Excessive devaluation at a time when corporates are increasingly choosing to hold their export profits in currencies other than the yuan may hasten capital outflows. The irony of course is that failing to act aggressively to arrest REER appreciation risks cutting into those very same profits or, as we put it previously, “devalue too much, and the capital outflows will accelerate, not devalue enough, and the mercantilist economy gets it.”

Ultimately, this led us to conclude that “the flowchart for what is in store for the world for the next 12-24 months [looks like this]: an ongoing deterioration in Chinese economic conditions, coupled with a weaker, but not weak enough, currency, before the PBOC first go to ZIRP, and then engages in outright QE.

Against this backdrop, we got even more evidence today that the Chinese economic slowdown may be accelerating as industrial production, retail sales, and FAI all came in light of expectations prompting us to ask (again), “just how much longer do we have to wait until the inevitable moment when the last marginal central bank joins the global currency war and starts printing money on its own, finally pushing the world over to the next escalation level in the [insert noun] wars chain?”

To be sure, the Chinese Ministry of Finance isn’t too keen on “groundless” QE rumors and had the following to say overnight on the subject:

• MOF’S ZHU GUANGYAO SAYS TALKS OF CHINA `QE’ GROUNDLESS
• CHINA MOF OFFICIAL SAYS NO SUCH THING AS CHINA QE: SEC. JOURNAL

This is where it gets interesting. China is in the midst of attempting to help local governments refinance a mountain of debt, some of which was accumulated off balance sheet via shadow banking conduits at relatively high rates. Here’s more, from The Economist.

To begin with, local governments will be allowed to swap 1 trillion yuan ($160 billion) of their existing high-interest debts for lower-cost bonds. According to the Economic Observer, a credible local newspaper, this may just be the first tranche, with the finance ministry preparing to give local governments a 3 trillion yuan quota for refinancing. It is easy to imagine that such quotas will become a regular feature of China’s fiscal landscape over the next few years. As this chart shows, the combination of new debt issuance plus swaps will help cover what local governments owe this year, but will make only a small debt in their overall liabilities…

China’s local-government debt problem has always been twofold. First, there is the sheer amount of money they owe. That has doubled from less than 20% of GDP in 2007 to nearly 40% today. Second, there is the very peculiar and opaque structure of these liabilities. Because local governments can only borrow with the explicit permission of the finance ministry, which has been miserly in the past, they have been forced to use off-balance-sheet entities to raise funds. Those entities (commonly known as local government financing vehicles, or LGFVs) have borrowed from banks and shadow banks alike. As a result, the size of their debts is unclear, but it is certain that the cost of their debts is much higher than would have been the case had they issued bonds in the first place.

While this raises a number of questions (including whether creditors will be railroaded into participating and thus forced to accept much lower rates of return), the most important thing to note here is that the swaps account for but a small percentage of total local government debt, which the following chart shows:

It seems as though one way to address the issue would be for the PBoC to simply purchase a portion of the local debt pile and we wonder if indeed this will ultimately be the form that QE will take in China. Here’s UBS with more:

Chinese domestic media citing sources saying that the authorities are considering a Chinese QE with the central bank funding the purchase of RMB 10 trillion in local government debt. In fact, the sources seem to be some brokerage research reports speculating ways of addressing the stock of local government debt, following the MOF announcement that local governments have been given a RMB 1 trillion quota to issue bonds to replace other forms of local debt.

The current central bank law in China prohibits direct monetization of government deficit. As we have written in China unveils local government debt solutions last October following the government’s announcement, China is likely to swap existing debt stock with bonds that have longer maturity and lower yields. Further, we wrote that such replacement bonds could mount to RMB 1 trillion, which is in line with MOF announcement over the past weekend. In addition, we think the government will consider allowing private placement of local bonds or similar means to directly swap bank loans into local government bonds (without changing debtor or creditor), which would allow for much larger debt restructuring, helping to lower local government debt service payment, and at the same time improve banks’ liquidity and capital position.

It looks as though our prediction of outright debt monetization in China may be proven correct sooner than even we thought thanks to the trillions in loans the Chinese shadow banking complex has made to the country’s local governments who desperately need some manner of relief lest the 500bps over treasurys they’re paying should end up swallowing them all whole. We also wonder what’s next for Chinese stocks in the event “real” QE is introduced given that QE-lite (PSL ) resulted in the following: