taxpayers will bear to bail out Greece. According to the same EU source,
Eurozone leaders gave bankers in Brussels this weekend a "take it or leave it" message,
implying that they would force the bigger haircut on them if need be.

While the apparent coalescence around a
specific haircut percentage might seem       ”While the apparent
like progress, there is a danger of
backlash from banks and financial
                                             coalescence around a
The Institute of International Finance, a    specific haircut
global banking group that is representing
the banks in the haircut negotiations,
fired a shot across the bow late Monday
                                             percentage might seem
in Brussels.
"There are limits to what could be           like progress, there is a
considered as voluntary to the investor
base     and     to   broader     market
participants," IIF head Charles Dallara
                                             danger of backlash
                                             from banks and
"Any approach that is not based on
cooperative discussions and involves
unilateral actions would be tantamount
                                             financial markets.”
to default, would isolate the Greek
economy from international capital markets for many years, and would impose a harsh
burden on the Greek people as well as European taxpayers who have already done a lot
to support Greece," Dallara added. "It would also likely have severe contagion effects,
which would cost the European and the world economy dearly in terms of employment
and growth."

In a research note also published on Monday, the Royal Bank of Scotland cautioned that:
"a large haircut for Greece, and potentially not even the last one, will set a very bad
precedent for expectations vis-a-vis other sovereigns."


The still-unfinished debt write off deal with the banks is only one of three major
components of the crisis that leaders are seeking to address. They are seeking to agree
on a recapitalization plan for Europe's banks to innoculate them against the potential
fallout from a Greek default. And they are still wrangling over how best to optimize the
limited funding of the EFSF, which at E440 billion is, according to Germany, immutable

In another sign of progress over the weekend, EU leaders said they had drafted the
broad outlines of a bank recapitalization agreement. It would require European banks to
achieve the Basel III tier 1 capital ratio requirement of 9% by mid-2012, about seven
years earlier than envisioned in the Basel III agreement itself. That would require about
E108 billion in new capital, which leaders said should come first from private sources,
then from the government, and only as a last resort from the EFSF.
Page |5                                                 …connecting Central Banks to the market

Officials also announced that they had narrowed the list of EFSF leveraging options to
two: (1) the use of the bailout fund to insure newly issued sovereign bonds up to a
certain percentage; and (2) the creation of a special purpose vehicle -- with EFSF funds
supplemented by financing from the IMF, other public agencies and private sources -- in
order to buy sovereign debt in the secondary market, thus taking over or supplementing
the interventions currently being made solely by the European Central Bank.

Officials also said that a proposal to issue the EFSF a bank license so it could borrow from
the ECB has been ruled out. If that decision holds, it would represent a victory for
Germany and a retreat for France, which pushed the ECB-based solution in the face of
stiff resistance from Berlin and from the central bank itself.

But like the debt write off talks with private sector creditors, significant sticking points
remain both on the subject of leveraging the EFSF and recapitalizing the banks. If
Eurozone leaders are to unveil a detailed, definitive response to the crisis by this
Wednesday, their underlings certainly have their work cut out for them.

All the elements of the plan in progress are deeply intertwined. An increased haircut on
Greek debt, especially of the magnitude being considered, could lead to big problems at
banks, which are already under pressure in equity markets, significantly raising the bar
for them to acquire new capital on their own. According to the recapitalization plan on
the table, the banks' next port of call would be governments. But many governments are
                                                     struggling to contain burgeoning
                                                     deficits and debt, and this is
  “All elements of the plan                          particularly true in the Eurozone's
                                                     periphery, where much of the need
                                                     for fresh bank capital is likely to be
  in progress are deeply                             concentrated.

  intertwined.”                                       That leaves the EFSF. But it is far
                                                      from clear that the two leveraging
                                                      plans on the table -- even in
combination, which is an increasingly likely possibility -- would be sufficient to allow the
bailout fund to recapitalize banks while simultaneously adopting the ECB's bond buying
role, providing pre-cautionary financing to countries like Spain and Italy, and remaining
on call for possible future bailouts.


The idea of a special purpose vehicle (SPV) attached to the EFSF could provide some
relief in bond markets. But with only E440 billion and so many other potential
responsibilities, it is hard to see how the EFSF could put up a very large chunk of seed
money compared with what the ECB can deploy. And it is difficult to know whether
private investors or other public agencies would rush in to fill the empty space.

One ray of hope is that the IMF would be prepared to invest in such a scheme, which
explains why EMU leaders issued a call at their Sunday summit to bolster the Fund's
financial resources. Even so, the rules governing EFSF operations -- including the
German law requiring a Bundestag signoff for material actions of the fund -- are slow and
cumbersome. They could make it difficult for the EFSF to work smoothly and efficiently,
especially when intervening in bond markets. As for an IMF role, that too involves tricky
issues about flexibility and conditionality.

The idea of an EFSF guarantee, or "first loss," on newly-issued sovereign bonds could be
even more problematic than the SPV idea, because it would put the Eurozone
governments that backstop the bailout fund directly on the hook for an amount that
some sources say could be as much as of 20% of new debt purchased. Such a potential
liability could put additional stress on the triple-A countries, whose top rating is what
allows the EFSF to maintain its own.
Page |6                                               …connecting Central Banks to the market

This could be particularly problematic for France, which is already under the threat of a
downgrade and was forced this week to reveal that it would introduce additional austerity
measures in the near future. Should the EFSF's rating be tainted by a downgrade of
France or any other triple-A member, its guarantees on sovereign bonds would quickly
lose value. The idea could also run into legal problems, because guarantees on new
bonds would create a two-tier market vis-a-vis old securities that don't carry such an
advantage for investors.

It is entirely possible, should the leaders announce on Wednesday something similar to
the details already unveiled over the weekend, that markets will revolt. One quick and
reliable test of how the plan is being received will be whether private investors pile back
into Italian bonds after the announcement. Jitters about the lack of progress towards a
crisis solution sent investors fleeing last week, pushing Italian yields up sharply to the
red-alert level of 6%.


