What's Going On In China Is Not Really About China
What is going on in China is not really about China, except that the country is and has been the focal point for the modern currency exchange system. Most commentary about recent events has fixated on "outflows" which is a curious interpretation since nobody can actually find them. In other words, yesterday Chinese stock traders were at their stations for all of 29 minutes, so severe was the plunge, and yet the stories in the media were about "capital" flowing somewhere else. But nothing else showed an opposite "inflow"; quite the contrary. Commodities were crushed, crude and copper especially, credit was tainted and even stocks all around the world fell in continuation.
This was exactly the same as had occurred in August, the last time China was believed so befouled by "outflows." It seems now in reoccurrence that when the Middle Kingdom gets to outflows so does everyone else. The only way that might be possible is if global liquidity, global money, is affected by Chinese concerns.
We can start on that by addressing what counts for Chinese liquidity. The liabilities are denominated in RMB but that doesn't mean as much as you might think, and certainly not what it should. The PBOC, China's central bank, the one in the world thought most powerful and effective because it is a statist engine actually situated within an outwardly statist political system, is mostly dollars. It is one of the true wonders of modern money, but the PBOC on its asset side is almost purely forex "reserves." As anyone paying attention to all the QE's knows, increasing the asset side of a central bank balance sheet is how you increase the liability side or what counts as reserves or currency.
What happens, then, with that major component on the asset side in reverse? There are only two possibilities at that point: do something else to increase assets or allow liabilities to similarly and proportionally dwindle. Examining the forex basis of PBOC assets reveals that the peak level was reached in May 2014. Since June 2014, forex assets reported by the PBOC have been declining, revealing once more the footprint of the "dollar" (the dollar started to "rise" in June 2014).
However, if you look on the liability side of the PBOC, you will find that the major "liquidity" component, "Deposits of Other Depository Corporations", was steadily rising. In fact, this had happened before in China starting August 2011. Once more, we find that date corroborative as that was yet another "dollar" event culminating in near-panic just a few months later. The PBOC response then was similar to how it performed in the second half of 2014; other programs and asset classes were mobilized in order to smooth out the forex imbalance.
It sounds inordinately simple to just "buy" something else and move on about the country's economic business, but doing so is tantamount to direct redistribution. Unlike central banks outside of China, especially the Bank of Japan by contrast, redistribution of this kind is very much appreciated as fraught with all sorts of potentially devastating consequences. Perhaps the clear difference in avoiding monetary redistribution as much as possible in China is that China is already itself the product of such engineering in so many places. But even with that reluctance, the PBOC carried out short-term liquidity operations, especially "Claims on Other Depository Corporations" which include special loans and monetary schemes tied to the major state banks, like China Development Bank (CDB).
In the middle of 2014, that is exactly what the PBOC did as it "offered" RMB1 trillion in a standing three-year liquidity commitment through its Standing Lending Facility (SLF). This was almost exactly like the LTRO's the ECB had used starting in early 2012 to combat its euro crisis, except that the Chinese were actually directing where that liquidity would flow. That original SLF was intended to China Development Bank for urban renewal and renovation loans. When it was announced, it was taken as some sort of "stimulus", as they always are, but the reality of the whole PBOC balance sheet showed very much otherwise.
In other words, the Chinese were trying to perform a market redirection in overall orientation; allowing actual market flow of forex in reduction to be supplanted by internal RMB flow via central bank mandate. The general market for RMB liquidity would be "drained" somewhat while internally it all looked as if nothing had changed; "Deposits of Other Depository Corporations", the effective bank reserves of the liability side, remained on its steady upward slope.
In March 2015, all that changed. The exact catalyst remains unknown, but what we do know is that the liability side, those RMB bank reserves, stopped in their tracks. Since March, "Deposits of Other Depository Corporations" have been in reverse, and often heavily so. The amount through November, the latest figures, has been an enormous RMB2.2 trillion, or almost 10%! If we don't know exactly why the reversal, what we can reasonably infer is that "something" changed of a greater magnitude that would essentially undermine, and eventually destroy, PBOC control of its own internal liquidity regime.
That much was apparent almost straight away. The exchange rate between yuan and dollar starting on March 19 stopped. I don't mean that there was no longer any exchange taking place but rather that the exchange rate volatility dropped almost to nothing; the exchange price in dollars moved almost perfectly sideways thereafter. In early March, the rate had "devalued" just past 6.27 RMB to the dollar in CNY (onshore Chinese currency exchange, which is separate, intentionally, from offshore Chinese currency in Hong Kong, CNH). The CNY rate had similarly been "devaluing" in early 2014, halted, tellingly, on June 18, 2014, when the PBOC announced something called the Pledged Supplementary Lending program (the details aren't important to this review, instead it was another of those asset-side redistributions of the PBOC balance sheet). The CNY rate was given a further boost of appreciation with the SLF announcement for China Development Bank, rising all the way to 6.113 by October 2014.
That inflection point should also register as an artifact of "dollar" history as the events surrounding October 15, 2014, proved pivotal in defining global liquidity for the rest of that year, leading up to the "shocking" move of the Bank of Switzerland on January 15, 2015 (the Swiss have, like China, a "dollar" problem). From October 2014 through March 2015, the CNY rate sank like a stone ("rising dollar") until that "something" changed to redirect PBOC focus from internal RMB machinations. In short, the events of March 2015 were not a sudden appearance of imbalance but rather the intensification of an existing one.
To see a straight line sideways in a financial indication, let alone a major currency exchange, is a bright, flashing warning. It can only mean artificiality, and artificiality is almost always present for an alarming reason. If a central bank or government agency has to take to stamping out all volatility then something is very wrong in that exact place. Since that "place" was CNY, this was no minor disturbance.
What the PBOC was exactly doing also remains unknown, but again we can make some very reasonable inferences. In my own view, I have little doubt that they were deploying their forex "reserves" in greater and greater magnitude. However, when I write about forex "reserves" I mean often nothing like what is written elsewhere that leads economists to suggest "outflows." The common description is "selling US treasuries", which the proceeds are assumed to then take the form of those "outflows." And while there might be some "selling US treasuries" taking place in whatever the PBOC has been up to the past almost year, that isn't likely the strength of their effort nor perhaps even anything more than incidental.
You are not going to be totally suppressing a major exchange rate by picking CUSIP's of specific US notes or bonds. That, again, might happen but as a complement to the main thrust of the strategy, more so as the shift of collateral postings related to swaps and forwards; the very nuts and bolts of the eurodollar system and its more organic and modern liquidity redistributions. Understanding the ramifications of such an enormous task (setting all objections aside about whether a central bank should be doing so in the first place; PBOC, after all) likely prevented the prior backfill of internal RMB redistributions like the PSL and SLF.
The consequences of getting such a huge intervention wrong cannot be overstated. The PBOC, unlike apparently all the other central banks around the world, understands quite well the system with which they are engaged. As well they should, no other country or economic trajectory was so affected quite like China. The Chinese economic "miracle" was no such thing, it was Alan Greenspan's "global savings glut", the rise of the eurodollar in its disastrous "golden age." As I have noted on many, many occasions, PBOC Governor Zhou Xiaochuan wrote for the BIS in March 2009, with the financial wreckage still enflamed, that:
"The outbreak of the current crisis and its spillover in the world have confronted us with a long-existing but still unanswered question, i.e., what kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth, which was one of the purposes for establishing the IMF? There were various institutional arrangements in an attempt to find a solution, including the Silver Standard, the Gold Standard, the Gold Exchange Standard and the Bretton Woods system. The above question, however, as the ongoing financial crisis demonstrates, is far from being solved, and has become even more severe due to the inherent weaknesses of the current international monetary system."
