In Their Flair for the Dramatic, the Chinese Make Things Interesting
You have to love the Chinese flair for the dramatic, for they make things very interesting. Last week, Moody’s examined debt levels throughout the Chinese system and found them more than a little concerning. It wasn’t just that credit has been created with such an enthusiastic purpose, it was that the purpose no longer exists, or very likely so. The debt binge was a global crisis response, the textbook “stimulus” approach where the Chinese expected the Great “Recession” to have been a recession; meaning after some period of time a restoration of all prior trends.
It was expected over there, just as it was here and everywhere else, that no matter the imbalances fostered or even directly created in response to the contraction, the cyclical recovery and resumption of, for China, its economic miracle would easily absorb them. They would not be a problem for exports growing at 20-30% as they had been doing throughout the 2000’s. There practically are no debt problems under a paradigm of rapid growth.
To find the opposite, however, puts the Chinese into a bind on at least two major counts. Most of that debt was underwritten using these cyclical assumptions. All the standards by which it was issued suggested rapid growth at some reasonable point in the future. Default probabilities as well as risk calculations were all undertaken with those ideas fixed steadfast to the obligations. Take away those expectations for any cyclical upturn and what happens to those assumptions? We know the answer here in the West because they are the same as was once applied to things like subprime mortgages.
The second problem is what Moody’s finally sees. On a systemic level, debt has been redistributed in all these various small places so as to make it appear to be of a broader nature. In truth, there isn’t any meaningful distinction between central government debt and that of a locality or a quasi-state actor. If growth were heading back toward double digits again, maybe it wouldn’t matter. But despite some economic improvement in China as the global economy in 2017, it has been in truth very uninspiring; concerning even.
It has been made more so by a great deal of effort expended to try and plow at least a plausible path back to more rapid growth. The state directed another enormous fiscal “stimulus” in the form of Fixed Asset Investment spending (not really investment) through state-owned construction and development firms. At around 2% of GDP, it was of similar proportions to the “stimulus” of 2012 and just a little less than the one in 2009.
The other form of intervention was a dramatic shift in Chinese monetary behavior. The media has described particularly of late a “tight” money policy on behalf of the PBOC. That is simply not true, at least as far as intent. Starting in early 2014, China’s central bank was hit with a “dollar” problem. Such a thing is enormous trouble for any individual economic system, but far more so when the “dollar” (in the form of foreign “reserves”) serves as the basis for the whole of the monetary system.
As foreign reserves disappeared (these were not “capital outflows” as eurodollar contraction of various dimensions, including FX), Chinese authorities made a conscious choice to allow the internal Chinese banking system to absorb the contraction, and then countermand it. The decline on the PBOC’s asset side necessarily led to a decline on the liability side, meaning bank reserves. By March 2015, reserve growth had stopped and the overall level even began to contract.
To free up reserves already accumulated within the banking system, the PBOC reduced benchmark interest rates but more so the triple R (reserve requirement ratio). Thus, while there would be fewer total reserves in the RMB system, banks could theoretically use more of those in their operational activities. Whatever the “dollar” withdrawal, RMB should have been little bothered by it.
Of course, it didn’t work out that way; not at all. Instead, Chinese banks began hoarding RMB rather than using them, so that the contraction in the systemic level of bank reserves became a monetary and thus economic contractionary agent for the whole of China’s economy. Coming at a time when the entire global economy was for the same reasons (“dollar”) experiencing a downturn, even near-recession, it was for Chinese authorities a truly dangerous situation.
They changed tactics in February 2016, where the PBOC ditched the RRR program (cutting it only one more time at the end of March last year) and began directly injecting trillions in RMB to the banking system through its largest banks. Using the relatively new MLF and other monetary programs (including the SLF that operates like the Chinese version of the Discount Window), the official intent has been perfectly clear. Any tight money conditions were not related to policy but rather still the asset side “dollar” issue.
In other words, PBOC policy is not for “tightening” as that is instead just the result of so far whatever has been done not being done enough. Introducing RMB in enormous amounts has restarted the growth pattern of bank reserves. It is not, however, at the same rate as before 2015, nor is it obviously then enough to make up for that almost full year of reserve contraction. We can observe this deficiency in Chinese money market rates (which is why the mainstream believes it just has to be intentional policy) as well as the aggregate balance sheet of China’s four largest banks; those most directly in line of the MLF and direct central bank funding.
Given that most people conceive of central bankers as near omniscient and thus capable of just doing whatever they set their minds to, this sort of monetary trap seems illogical. Why can’t the PBOC just conjure in fiat whatever RMB might be necessary to restore monetary growth?
For China, the answer lies in their past deal with the “dollar” devil. Nobody complained about the eurodollar’s rapid ascent up until 2007 because by all appearances it created those very economic “miracles” in the first place. The eurodollar built China into a modern industrial powerhouse. The PBOC was perfectly content to dollarize its balance sheet as the primary basis for all RMB money so long as it was rapidly expanding. It meant for CNY the legitimacy of the post-Asian flu doctrine of accumulating such a large basis for exchange. They needed the “dollar” and were only too happy with it.
As with any bubble, the front side is all fun and games; it is the back side that is contemporarily rationalized as impossible. For China, that meant expecting despite the eurodollar interruption throughout 2008 and 2009 for its economy to simply go back to the pre-crisis growth paradigm, as if it was truly a “miracle” unrelated to that monetary condition.
The last several years in China, as the rest of the global economy, has been a third direct lesson in eurodollar monetary mechanics that leave no doubt as to what sets the global agenda. For emerging markets including a relatively mature Chinese industrial economy, the “rising dollar” period was particularly hard because it was in that portion where the illiquidity, meaning deficient global money, was centered. Since 2007, the eurodollar system has evolved, as it always evolves, never standing still no matter what, to become more Asian as well as derivative.
In observing official Chinese behavior to it, there seems to be clear stages in their response. Initially, like all central banks, it was ignored or dealt with using minor adjustments that speak to the official expectations that it would be no big deal (subprime is contained; CNY won’t devalue). As it only escalates, the policy response follows, never leads. The shift in February 2016 marked the end of Chinese authorities not taking it serious enough.
Over the year and a quarter since that time, the PBOC has been handcuffed by its remaining dollar basis. Falling CNY is bad for China, and bad for the global system. It represents “dollar” tightening, the penalty rate at which Chinese banks must bid for “dollar” that they still need in massive quantities. That is the part that doesn’t ever seem to be appreciated, in large part because Economics has all this time assumed economic systems are idiosyncratic and isolated; very little connecting one to the other, let alone a massive and necessary channel through the dollar to everything else in the world.
We often think (or are made to think) of a “global reserve” currency as if something relatively unimportant in the background doing nothing more than mediate the exchange value pressures of either a fixed or floating system. This is a highly misleading conception, most especially in the eurodollar case. Bretton Woods officially ended in August 1971, but it was the eurodollar that had already supplanted it far earlier in the 1960’s.
What that meant in functional terms was eurodollars were providing the liquidity for global financial exchange. It is not coincidence that global trade skyrocketed as the eurodollar did, as the latter was the monetary basis for the former. This was the upside of rapid, unregulated, and offshore money growth. Again, it is always unicorns and rainbows (and “maestros”) on the upswing.
For the global economy, in 2007 there were not small and tangential connections between isolated systems but rather an enormous and in many ways completely parallel monetary system directly connecting each and every economic node. It all ran on the premise that bookkeeping entries were of sufficient monetary form to be acceptable for whatever monetary purpose. Banks within the system could simply exchange, without any reserves, whatever liability they decided would be acceptable to each other; whether a simple deposit liability, or something more complex like a multilayer derivative strategy with several legs triggered by stated options (swaptions and the like).
It was a system run without dollars where everyone professed to have them, but nobody cared that they didn’t. It’s an awful imprecise way to run a global monetary system, so inherently unstable that it wouldn’t survive serious moments of doubt. That was what happened only starting in 2007, and the doubts have never have stopped.
For China and the like, despite these chronic “dollar” issues they have never sought to abandon it as their monetary standard. How could they? As much as they might be thought authoritarian, CNY is not of global acceptance that can dictate terms. The Chinese can negotiate bilateral currency agreements, but those are for show. CNY is acceptable only so long as it is acceptable; a tautology that perfectly describes these systemic references. China cannot simply abandon the eurodollar, just as they cannot, as is often warned, sell off all their US Treasuries. Those are one and the same, meaning that to relinquish the dollar as the UST’s would be to move RMB into full isolation; a fractured world that though monetarily has already happened in economic terms everyone knows the score.
In a world described by orthodox economics, that wouldn’t be nothing; in the real world where eurodollars are everything, it might be suicide.
And yet, there is the possibility that Chinese authorities have opted for just that, or at least turning in that direction whilst hoping their choice not at all suicidal but rational. As Moody’s downgraded China, the currency exchange rate rather than drop precipitously as might be expected has instead moved almost straight up.
The operative reason for that isn’t clear, but we know now that Chinese authorities changed the way CNY is fixed. Though the currency floats, it does so on a limited basis at the mixed discretion of the PBOC (which is why August 10, 2015, was a prominent “dollar” event). The other part, the non-discretionary piece, is supposed to be market-based. Instead, authorities decided last week, just coincidental to Moody’s, I guess, to add a “counter-cyclical” factor for only the exchange value with the dollar.
What is at issue here is more than fudging the daily currency band. My gut instinct is that Chinese authorities are simply fed up with being slave to the eurodollar’s permanent bad mood. Enough is enough; maybe.