It is clear that as the Eurozone enters the treacherous waters of a possible endgame to
the EMU crisis, the ECB will be forced to cling to its uncoveted role as firewall against a
financial meltdown. As incoming ECB President Mario Draghi takes over the reins from
current ECB President Jean-Claude Trichet on November 1, he will be likely to preside
over ongoing bond market interventions, even as he comes under pressure -- largely
because of his Italian nationality -- to prove his Bundesbank-like anti-inflation

And as the economic picture in the Eurozone darkens, Draghi might also need to
contemplate a cut in official interest rates sooner than would otherwise suit his political
purposes. Indeed, recent indicators show
the Eurozone economy clearly sliding
towards, or perhaps already into, another         ”…as the economic

The Eurozone's October Purchasing
                                                  picture in the
Managing Index made for grim reading, as
the composite index lurched further into          Eurozone darkens,
recession territory, with declines in both
manufacturing and services and both sectors
below the 50-mark that separates expansion
                                                  Draghi might…need to
from contraction.
                                                  contemplate a cut in
France, the Eurozone's second largest
economy, tumbled into the recession zone,
with the composite index hitting a 29-month       official interest rates
low. Germany, the Eurozone's largest
economy, fared better, clinging tenaciously
to the expansion side of the line, but just
                                                  sooner than would
barely. Its manufacturing sector contracted,
with a PMI reading below 50 -- a 27-month         otherwise suit his
low. Other indicators show confidence and
demand slumping, and output likely to fall in
the fourth quarter.
                                                  political purposes.”
With the economy obviously skidding and price pressures on the wane, it is likely the ECB
will come under renewed pressure to consider a rate cut. It has the room, since it hiked
rates two times earlier this year by a total of 50 basis points, and its key policy rate is
now 1.5%, well above other major central banks. At the ECB's monetary policy meeting
earlier this month, a significant minority argued for a rate cut, although they did not
carry the debate. Their voices will be emboldened now.
Page |7                                             …connecting Central Banks to the market

As Mario Draghi embarks on his eight-year journey on stormy financial seas, it is clear
that the ECB is very far from a safe port.

Bernard Wolfson
Page |8                                               …connecting Central Banks to the market

                          Underwriting inflation
By David Thomas, Chief BOE Correspondent

The decision earlier this month of the Bank of England's Monetary Policy
Committee to launch an additional stg75bn of QE surprised markets both on the
timing and on the size.

Last week's publication of the minutes for the October MPC meeting also revealed that
the committee had indeed been unanimous, underlining that this was emergency action
taken to stave off the worst effects of a fast-intensifying financial crisis as well as its
economic ramifications.

Even so, the committee’s minutes have been careful to embed its QE2 narrative in the
context of a constitutional mandate to keep inflation at 2%. This posed some tricky -
almost tortuous - communications issues, given that inflation is presently over 5%. MPC
members argued that there was a real risk of inflation falling below target and persisting
there without further monetary loosening in the form of QE. Critics might be hard
pressed to recall when this has ever happened, at least in the recent past. The QE
gainsayers would add that UK QE1, and US QE1 and QE2 via higher commodity import
prices, bear much of the blame for the present inflationary overshoot.


But the MPC made clear during its response to the 2007-08 crisis that when faced with
the strong threat of deflation versus inflation, it does not regard these as symmetric
risks. Tipping into the former trap would leave the BOE rudderless whereas a bout of too-
high inflation can always be post facto attacked by much tighter policy - however painful
that might be.

The minutes justified the drastic action by an almost Damocletian sense of doom. The
debate on the timing of QE2 makes
this crystal clear. Not for the first
time in seeking to assess a BOE           ”…the MPC made clear
policy response, we can revert to
Macbeth: 'If it were done when 'tis
done, then t'were well it were done
                                          during its response to the
                                          2007-08 crisis that when
In the more prosaic language of the
MPC’s latest set of minutes: "In
terms of the timing of further asset      faced with the strong
purchases,      there    were   clear
arguments for acting quickly and
decisively now that the need for
                                          threat of deflation versus
further    monetary    stimulus  had
become      clear.   The   Committee      inflation, it does not
recognised that there could be some
benefit in delaying a policy change
until     November,      when     the
                                          regard these as symmetric
background could be explained in
more detail in the Inflation Report.      risks.”
Page |9                                             …connecting Central Banks to the market

But, on balance, any advantage to delay was thought insufficient to outweigh the
arguments for acting immediately.”

Showing its hand with QE2 of stg75bn shows that the BOE believes that it is certainly not
yet without tools to combat some of the risks out there. But while the committee remains
convinced that QE still works, what an effective scale of asset purchases might be is far
from certain. Given the BOE's asymmetric assessment of the risks, this inability to
calibrate the precise dosage of additional QE means that the committee had to err on the
generous side. And given the seriousness of the threat from the Eurozone - it may well
find itself erring in the same direction again.

The MPC's newest member Ben Broadbent commented on BBC Radio Lancashire on
October 19 that QE is not a precise science, saying it was: "designed to increase the
amount of money circulating in the economy and to raise some asset prices and thereby
raise spending and demand, and I am confident it will have some impact." Barely
reassuring even if he was doing his best. If the tone was scarcely reassuring, Broadbent
perhaps revealed why when he later told the Financial Times that no amount of 'money
printing' (reserve creation) would help save the UK economy if the Eurozone crisis were
to get much worse.


The October minutes too showed the committee thinking in expansive if vague terms:
"The scale of the downward reassessment of the medium-term inflation outlook
suggested that substantial further asset purchases were appropriate. In terms of the
immediate decision, the Committee considered a range of asset purchases of between
stg50 billion and stg100 billion. Committee members agreed that differences in the
impact of asset purchases within this range were, in current conditions, likely to be
                                         outweighed by the degree of uncertainty about
                                         the outlook for inflation. Moreover, the size of
 ”…reading between                       the asset purchase programme would be kept
                                         under review in the light of subsequent analysis
 the lines (of the                       and events".

                                         That sounds neutral but reading between the
 BOE’s October                           lines makes it clear that the risks to QE go just
                                         one way - of doing more not less:"Depending on
 minutes) makes it                       developments in the euro area and financial
                                         markets, the size of the stimulus could be
                                         adjusted in either direction. For some members,
 clear that the risks                    the substantial downside risks pointed to
                                         injecting a larger monetary stimulus than
 to QE go just one                       otherwise in order to place the UK economy in a
                                         stronger position were those risks to
 way – of doing
                                          The use of the word “some” provides real food
 more not less.”                          for thought. First, who precisely would have
                                          joined QE-enthusiast Posen (we can guess that
                                          he at least was upping the ante by pushing for
stg100bn already) in seeking more than stg75bn of asset purchases? BOE Executive
Director Markets Paul Fisher has been reckoned a QE true believer while Governor
Mervyn King himself has generally been on the dovish end of the MPC policy spectrum
through the crisis. David Miles has also dissented from the rest of the Committee in the
past in favour of doing more QE.