The "inherent weaknesses" that Zhou spoke of were all key aspects of the "credit-based reserve currency" scheme - the eurodollar. Now, starting in March 2015, Zhou was for the first time being pressed by the credit-based currency in a way in which I don't think he was prepared for. There is a great difference between the eurodollar in 2007 and 2008 and what we have seen since June 2014; in the former it was seen as perhaps devastating and existentially dangerous, but likely, as Zhou wrote, just unstable and temporarily so; in the latter, from really 2011 onward, it is fated.
The problem with fighting a wholesale, credit-based currency disruption on its own terms isn't always apparent straight away. In other words, using swaps and forwards within a currency full of swaps and forwards sounds logical and even basic, but it amounts to, potentially, suicide. In light of the incredibly narrowed trading range, an almost perfectly straight line, for CNY exchange to the dollar, I wrote on July 22:
"Trading has been confined, except for very brief, intraday outbursts, to an increasingly narrow range. Given its behavior particularly as a full part of the reform agenda to that point, this amounts to what can only be hidden and inorganic factors. Whether that means PBOC intervention is unclear, though suggested by even TIC, but this is the most important and unexplained dynamic in the "dollar" world at present."
Of course, that last point became understood in full just a month and two days later, but it should have been appreciated at least by August 10 when the PBOC finally broke and "allowed" the CNY rate "devaluation" in shocking and short comprehensiveness. The reason for all of this relates to the very core of what eurodollar actually means; it is a system where everyone claims to hold dollars and nobody actually does. Reviewing how these sorts of processes used to work, using something called Banker's Acceptances, illuminates that charge as well as the modern "necessity" of wholesale "money". I wrote a few days ago:
"In the latter half of the 20th century, the acceptance market did not disappear as it was simply supplanted by the eurodollar market. The difference was the form of availability in eventual payment. In the acceptance market, the drawer of the acceptance is required to post funds on an individual basis immediately that become the bank's shared liability; in eurodollars it gets more complicated.
"The wholesale international paradigm of trade finance is moved to a more active intermediary basis. Take the example of firms not connected at all to the dollar directly; one in Sweden exporting goods to another in Japan. The Swedish firm must be paid in kronor, so the Japanese firm would contract with a Japanese bank to buy kronor at some specified time, usually three months forward timed to the expected delivery of the goods. If the Japanese bank carried reserves of kronor, not likely, the bank would simply charge its commission and everyone would move on. Holding reserves of this kind, however, is inefficient and costly. Instead, the Japanese bank would intermediate through eurodollars: buy dollars for yen and then sell dollars for kronor."
In actual instrumentation, there is much that is important in how the dollar intermediates with global exchange. Using the example above, the Japanese bank might buy a three-month eurodollar deposit and simultaneously sell dollars forward for delivery in kronor. Unlike Banker's Acceptances where the dollars are posted at origination and held in custody, in the eurodollar format of eurodollar deposits and forward sales it isn't at all clear who has them. What is taken for granted is that somebody, somewhere does, and that when the time comes whichever counterparty is ultimately on the hook for ponying up the "currency" (which is typically nothing more than some bank liability ledgered on some balance sheet) will easily do so. This is the "global dollar short."
The idea of a "dollar short" is as old as fractional bank lending itself. A bank that is fractionally multiplying deposit liabilities for a finite amount of reserves, be them actual money (gold) or currency (Federal Reserve Notes), is synthetically "short" those reserves. That part is revealed in the various bank panics which were really "short squeezes" having the terrible effect of increasing the "price" of money and true reserves (a "rising dollar").
The difference in the eurodollar system is that format of accepted liabilities. Since the modern wholesale system is not redistributing actual money nor physical currency, the delivery that satisfies the "short" part in these kinds of payment transactions are intangible bank liabilities of whatever kind that bank can secure. Those would include still more forwards and swaps.
