Source: China Securities Co.,Ltd. Research
Author: Zhou Junzhi

This press conference did not provide incremental bond issuance data, nor did it specify large-scale stimulus, but mentioned debt conversion and central deleveraging, expressing positivity.

In our analysis framework, the positive impact of debt conversion on the economy is greater than that of incremental stimulus. Effective debt conversion means we are on the right path to combat deflation.

This meeting also marks the beginning of central deleveraging, which is also the long-awaited "central downgrade" by the market. The loose coordination of central fiscal and monetary policies is a liquidity feast for the market.

Under the liquidity feast, the trends of stocks and bonds have historical answers. Ten years ago, before the new Budget Law was finalized, debt replacement progressed, and both stocks and bonds performed well.

History will not repeat perfectly. Compared to 2014-2015, in this round of coming out of the deflation path, the market needs to think more about economic growth and industry opportunities.

Although the specific financial details and intensity of the current debt-for-bond swap will not be known until the legal procedures are completed. However, the "most significant measure of support for the debt-for-bond swap in recent years" is worth market expectations.

This press conference has attracted wide attention.

The joint press conference of the financial departments on September 24 confirmed the direction of monetary easing, and the Politburo meeting on September 26 decided to move away from the deflation policy orientation. Since then, the market's expectations have shifted to the fiscal side.

The five statements that surprised the market at this press conference by the Ministry of Finance are:

1. "Propose a one-time increase in the debt limit to replace the hidden debts of local governments on a significant scale."

2. "Increase support to help local governments resolve debt risks, with relevant policies to be fully explained to the public after completing legal procedures."

3. "The upcoming policy, which is the most significant measure of support for the debt-for-bond swap in recent years, is undoubtedly a timely policy that will greatly alleviate the pressure of local government debt."

4. "We will adhere to strict control of new additions, optimize existing debts, and enhance quality, actively researching and introducing policies and measures conducive to the stable development of the real estate sector."

5. "The central government has significant room for debt issuance and deficit enhancement".

First, why did this press conference not specify the increase in bond issuance data or indicate a large-scale stimulus direction?

To increase the deficit or expand the debt limit, it must be approved by the National People's Congress (or its Standing Committee). The mid to late October is when the Standing Committee of the National People's Congress convenes, which is why Minister Lan mentioned in this meeting, "Counter-cyclical adjustments are definitely not just these four points, these four points are policies that are already in the decision-making process." The specific debt expansion limits will not be known to the market until at least late October.

Although the Political Bureau meeting on September 26th confirmed the policy orientation to move out of deflation, it also clearly stated "strict control over incremental increases." This press conference by the Ministry of Finance continues the essence of the September 26th Political Bureau meeting, and also emphasizes "strict control over incremental increases." Therefore, expecting a large-scale infrastructure stimulus would increase construction industry oversupply, which is no longer suitable for the current macro environment. Fortunately, expectations for a substantial increase in investment stimulus have been fully adjusted over the past week. Especially after the National Development and Reform Commission held a press conference, stocks fell and bonds rose, indicating a shift in market expectations for policies.

Second, how significant is this meeting? It signifies the central government leveraging up, repairing the balance sheets of local governments and the real estate sector.

Even without a major investment stimulus, why do we still believe this fiscal press conference exceeded expectations? The answer lies in the statement "the most significant measure in recent years to support debt restructuring."

In our analytical framework, debt restructuring has a more positive impact on the economy than a large-scale stimulus increment. To understand this, we first need to grasp the underlying logic of the current macroeconomic situation of "insufficient effective demand."

The three parts of domestic demand - enterprises, residents, and local governments - have all experienced varying degrees of deleveraging this year. Compared to the clear deleveraging of residents and local governments, the deleveraging of the enterprise sector is not as pronounced, benefiting from overseas demand that can still contribute to export growth, driving business investment and production.

This year, residents and local government departments are deleveraging, leading to a contraction in demand, which is the underlying weakness of domestic demand. When these two major departments deleverage simultaneously, historical comparisons can be made with 2012 and 2014, both of which were typical deflationary periods in Chinese history, with PPI experiencing negative year-on-year growth.

There are two ways to address deleveraging: one is to allow deleveraging departments to re-leverage, and the other is to reduce debt pressure by lowering interest rates, debt swapping, or debt writedown.

In the past two typical deflationary cycles in China, one was in the late 1990s, and the other was from 2012 to 2014, both of which used the first method. The reasons are not difficult to understand. At that time, China was still in a rapid urbanization process, with sufficient leverage space for residents and local governments. However, this round of deflation is different. In 2021, China's urban residential housing ratio exceeded 1, indicating that the real estate long-term trend has changed. Further stimulating with a large round of stimuli to promote substantial expansion by residents and local government departments is no longer in line with the overall trend. This is also why the judgment of the September 26th Politburo meeting on real estate is 'stabilizing the decline' and requiring 'strict control of incremental increase.'

The central government has increased debt issuance to formalize leveraging to alleviate local debt pressure and support the real estate sector. This is the second type of debt resolution method that aligns with the long-term economic trend, helping to alleviate the continued contraction of domestic demand and prevent another round of excess in the construction industry.

What does localizing debt and central deleveraging mean for the capital markets? The market will enjoy a liquidity feast.

What policy measures are needed to exit deflation? We previously mentioned in 'Consensus and Differences in the Current Stock Bull Market' (October 6, 2024) that there are three types of methods to combat deflation: lowering interest rates, boosting demand, and clearing excess capacity. Lowering interest rates is to reduce debt pressure, boosting demand is to restore income cash flow, and clearing excess capacity is to restore asset prices.

Even without triggering new investments, central deleveraging for localizing debt helps balance local government debt and prevents the debt deflation spiral. We are on the right path to combat deflation.

As long as there is no major stimulus for investment, central deleveraging supports the balance sheets of local governments and the real estate sector, although this process involves fiscal expansion, it will inevitably be accompanied by monetary easing.

The coordinated loosening of fiscal and monetary policies by the central government essentially represents an expansion of central government credit. For the market, this is a liquidity feast.

Within this liquidity feast, vulnerable liabilities with high interest rates but high risks are being reduced, with fund demand shifting towards both ends, boosting risk appetites, and the central pivot of risk-free interest rates moving down. Such repricing is not bad news for stocks and bonds. History has had similar experiences before. 10 years ago, around the time of the enactment of the new Budget Law, debt replacement progressed and both stocks and bonds performed well.

Of course, history will not repeat itself perfectly. Compared to 2014-2015, under the current liquidity feast, the stock market also needs to consider the growth at the molecular end and industrial opportunities. In 2015, there was the monetization of shantytown renovation, followed by an unprecedented expansion in infrastructure and real estate investment, along with the outbreak of the TMT industry that year, making growth opportunities and industrial prospects more evident.

Although the specific details of this current debt reduction and fiscal specifics need to wait for the statutory procedure to be disclosed, the "most significant measure to support debt reduction introduced in recent years" is worth looking forward to in the market.

Editor/Jeffy