Posen must now feel himself on a roll, with the debate having swung so squarely behind
his long-advocated position of more asset purchases and the Treasury looking at some of
his other ideas for so-called credit easing. While other MPC members did their utmost to
P a g e | 10                                          …connecting Central Banks to the market

dress up the decision in drab inflation
targeting mufti - it is interesting that Posen
framed the move in much more dramatic
                                                    ”Any further bad

"It's (QE is) really just trying to do the normal
                                                    news on the euro
monetary policy job when rates are really
zero per cent and the banking industry is in a      front and the signs
mess," Posen said in remarks reported 30
October in the Blackpool Gazette. "The whole
committee came around to the idea - when
                                                    are that we could get
inflation is too low and growth is too low we
need to act. We're looking five years ahead         to stg100bn of QE
and trying to make the right decisions."

Posen is certainly a man who is pushing the
                                                    before February.”
envelope - the committee generally considers
itself to be setting a policy which will help it meet the inflation target in the medium term
- generally defined as 18 months-to-two-years ahead. And he is certainly telling it like it
is when he says we are here because the banking system is in a mess. "Things are
moving that fast in a downward direction that we have to be one step ahead in terms of
policy," Posen went on to tell the local newspaper.

"While the worst risks had not crystallised, the threat of them doing so had resulted in
severe strains in bank funding markets and financial markets more generally. These
tensions in the world economy appeared to have already affected consumer and business
confidence and could result in a further tightening of credit conditions, posing a threat to
the recovery in the United Kingdom," he continued.


Any further bad news on the euro front and the signs are that we could get to stg100bn
of QE before February. Even should the situation remain just as bad as it presently is -
an optimistic view - the MPC looks like having to at least signal an extension of QE ahead
of the February MPC meeting just to ensure markets don't start speculating that the
programme will end at stg75bn.

The CPI forecast in next month's BOE Inflation Report (based on 0.5% Bank Rate and
combined stg275bn of QE) ought to give some clue as to the scope for an extension of
QE in the coming months.

The latest comments from MPC members show most of them already resorting to what
central bankers like to term 'the reassurance channel'. Put simply, the worst could be
very bad indeed. At time of going to press on this article the outcome of the EU Summit
on Wednesday is unclear as the protracted preamble points to a nasty game of hardball.

France is pushing for a European Financial Stability Facility which will be able to draw on
ECB leverage to bolster the capital of its own banks. If France has to find the money
itself a downgrade surely beckons, but such a use of the ECB is as yet fiercely opposed
by Germany and the Netherlands. And with the European Banking Authority pushing for a
significant rise in capital at all systematically important EU banks, the UK may well face
some of these problems itself and even tougher funding constraints.


Talk from UK politicians that UK banks are sufficiently well-padded with capital and/or
immune to the spreading crisis should be taken with a heavy pinch of salt. The talk is
that Greece has E80bn of CDSs out there and no-one knows where that risk lies.
P a g e | 11                                         …connecting Central Banks to the market

                                                 It is small wonder then that King
  ”The governor made it                          launched another jeremiad in Liverpool
                                                 on Tuesday night (October 18) in which
                                                 he warned that an already tentative UK
  clear that the crisis in                       recovery had been derailed by the
                                                 Eurozone crisis. The governor made it
                                                 clear that the crisis in the wholesale
  the wholesale funding                          funding markets heavily influenced the
                                                 QE2 decision. Funding for many banks
  markets heavily                                had dried up over the summer and EU-
                                                 based bank share prices were around
                                                 35% lower today than at the start of
  influenced the QE2                             July, he noted.

  decision.”                                        But while "a transparent recognition of
                                                    losses and a substantial injection of
                                                    additional capital are necessary to
restore market confidence," King also sought to warn that this is no free lunch and raises
"difficult political questions about the capacity of the weaker sovereigns to pay for any
recapitalisation of their banks." The provision of liquidity measures by central banks and
official lending by governments could only "buy time", he said, for more coherent
solutions to the underlying problems of solvency of banks and sovereigns to be put in

"But easy monetary policy, by bringing forward spending from the future to the present,
means that the ultimate adjustment of borrowing and spending will be even greater. That
is our dilemma and that of other deficit countries".

The closer we get to it - the wider and deeper this abyss looks.

David Thomas
P a g e | 12                                         …connecting Central Banks to the market

                      Spooked by the downside
By Steven K. Beckner, Chief Fed Correspondent

 Unless the U.S. economy puts on an unexpected surge, it may not take long,
 and it may not take much, to convince Federal Reserve policy-makers that they
 need to do still more to boost a struggling U.S. economy and to bring down
 stubbornly high unemployment.

The Nov. 1-2 meeting of the Fed's policy-making Federal Open Market Committee is
probably too soon to expect anything dramatic, though. Indeed, whether or not
monetary policy can accomplish those objectives is a matter of intense debate within the
Federal Reserve system.

Having long since run out of room to cut short-term interest rates, the Fed has shown it
can bring down long-term rates. The Fed contends that large-scale asset purchases
reduce bond yields roughly 20 basis points, which it says is equivalent to a 50 basis point
reduction in the federal funds rate.

After the FOMC, on Sept. 21, announced $400 billion of long-term Treasury security
purchases, financed by sale of short-term securities in its portfolio, yields did indeed
plunge. But it's hard to say how much lasting effect the "maturity extension program"
really had, given all of the other things affecting the market. The 10-year Treasury note
yield fell from roughly 1.95% before the FOMC announced so-called "Operation Twist" to
as low as low as 1.71% in ensuing days. But it has since bounced back to 2.20% or

Its proponents would contend that rates would be higher if not for Operation Twist.
But even conceding that the Fed can, indeed, lower long-term rates through asset
purchases, there is not a lot of evidence that they are having much real economic

There again, defenders of asset purchases would argue that things would have been
worse otherwise. Even some of those who opposed Operation Twist and who have said
they would be against unsterilized asset purchases (financed by creation of new money)
would agree that QE2 was justified when it was launched. But now is a different story.
Opponents say that further easing steps are not justified and will not be effective;
indeed, they could be counterproductive.