This would not be the first time CNY has over the past few years appreciated. However, when it does so under these conditions it has that immediate effect on internal RMB. No policy is ever free of costs or tradeoffs, and intervening in a higher CNY value usually pressures RMB liquidity. Again, the limits imposed by the “dollar” conditions meant that these countermeasures proceeded at regular intervals of three months, what I have dubbed the “ticking clock.”
The last one expired, near as I can tell, around March 15. A lot happened after March 15, though unnecessarily tangled up in the last “rate hike” by the Federal Reserve. Among it all, “reflation” died especially in the UST market but more so eurodollar futures; the tell-tale indicative caution over expected “tightening” globally.
During that time, really going back to December, it had become more evident that China’s central bank was increasingly uncomfortable with the level of 7.0 to the dollar. At the end of 2016, the PBOC protested publicly what was a clear flash crash in CNY recorded in data streams all throughout the financial system. It happened; the PBOC said it never did. Why be so sensitive?
The answer, I believe, is that monetary policy in China has gone all the way in on currency stability as their one last hope for getting out of this global economic trap before it becomes too late. But to do that might require extraordinary internal measures, perhaps unlike what has been seen throughout 2016 and so far in 2017. That might precipitate going beyond soft limits in terms of de-dollarizing.
If at the same time the PBOC pushes CNY upward against “dollars” then it might also inject much more RMB to cushion the blow. Doing so would surpass a psychological threshold; before 2010, there were 2 RMB in foreign reserves (PBOC assets) for every 1 RMB in bank reserves (PBOC liabilities; base money). As of December 2016, the constant withdrawal of “dollars” paired with those limited though massive RMB interventions had left China’s monetary system with but 1 RMB in foreign reserves for each RMB in bank reserves. It may not seem like much, but China is in danger of its RMB becoming uncovered by what used to be an unquestioned pile of forex stores.
Maybe that was where this all had to end up at some point, but I can’t help but think on the implications of Chinese authorities even trying it. They have at several points since the Great “Recession” agitated on behalf of some other international currency arrangement, and who can really blame them? The Federal Reserve, the supposed caretaker of the dollar, offered nothing but ZIRP and four QE’s that left the global “dollar” system essentially without anything but further doubts (apart from intermittent spasms of positive sentiment related to QE initiations, that in the end only made it worse because each of them proved US monetary policy was nothing other than sentiment).
The “dollar” doesn’t work for China and hasn’t for many years. It doesn’t work for us, either, nor anyone, a central point that places China as the representative middle for everything. What is going on in China is not strictly about the Chinese. What they might have now decided means a great deal about any further workability of the eurodollar system. In one sense, the mere fact that even seriously wounded the system has maintained itself in limited capacity for ten years is a marvel. But make no mistake, the direction of it is down, always down.
Because of that, at some point it had to reach limits of what participants could withstand. We can observe this already in many ways. US TIC data on cross border dollar flow shows that European banks gave up in 2008; Caribbean banks in the crisis of 2011; and now Asian banks questioning the sanity of trying to redistribute these non-specific bank liabilities shorn of reserves and often logic. In derivative figures compiled by the Office of Comptroller of the Currency, JP Morgan started to withdraw in 2008; Bank of America in the crisis of 2011; and Citigroup and Goldman Sachs in 2014. In both those dimensions, as well as others that can be observed often indirectly (swap spreads), after three successive and unanswered, indeed unrecognized, global “dollar” crises there isn’t left anyone offering up more capacity. The direction is now synchronized.
If China is about to more completely de-dollarize, what does that mean? Writing about these topics the most immediate response is usually to think about the worst case – utter chaos and collapse. Given the nature of the eurodollar decay, that sadly cannot be ruled out but I also don’t believe it the base case, either. I think we passed the point of no return in 2011, so China’s possible (and I stress possible; there is a lot of interpreting and speculating here on my part, but reasonable, I think, to suggest it in this way as a possibility) experiment with thresholds may not be so seismic along those lines.
That wouldn’t mean there are no consequences. I can, in fact, think of a positive outcome if the Chinese were to be successful in agitating for a new global currency regime (a very low probability, perhaps less than the crash worst case) that doesn’t necessarily mean a single global currency (something like the eurodollar but wholly unlike how it works or worked). More likely, in my view, would be something like the next “rising dollar”, the precipitation of whatever further stage of decay might again inject economic and financial weakness on an already sickened global system. How that might develop would be contingent on how it actually unfolds, this de-dollarization and the feedback effects that are in all likelihood to shoot through Japanese banks, at least first.
Being moved in observation more toward Asia with the “dollar’s” post-crisis evolution, I say again the Chinese make it interesting and oftentimes unnecessarily dramatic. Maybe this will all amount to nothing more than unimportant posturing, a knee-jerk if slightly panicky response to an otherwise sensical and truly restrained Moody’s report. But I have had this sense since the middle of last year the Chinese are being forced to do too much, nearing exhaustion about which there is no end or cure. Time will tell if it works out to be significant, but until then I have to think that it is and will be.