In these broad and general terms, then, the PBOC writing dollar swaps and forwards starting in March 2015 in order to try to gain greater control over an increasingly difficult and dangerous liquidity environment have the practical effect of making their dollar short more short. I usually try to avoid such simplifications because there is so much meaning and meaningful nuance lost in the distillation. In this case, however, such simplicity is itself defining. The primary problem with the global dollar short is not really the dollar, it is the "short." There is nothing the PBOC can do except to hope that by increasing its "short" it will be enough only to gain time; to perform a maturity transformation whereby the acute problem of today is pushed out in the future where hopefully conditions can more easily absorb that greater "short."
The shortest currency derivatives usually have a three-month maturity, a factor that traces back to the historical economic needs met by Banker's Acceptances. If we assume that the PBOC was "forced" to write more and more swaps and forwards as conditions worsened in late July and early August, and then intensifying yet again after the CNY exchange broke, we would expect those first waves to start maturing in late October and early November. Sure enough, between August 25, when the global liquidation wave finally ran its course, and October 30, the CNY exchange actually rose from its "devaluation"; 6.41 or so on August 25 all the way to 6.31 on October 30, erasing almost half of the August "shock."
It was during that time that conventional commentary deriving from economists' opinions grounded in a monetary understanding more so like Banker's Acceptances than eurodollars turned quite optimistic. The "outflows" appeared to have stopped altogether and China was given once more lightly guarded approval. It was entirely misplaced, not just in misunderstanding the nature of China being "more short" as a result of its short-term interventions, but also the money market climate of the "dollar" into which all those derivatives were to be coming due. In almost every way, global money markets have been consistent in producing alarms; in terms of the "dollar" and China, turmoil has been the most apt description of especially offshore liquidity. Internally, we can make the same interpretation but it isn't so evident; overnight SHIBOR all of a sudden began to move in a straight line sideways in clear PBOC intervention there.
On the "dollar" side of it all, despite what the FOMC and Janet Yellen declare, dollar markets have also been nothing if not irregular. There has been no shortage of alarms on "this" side of the system, only that they have been somewhat obscured by all the attention on China. Most prominent has been the negative swap spreads that so confounded commentary just a few months ago. As I have noted on so many occasions, negative swap spreads are nonsense; they don't mean anything as prices except to scream out balance sheet resource imbalance. In other words, it takes an enormous reduction in financial capacity to turn what should be a meaningful interest rate swap price into a meaningless spread. Since interest rate swaps perform a great proportion of money market dealing and money market function, those chained derivative liabilities that aid and even enable payment deliveries of dollars, the lack of them can only produce global monetary dysfunction.
That was the condition that greeted the first maturities of China's swaps and forwards. Starting on November 6, exactly three months later, the CNY rate has plummeted, touching almost 6.60 yesterday! The PBOC gained three months or so of relative calm in order to make its problems that much worse in the near future - because they assumed that the future would be at least enough past the disruption in "dollars." Instead, the turmoil has worsened and amplified because the derivative activities of wholesale currency intervention made for a bigger "short" when being short was still the primary problem.
The potential for calamity now is as Zhou mentioned in March 2009, that the credit-based reserve currency is too unstable to provide a solid foundation for global growth. Instability may just be intrinsic in a system focused and grounded in esoteric and complex bank liabilities and creations; many of which we still have yet to uncover and understand. What is easily understood, however, is that by whatever means, including compression trading, banks are no longer willing to be that central role in currency expansion, or what might traditionally be understood as tightening or outright shrinking money supply. If there is one country that appreciates what that means and the implications for it, it is China. Again, the eurodollar build up built that economy, and the eurodollar decay is tearing it down. If there is truly desperation to it, it is because there is permanence here unlike 2008, which was treated as a cyclical and temporary interruption.
The dollar short is the dollar trap into which everyone has been caught. China and other places like Brazil, another country whose central bank opted for the much bigger short, are just more obvious in that position, whether or not economists appreciate what "outflow" truly means.