All three Federal Reserve Bank presidents who dissented on Sept. 21, were vocal last

Philadelphia Federal Reserve Bank President Charles Plosser told me that "even if
(Operation Twist) worked as promised, I didn't think the effect would be very big."
Plosser said it is impossible to know whether rates are lower than they otherwise would
be thanks to the Fed's bond buying. Although Operation Twist's advocates thought the
yield impact would be as much as 20 basis points, he pointed out that: "the daily
standard deviation of bond yields is 10 basis points, so we're talking about having effects
that are just swamped over time by other factors ...."
P a g e | 13                                         …connecting Central Banks to the market

What's more, "even if we believed the effect
was going be 20 basis points and that turned       ”Dallas Fed President
out to be true ... the effect (on consumer and
business borrowing rates) is much less than
that," Plosser said, so "it's hard for me to       Richard Fisher
believe it's going to have much impetus to
business borrowing, consumer spending or
                                                   declared that the Fed
Dallas Fed President Richard Fisher declared       is “exhausting the
that the Fed is "exhausting the limits of
prudent monetary policy. The programs
popularly known as QE2 and Operation Twist
                                                   limits of prudent
are, to my way of thinking, of doubtful efficacy
.... (E)ven if you believe ... that the benefits ofmonetary policy…”
QE2 and Operation Twist outweigh their costs,
you would be hard-pressed to now say that still more liquidity, or more fuel, is called for
given the $1.5 trillion in excess bank reserves and the substantial liquid holdings
businesses are hoarding above their normal working-capital needs."

The real key to stronger growth and lower unemployment in the view of Fisher, among
others, is to address fiscal and regulatory impediments to recovery: "At this juncture, I
think it sufficient to say that, assuming the people we elect to tax us and spend our
money and create the rules and regulations that govern our economic behavior can get
their act together, confront their own denial of most rudimentary budgetary discipline,
learn to shoot straight and remove the Damocles Sword of uncertainty that they have for
too long wielded over our job-creating private sector, there is plenty of potential for
confidence to be bolstered and propel the economy forward at an accelerating clip."


Minneapolis Federal Reserve Bank President Narayana Kocherlakota, argued that the Fed
should be tightening policy, not loosening it, and charged that the FOMC has changed the
rules of the game in an invidious manner. Given the drop in unemployment and rise in
inflation that has taken place since QE2 was launched last November, "the Committee
should have lowered the level of monetary accommodation over the course of the year.
Instead, the Committee chose to raise the level of monetary accommodation," he said.

"The Committee's actions in the last two meetings are thus inconsistent with the
evolution of the economy in 2011," said Kocherlakota, who left no doubt that he will
dissent again if Fed Chairman Ben Bernanke seeks another round of quantitative easing
or other stimulative actions.

Kocherlakota charged that the FOMC is changing the way it makes the trade-off between
reducing unemployment and increasing inflation risks: "The FOMC's actions in 2011
suggest that the Committee is resolving this key benefit-cost trade-off differently in 2011
from however it viewed the trade-off in 2010. In particular, it appears that the
Committee is now more tolerant of the risk of higher-than-2-percent inflation than it was
in 2010."

Kocherlakota also alleged that the FOMC is changing its short-term/long-term monetary
policy calculus. If Fed easing to reduce unemployment in the short-term drives up
inflation expectations and in turn inflation itself, the Fed would eventually be forced to
tighten in a way that would increase unemployment in the long term, he warned. But
"the FOMC's actions in 2011 suggest that it is resolving this trade-off differently from
however it viewed the trade-off in 2010...(I)t appears that the Committee has reduced
the weight that it is putting on the long term and increased the weight that it is putting
on the short term."
P a g e | 14                                          …connecting Central Banks to the market

But the FOMC majority just doesn't see it that way. Bernanke and most of his fellow
policy-makers, while acknowledging that monetary policy is "not a panacea" and that the
Fed needs help from fiscal and regulatory authorities, would not concede the point that
further easing will be ineffective.


But for them the question of efficacy is almost moot. The Fed has a dual mandate to
pursue maximum employment and price stability, and that's all that matters. It must at
least try to reduce unemployment and resist disinflation if it threatens to become

That point of view was put forth by Fed Governor Daniel Tarullo last week. While better
government policies in non-monetary areas could help, he said "the absence of such
policies cannot be an excuse for the Federal Reserve to ignore its own statutory

"The Federal Reserve Act requires that the FOMC promote the goals of maximum
employment and stable prices," Tarullo said. "The statute does not qualify that mandate
by saying that we should promote these goals only if all parts of the government -- or,
for that matter, the private sector -- are acting just the way we think they should. In
other words, we have to take the world as we find it and adjust our actions accordingly,"
he added.

Tarullo conceded that "neither monetary nor fiscal policy will be able to fill the whole
aggregate demand shortfall quickly," but said "appropriate policies could surely boost
output and employment."

And so, while there is a hard core of opposition to further monetary stimulus, others are
in varying stages of readiness to do more.

Chicago Fed President Charles Evans, an FOMC voter, has made it abundantly clear that
he thinks the Fed should ease more aggressively. Fed Vice Chairman Janet Yellen warned
last week of "significant downside risks" and said the FOMC is "prepared to employ our
tools as appropriate to foster a stronger economic recovery in a context of price

                                          Tarullo was more blunt. He said "there is need,
  ”…while there is a                      and ample room, for additional measures to
                                          increase aggregate demand in the near to
                                          medium term, particularly in light of the limited
  hard core of                            upside risks to inflation over the medium
  opposition to                           Like other advocates of more easing, Tarullo
                                          rejects the argument that much joblessness is
  further monetary                        "structural" and hence not responsive to
                                          monetary stimulus. He maintains that the
                                          problem is a shortfall of aggregate demand
  stimulus, others are                    which the Fed can and must address.

  in varying stages of                    "The fact that these (unemployment) problems
                                          cannot be solved quickly does not mean there is
                                          nothing to be done," Tarullo said. "Without more
  readiness to do                         (Fed easing), the harm to the unemployed and
                                          their families continues, and the risks of longer-
  more.”                                  term harm increase -- both to the unemployed
                                          and to the country as a whole ...."
P a g e | 15                                          …connecting Central Banks to the market

Not only would Tarullo favor QE3, he argued for a particular kind of QE. "I believe we
should move back up toward the top of the list of options the large-scale purchase of
additional mortgage-backed securities (MBS) ...."

Rejecting arguments by some of his colleagues that buying MBS amounts to "credit
allocation," Tarullo argued that the Fed could have more impact by purchasing MBS to
narrow MBS-Treasury yield spreads and lower mortgage rates than by just buying
Treasuries in any future large-scale asset purchase program. One can hear these kinds of
comments echoed privately and at high levels.


How much more the FOMC ultimately ends up doing depends on economic and financial
conditions, including inflationary trends. It also depends on the definition of "more." Does
"more" mean a third round of quantitative easing, or does it just mean some further
tinkering with the FOMC's communications strategy -- its "forward guidance?"

Some would be prepared to act if the economy does not improve from where it is now --
or if it fails to meet what are likely to be the downwardly-revised economic projections
that the FOMC will produce at the Nov. 1-2 meeting. Thus, Tarullo said: "in the absence
of favorable developments in the coming months, there will be a strong case for
additional measures."

Others    would    want   to   see    some       ”…(Fed Governor
deterioration in the economy and the
economic outlook, including the outlook for
"price stability."
                                                 Daniel) Tarullo argued
It's important to understand what is meant       that the Fed could
by that last phrase. When officials like
Yellen talk about wanting to "foster a
stronger economic recovery in a context of
                                                 have more impact by
price stability," they are not just talking
about the need for the Fed to avoid              purchasing MBS…One
increasing inflation as it injects stimulus.
They are talking about the need to keep the
inflation rate from falling too much relative    can hear these kind of
to the Fed's implicit target range of 1.7 to
2.0%.                                            comments echoed
To back QE3, some policy-makers would
want to be able to point to, if not a rise in    privately and at high
unemployment, then a heightened risk of
excessive disinflation, raising the spectre of
But it might not be hard to convince some key officials of a deflationary threat. I can tell
you that some already see it on the horizon.

Bernanke and his lieutenants would want to be able to point to clear evidence that
inflation is not only receding, as the FOMC has been predicting all year, but that it is
lessening at a worrisome pace. It's not clear that they can make a strong case just yet.
But I suspect we'll be hearing more and more about disinflation and/or deflation on the
road to additional easing.

It's probably too early to expect anything as dramatic as QE3 from the FOMC, although it
is the only real policy option for providing significant stimulus. Operation Twist was
essentially a one-shot deal because of the limited supply of short-term Treasuries in the
Fed's portfolio.
P a g e | 16                                         …connecting Central Banks to the market

                                     Cutting the rate of interest on excess reserves is an
 ”The next most                      option which Bernanke has mentioned from time to
                                     time, but few think it would accomplish very much,
                                     and there is mounting concern among Fed officials
 likely FOMC                         that it could do more harm than good.

 action is some                      The next most likely FOMC action is some further
                                     tinkering with its ‘forward guidance.’

 further tinkering                   At the Aug. 9 meeting, the FOMC stopped saying it
                                     expected to keep the federal funds rate near zero
 with its ‘forward                   "for an extended period" and instead said it
                                     "currently anticipates that economic conditions --
                                     including low rates of resource utilization and a
 guidance.’”                         subdued outlook for inflation over the medium run --
                                     are likely to warrant exceptionally low levels for the
federal funds rate at least through mid-2013." But this may well prove to be just an
interim step toward a more statistically precise delineation of the period of low rates.

The change was seen as a form of easing. The somewhat controversial idea is that by
advertising an intention to hold rates "exceptionally low" for a long period, market
uncertainty about when the Fed would tighten credit would be removed and expectations
that the Fed won't allow excessive disinflation would be cemented. But few are really
happy with the current formulation and want to see "more clarity" in FOMC

Atlanta Fed President Dennis Lockhart told me recently the forward guidance needs to be
more "state contingent," rather than "date contingent," arguing that "a date-specific
forward guidance statement is sort of a depleting accommodative posture as the date
approaches ...."

As I've reported before, Yellen is chairing a task force on improving communication,
which includes both Evans and Plosser. Last week, Yellen broached some possible

"One potentially promising way to clarify the dependence of policy on economic
conditions would be for the FOMC to frame the forward guidance in terms of specific
numerical thresholds for unemployment and inflation," she said, endorsing an approach
which Evans had made. Evans has proposed that the FOMC spell out a commitment to
keeping the funds rate near zero "until either the unemployment rate goes below 7% or
the outlook for inflation over the medium term goes above 3%."

Yellen said: "such an approach could be helpful in facilitating public understanding of how
various possible shifts in the economic outlook would be likely to affect the anticipated
timing of policy firming."

"For example, if there were a further downward revision of the economic outlook,
investors would recognize that the conditions for policy firming would not be reached
until a later date and hence would have a more concrete basis for extending the time
period during which they expect the federal funds rate to remain near zero," Yellen


The basic idea seems to have broad support. For example, Kocherlakota told me and
other reporters last Friday that Evans has put forth "a good framework," even though the
two have very different views about the direction monetary policy should take.
P a g e | 17                                        …connecting Central Banks to the market

The FOMC needs to put forth an "objective function that weights inflation versus
unemployment" and defines "what's our goal ... what are we trying to do here?"
Kocherlakota told us. "When rates are as low as they are an important part of
(communication is saying) how long rates will be at zero .... How long the public expects
them to be low is very important ...." But he said "more clarity" is needed on the
parameters for holding rates near zero.

Plosser told me that he too is amenable to changing the forward guidance, but was wary
of the Evans approach. Rather than just announcing some level of unemployment and/or
inflation at which the Fed would begin withdrawing accommodation, Plosser favors
providing some "systematic," "rule-based" framework that gives guidance as to how the
Fed will adjust interest rates on an on-going basis in response to the evolution in
economic conditions.

For instance, he would favor communicating to markets and the public that the Fed will
raise rates based perhaps on how unemployment, GDP growth, inflation or inflation
expectations, move within some rule-based framework -- possibly a kind of "Taylor
Rule." So, for example, if and when
the unemployment rate falls by a
certain amount relative to the Fed's     ”Regardless of the
longer-term projection and/or when
the inflation rate rises above the
Fed's long-term, implicit target the
                                         motivation, the FOMC
Fed would raise the funds rate.
                                         seems to be headed
Plosser said one reason he dissented
in August was that "we (the FOMC)
created something that seemed to
                                         toward some sort of
be more dependent on the calendar
and less dependent on economic           ‘trigger’ system, but it
conditions." But Plosser said: "I
don't think the trigger strategy of
just using two points on a Phillips      won’t be easy to reach a
Curve is a particularly useful way of
describing our behavior. I think
there are better ways to do that ...."
And Plosser objected to using communication strategy as just another easing tool. "If
someone were to say that 'I already believe that I want to keep rates lower longer, and I
just have to figure out a way to convince people that's what I want to do ... that's the
wrong way to conduct policy ...," he said. Those "who want a different set of
communication strategies and frameworks so we can rationalize keeping rates lower
longer" have it "backwards ...."

Regardless of the motivation, the FOMC seems to be headed toward some sort of ‘trigger’
system, but it won't be easy to reach a consensus. Kocherlakota told us he "would be
surprised" if it is announced on Nov. 2 when the FOMC makes its policy announcement
and Bernanke gives his quarterly press conference.

Needless to say, that press conference, which will take place after the FOMC's revised
quarterly, three-year forecasts have been released, will give Bernanke an opportunity to
communicate where he will lead U.S. monetary policy.

Steven K. Beckner
P a g e | 18                                         …connecting Central Banks to the market

                                Slipping back

By Max Sato, Tokyo Bureau Chief

This week Bank of Japan policy-makers will renew their pledge to fight stubborn
deflation while clinging to their conviction that Japan's export-led economic
recovery, although fragile, will lead to a more sustained growth track

For them, the key is to assess how slowing global demand for semiconductors will
translate into a damper on Japanese exports and how much persistent yen strength will
erode profits at major carmakers and electronics firms and their small subcontractors.
Both Ministry of Finance and BOJ officials are keeping a close watch on foreign exchange
rates, with the MOF calling the shots on when to intervene to sell yen for dollars and how

The BOJ for its part will decide on the need for a further credit easing based on the
effects of currency and stock price action on business and consumer sentiment as well as
corporate profits, not simply taking its cue from the day-to-day dollar/yen rate.


The yen hit a fresh post-war high of Y75.78 against the dollar in New York trading on
Friday amid heightened concerns about the European sovereign debt crisis.

On Saturday, Japanses Finance Minister Jun Azumi warned that Japan's government is
ready to "take decisive action against excessive and speculative moves" in foreign
exchange rates, media reports said.
This indicates Tokyo will intervene
in the forex market, if necessary, to   ”The yen hit a fresh post-
stop the yen's rapid rise from
hurting Japan's export-led recovery.    war high of Y75.58 against
On Monday, Azumi told visiting
Inter-American Development Bank         the dollar in New York
President Luis Alberto Moreno that
the lingering strong yen is having a
negative     impact    on    Japan's
                                        trading on Friday amid
exporters and that US and Eurozone
economic conditions remain the          heightened concerns about
major cause of concern.

MOF data released on Monday
                                        the European sovereign
showed that Japan's exports rose
for the second straight month in        debt crisis.”
September on the recovery of car
shipments but the pace of their year-on-year increase decelerated to 2.4% from 2.8% in
August amid slowing global growth and the yen's rise to record highs.
P a g e | 19                                           …connecting Central Banks to the market

Exports of automobiles, which were the hardest hit by the March 11 natural disaster, rose
just 4.9% from a year earlier following a 5.3% rise the previous month. Semiconductor
shipments fell 9.5% year-on-year in September after slumping 16.4% in August.


The BOJ board, in its semi-annual Outlook Report due on Oct. 27.will be likely to
maintain its practically zero interest rate policy through fiscal 2013 and will forecast only
a slight CPI gain under 1% for that year.

In line with forecasts by private-sector economists and the International Monetary Fund,
the board is widely expected to revise down its GDP and CPI forecasts for fiscal 2012
from its projections made three months ago in the face of heightened global uncertainty.

BOJ policy-makers are expected to refine their projection that core CPI (excluding
perishables) will show a positive figure for fiscal 2013 around the latter half of a zero to
1% range (their initial forecast), which would in all likelihood be the first annual increase
in five years (since the +1.2% recorded in fiscal 2008).

                                                   That would be a small step forward from
 ”The economic downturn                            years of deflation but the BOJ board will
                                                   need to be convinced that the year-on-
                                                   year change in CPI will not slip back into
 caused by the March 11                            negative territory before considering
                                                   unwinding the monetary stimulus. The
 disaster and the slowing                          central bank has vowed to maintain its
                                                   effectively zero interest rate policy until
                                                   it can detect signs of price stability in
 global economy are                                the longer term, measured by the CPI
                                                   annual rate in a range clearly above
 likely to prompt BOJ                              zero and under 2%, or centering around

 policy-makers to revise                       The board's median core CPI projections
                                               for both this fiscal year and next are
 down their previous GDP                       expected to be revised down to below
                                               0.5% from the 0.7% forecasts made in
                                               July in an update to the April Outlook
 growth forecasts…”                            Report. The year-on-year change in CPI
                                               has been depressed by the new data
formula adopted in August. The government has updated the CPI base year to 2010 from
2005 and reviewed the basket of goods and services used for calculating the main
consumer price measure.

Meanwhile, the latest monthly survey by the Cabinet Office's Economic Planning
Association showed that economists expected deflation to continue through early 2013,
with their average forecast for core CPI in fiscal 2013 at a slight 0.23% rise (the first
forecast for the poll). Their average forecast for fiscal 2011 was revised up slightly to -
0.15% on year from -0.19% in the previous survey while the forecast for fiscal 2012 was
unchanged at -0.20%.


As for economic growth, the BOJ board is expected to see Japan's GDP to expand around
the 1.0% level by fiscal 2013 (which compares with +1.4% projected by private
economists), following fairly high growth of just below 2.5% in fiscal 2012 and around
zero this fiscal year. The economic downturn caused by the March 11 disaster and the
slowing global economy are likely to prompt BOJ policy-makers to revise down their
previous forecasts for +2.9% for fiscal 2012 and +0.4% for fiscal 2011.
P a g e | 20                                           …connecting Central Banks to the market

Similarly, the average economist survey has been revised down to +0.22% for fiscal
2011 from +0.38% in the previous survey while that for fiscal 2012 has also been
revised down to 2.3% from 2.4%.

Last month the IMF revised up its forecast for Japan's GDP contraction this year to -0.5%
from -0.7% projected three months ago while revising down its 2012 growth estimate to
+2.3% from +2.9%. The IMF also expects deflation to continue in Japan at least through
2012, forecasting CPI declines by 0.4% this year and 0.5% next year.

Despite downgrades, the BOJ board will probably repeat its outlook that Japan's economy
will be supported by demand stemming from reconstruction of the earthquake-hit
northeastern regions, primed by a third supplementary budget estimated to total Y12.1

In the new Outlook Report, the BOJ is expected to maintain the view presented in July
that the economy should return to a moderate recovery path in the absence of decisive
data to prove otherwise. The strong yen and sluggish share prices have not yet derailed
Japan's export-led recovery. But the board will warn of continued downside risks, such as
weaker U.S., European and emerging economies, fluctuations in global financial markets,
domestic power supply constraints and a prolonged expectation for deflation.

It will be likely to note that those risk factors will cast a shadow over the BOJ's baseline
economic scenario. At the same time, the BOJ board will also judge that domestic
financial and capital markets are relatively stable as the direct impact of the European
sovereign debt crisis has been limited.


Meanwhile, the recent warning against the side effects of the BOJ's extensive monetary
easing that came from an unidentified BOJ policy board member is a common concern
among central bankers and does not necessarily suggest that the board will be divided
when voting on a further credit easing to counter a greater downside risk.

Indeed, the warning, which was unveiled in the minutes of the BOJ's Sept. 6-7 policy
meeting released earlier this month, might have come from Governor Masaaki Shirakawa
himself, a career central banker who has often discussed the benefits and costs of
keeping overnight lending rates practically at zero and buying large sums of various
financial assets from banks. Or it might have come from Koji Ishida, a former commercial
banker who joined the board in June. Ishida replaced Tadao Noda, who himself was a
commercial banker and cautioned against too much monetary stimulus while he was in

What is the case is that the board member who warned about the costs of the extremely
easy monetary policy shares the view that the downside risks to Japan's export-led
recovery have been heightened.

The consensus among BOJ officials seems to be that any board members who are
concerned about the side effects of such policy would still agree to a further easing if
downside risks were growing at an alarming pace in coming months. The board member
in question seems to be aware that higher downside risks may warrant a further easing,
such as boosting the BOJ's financial asset-buying program from the current Y50 trillion or
re-adopting an actual zero interest rate policy, according to sources familiar with the
central bank's policy-making process.

But at the same time, the board member pointed out at the September meeting that the
BOJ's super-easy policy hasn't produced tangible effects in stimulating the economy and
appeared to be calling on BOJ staff to look for more policy tools.
P a g e | 21                                        …connecting Central Banks to the market

Last month Shirakawa said central banks in advanced economies must review their
monetary easing programs, weighing the benefit of continuing unconventional asset-
buying and funding operations against its cost. In his speech to an annual meeting of the
International Association of Insurance Supervisors in Seoul, Shirakawa repeated his
earlier call on central bankers to consider whether their policy is "having its intended

                                           For his part, Ishida, who comes from the
  ”…there was also a                       banking sector, may share the industry's
                                           concern that prolonged super-low interest
  cautious view among                      rates will decrease profit margins at lenders.

                                           The minutes of the September meeting
  the nine-member                          showed that a few board members agreed
                                           that: "further monetary easing might become
  board on easing                          necessary depending on future developments
                                           given that there remained heightened
                                           downside risks to economic activity, as seen
  what was already                         in, for example, uncertainty about the
                                           possible consequences of the sovereign debt
  very stimulatory                         problems in Europe."

                                           But there was also a cautious view among the
  financial conditions                     nine-member board on easing what were
                                           already very stimulatory financial conditions
  in Japan.”                               in Japan.

                                             "One member said that a further
enhancement of monetary easing could instead lead to instability in the financial system
or prevent monetary policy effects from spreading to the economy through a decline in
market liquidity and a decrease in financial institutions' profit opportunities, and
therefore careful consideration was required to ensure that such developments did not
occur," the minutes disclosed.

At the Sept. 6-7 and Oct. 6-7 meetings, the BOJ board voted unanimously to continue
the central bank's very accommodative interest rate policy by maintaining the target for
the overnight lending rate among commercial banks at zero to 0.1%, as widely expected.

Max Sato
P a g e | 22                                           …connecting Central Banks to the market

                             One small step…
By David Wilder, Beijing Bureau Chief

While European leaders struggle to come up with a strategy for tackling the
eurozone's debt problems, Beijing has finally made a modest step toward
addressing its own.

The Ministry of Finance said last week that it will allow some local governments to start
issuing bonds directly to raise funds, taking another step toward creating a municipal
bond market. Under a new pilot program, the cities of Shanghai and Shenzhen and the
provinces of Zhejiang and Guangdong will be allowed to sell three- and five-year bonds
directly to the market.

It's a key move down the road toward a functioning municipal bond market, and Moody's
called it credit positive for the central government because it will increase transparency
and reduce the reliance on the banking system to plug holes in local government

As with all Chinese reform efforts, however, the devil lies in the details, and Beijing will
need to do a lot more if it is to finally resolve the issue of local government debt which
currently has investors so nervous.


That said, the pilot program does suggest that Beijing hasn't completely lost its appetite
for reform. Political stasis ahead of a key government reshuffle next year had given rise
to fears that reform was generally on hold.

But the threat of crisis has pushed the central government to act and finally start
addressing structural funding problems at the local level. Expect baby steps, but any
movement forwards on capital market reform these days is a positive.

                                                 Officials have been discussing the creation
”…the threat of crisis                           of a municipal bond market for several
                                                 years now as a means of addressing
                                                 problems with China's central-local fiscal
has pushed the central                           transfer system.

government to act and                            Reforms in 1994 centralized fiscal
                                                 transfers in an effort to tackle rising
                                                 central government budget deficits,
finally start addressing                         leaving local governments reliant on
                                                 Beijing for handouts (the revenue intake
structural funding                               of local governments dropped from 78%
                                                 of the total in 1993 to 48.9% at the end
                                                 of last year).
problems at the local
                                                 Inadequate central-local transfers have
level. Expect baby                               forced local government to find
                                                 alternative sources of funding, not least
                                                 through the sale of land, a trend that has
steps…”                                          entwined the interests of the real estate
P a g e | 23                                           …connecting Central Banks to the market

industry with government bureaucrats and fueled social unrest in rapidly-urbanizing

Guangxi province, for example, took in CNY223.89 billion last year, including a central
government transfer of CNY141.16 billion. An item called "fund income" accounted for
another CNY69.3 billion, the bulk of which is the result of land sales. The province --
among the poorest in China -- spent CNY200.19 billion.

Local governments are prohibited by the 1994 budget law from directly raising funds
through debt issuance. The central government has in recent years provided a fix
through annual CNY200 billion in bond sales on behalf of local governments as part of
Beijing's fiscal budget calculations. That was always a stop-gap, though internal
negotiations about a municipal bond market were hobbled by an inability to reach
consensus, and it was only the threat of crisis that forced the issue.


It is increasingly apparent that China's response to the global financial crisis provided a
much-needed shot in the arm for the domestic -- and world -- economy, but has also left
Beijing with a massive clean-up bill. Unable to raise funds directly, local governments
used financing vehicles under their control to borrow massive amounts to fuel investment
and keep growth humming.

China's National Audit Office reported earlier this year that local governments were
sitting on CNY10.7 trillion ($1.65 trillion) in debt as of the end of last year, equivalent to
just under 30% of GDP. Up to a quarter of that debt is at risk, the government has

Despite more bearish forecasts, the
local government debtload isn't large         ”It is increasingly
enough to endanger the Chinese growth
story; mindful of the spendthrift ways
of local officials, Beijing has been
                                              apparent that China’s
maintaining Maastricht levels of fiscal
constraint in its budgets for years now       response to the global
(it ran a surplus equivalent to 2.5% of
GDP last year, while this year's deficit
goal has been fixed at around 2%).
                                              financial crisis provided a
The central government is likely to have      much-needed shot in the
adequate       resources      to     tackle
anticipated bad debts at the local level,
and in the banking system. But it's only
                                              arm for the domestic –
seven years since the government last
bailed out the banks, in the form of          and world – economy,
recapitalizations, and it's with a view to
running a more sustainable fiscal model
that reformers have been pushing the
                                              but it has also left Beijing
creation of a municipal market.
                                              with a massive clean-up
So while last week's announcement is
encouraging, it doesn't go nearly far
enough -- China is still several years
away    from    a   liquid,   functioning
municipal bond market. If nothing else, the changes signalled by the Ministry of Finance
announcement could be largely cosmetic; initially, at least, debt issuance will be subject
to State Council quota, while interest and principal payments will still be paid by the state
treasury on behalf of the issuers.
P a g e | 24                                           …connecting Central Banks to the market

The finance ministry said those governments participating in the pilot program should
establish "debt repayment guarantee mechanisms," indicating that Beijing has
anticipated questions about credit worthiness. But this is still a modest beginning.


Further out, it remains to be seen how investors will assess the credit risk of Shenzhen,
Shanghai, Zhejiang and Guangdong, never mind of poorer areas such as Guangxi

And at a broader level, China's bond market remains shackled by a regime in which the
government plays regulator, issuer and investor, by its heavy-handed controls of interest
rates, by a barely-developed investor base and by an institutionalized culture of secrecy
which cripples objective assessments of credit risk.

China's fiscal authorities have finally taken an important step, but it is only a small

David Wilder
P a g e | 25                                                             …connecting Central Banks to the market

Editorial Board
                                                                                                      MNI Connect
Kevin Woodfield (editor-in-chief)                                                                         Contact:
John Carter                                                                                        Kevin Woodfield
Tony Mace                                                                            European Managing Director
William Poole (Special Adviser)                                                        Market News International
                                                                                               Tel. 0207 862 7400
Contributors                                                                       Email:
Steven K. Beckner
Max Sato
David Thomas
David Wilder
Bernard Wolfson

                                              Market News Disclaimer


ALL NON-SUBSCRIBERS please take note: This service is not intended for your use. If you would like to use
this service you must first enter into a subscription agreement with Market News International or a third party
provider of the service. If you are not a current Subscriber or otherwise authorized by Market News International
("we", "us" or "our") please stop using this service immediately.

ALL CURRENT SUBSCRIBERS please note: your use of this service is governed by the terms of your current
subscription agreement including (without limitation) the provisions contained in that agreement limiting Market
News International's liability and/or (where your subscription is via a third party) that party's liability.

YOUR RISK. Although we do not give any guarantee or warranty in respect of the news, data or service which
we provide, the information we provide is taken from sources which we believe are reliable. We accept no liability
for transmission failure, interruption or distortion of the service caused by matters beyond our control.

Market News International hereby excludes all liability whatsoever to any person whether or not a current
Subscriber, regardless whether or not that liability is a direct, indirect, consequential, or other loss suffered or
incurred by you as a result of the use or supply of our service. In addition, we will not be liable to any such person
for any loss of contract, loss of goodwill or loss of business opportunity whether suffered as a direct or indirect
consequence of the supply or use of our services. However, nothing in this disclaimer will or is intended to
operate to exclude our liability to any person for any death or personal injury caused as a result of our negligence.
This disclaimer will be effective notwithstanding the assertion by any person of any liability against us.

The limitations and exclusions of liability in this disclaimer may be subject to certain restrictions and/or exceptions
under the law of jurisdictions within or outside the United Kingdom of Great Britain and Northern Ireland and the
United States of America. Accordingly, in such jurisdictions this disclaimer should be read and will take effect to
the extent permitted by such restrictions and/or exceptions. Each provision of this disclaimer is to be treated as a
separate and severable provision. To the extent that any provision of this disclaimer is held to be invalid in any
jurisdiction by operation of local law, the invalidity of that provision will not affect the validity or enforceability of the
remaining provisions of this disclaimer, all of which will remain in full force and effect.

To top