China's Currency Move Predictable As a Ticking Clock

China's Currency Move Predictable As a Ticking Clock
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The Chinese yuan descended dramatically this week, moving very close to 6.89 to the dollar. That is down sharply from just two weeks ago when it had hugged the 6.75 - 6.78 range for a few weeks of temporary reprieve. Though trading in CNY might at first glance seem chaotic, it is, in fact, regular. If you know where to look and how to perceive it, China's currency move has been as predictable as a ticking clock.

Despite more than two years of this, close to two and a half, there are a great many misconceptions about the Chinese currency. There are those, primarily economists, who still try to describe its movements as some kind of "stealth stimulus." It's an absurd proposition, not the least of which because it just hasn't worked (just as it didn't in Japan where the yen was actually an export mandate). If the PBOC was actually rewriting relative parity in order to boost its export sector, then it would have long ago abandoned the effort since exports continue to contract sharply even this late in 2016 (where 20-30% growth was once the norm).

CNY had been pegged to the dollar for much of its modern history. In Milton Friedman's modern world of supposedly floating currencies, that is what you did. To the Friedman model there are three choices for a currency regime. The first is where any nation sets monetary policy internally, but then must allow the currency price to truly float so as to act as a market-determined check on that discretion. The second reverses the arrangement, where a currency board or other designated apparatus sets the currency, but then gives up control over internal monetary policy. The last option is something like "dollarization", where whatever country uses a foreign currency basis as its monetary foundation. The Chinese have more closely approximated the third.

On July 21, 2005, the Chinese officially ended their strict peg of CNY to the dollar under intense international pressure. Earlier that year, Republicans in the US Senate had threatened legislation seeking to impose a 27.5% tariff on Chinese-made goods. It wasn't just the US, however, as there were stirrings of discontent in other parts of the world as China's manufacturing was completing its marginal takeover; the export "miracle" of the early 2000's had brought China, it seemed, great wealth and strength, but also a huge pile of "dollars" due to the currency peg that it used, pace Friedman, as its basis for internal monetary liquidity.

The day of the first floating "band" for CNY saw the exchange rate rise by more than 2%; from 8.2765 where it had been since 1998 to 8.111 and then, seemingly, forever upward more to the liking of orthodox economists outside China. The ascent was interrupted, importantly, in July 2008 just as oil prices started to crash in finally signaling what would become a full and global interbank panic. The easiest and cleanest way to describe those events would be a "dollar" shortage. Stuck at around 6.82 - 6.83 to the dollar, the PBOC had clearly turned to pegging CNY again, though very few noticed, distracted as they were by the lack of "dollars" turning against anything and everything everywhere.

China's efforts on behalf of CNY, really "dollars", lasted until May 2010 when, counterintuitively, the globe fell back into crisis in a fit of minor (still interbank) panic over Greece. The exchange rate kept rising all the way to January 2014, where it had reached just about 6 even. For the next several months, however, CNY had started to drop and quite seriously. In the almost decade since it had been allowed a partial float, it was to that point the largest reversal. Only a smaller drop in the middle of 2012 was similar, though it had ended, once again importantly, the day Mario Draghi issued his infamous "do whatever it takes" promise.

What had changed in 2014 wasn't clear to most, especially in the mainstream. Because the PBOC had a reputation generally in the West for exhibiting such tight control and wielding great monetary influence with enormous precision, most just believed it had to be an intentional central bank policy, though they had no idea what that might be or why. Naturally, as seems to be the tendency in these cases, "speculators" were blamed. In March that year, the PBOC quite unexpectedly widened the trading band for the CNY float, which only further confused the issue. The Wall Street Journal wrote at the time:

"The band-widening announcement came as China's central bank in recent weeks has engineered a decline in the yuan's value to drive out speculators betting on the yuan's continued rise and to introduce greater two-way volatility into its trading, in a bid to pave the way for expanding the band. The PBOC has done so by guiding the parity rate lower and by instructing big state-owned Chinese banks to aggressively purchase dollars."

I wrote in response that this was wrong, almost completely backward.

"In the Journal's formulation, the PBOC is directing affairs, sending out ‘instructions' that Chinese banks should ‘aggressively purchase dollars' ostensibly to punish those hot money speculators. Given what we know of copper and dollar financing in general, is that really the case? Is it not more likely that the PBOC has lost control of dollar conditions and was forced by the ‘market' to widen the daily band in order for dollar-starved banks to aggressively bid for dollars they could not otherwise obtain?"

The WSJ saw "aggressive" and intentional action to "drive out speculators" who were seeking to profit from the only direction the Journal or any commentators at the time were sure CNY could go. In my view, it was a "dollar" shortage hitting China, because,

" is far more plausible that a dollar shortage (showing up as a rising dollar, or depreciating yuan) is forcing the PBOC to allow a wider band in order that Chinese banks can more ‘aggressively' obtain dollars they desperately need. Worse than that, the PBOC itself cannot meet that need with its own ‘reserve' actions without further upsetting the entire fragile system."

It was understanding the subtle differences of how these currency systems actually work in reality, rather than what is included in every economics course and textbook. The Chinese could afford to intervene in 2008 and 2009 because nobody was paying attention, but also because the world was awash in massive "stimulus" of all kinds, China included. That is what has to happen in these situations under the terms Milton Friedman described; almost a Newtonian third law of modern currency regimes, that for every "dollar" action to intervene against a private shortage there must be an internal reaction reducing local currency availability.

And so there is an internal balance as well as an external one that must be struck that over time can greatly complicate all these circumstances. It starts with further appreciating how it is that these central banks actually intervene when they do from time to time. The greatest frustration that you will have related to interpreting and analyzing these episodes and policies is that they will forever remain unobservable from a direct perspective; but detectible according to action/reaction.

In early June 2014, the CNY exchange rate suddenly reversed course. Having dropped just below 6.25, it started to move upward again as if everything had returned to normal. Not quite two months later, in late July, the PBOC announced that it had already begun to use more unconventional liquidity operations with more acronyms that in the grand scheme only proved this "third law" of "dollar" conditions. Among the central pieces of what would be known as "targeted liquidity" was the PSL (Pledged Supplementary Lending), by that point already active at CNY 1 trillion for China Development Bank. It, and the other programs like it, such as the SLF, would continue to be used throughout that year, injecting hundreds of billions of RMB in the months that followed.

Yet, by November 2014, the exchange rate for CNY was falling again, and the Chinese economy growing still alarmingly worse. Increasingly the PBOC was criticized even though it was just months before applauded as semi-omniscient. Economists, especially, demanded that the central bank unleash "proper" "stimulus", including cuts to rates as well as reserve requirements. It prompted a Bloomberg article in mid-November 2014 that summed up the mainstream confusion, titled China Slowdown Deepens As Targeted Stimulus Fails.

It was, again, a fundamental misreading of the Chinese situation; targeted liquidity was not ever supposed to be "stimulus" as orthodox economists conceive of it, rather it was this "third law" of reaction to whatever it was the PBOC was clearly doing in "dollars" in order to get the CNY exchange rate moving back higher. The reason the PBOC was uninterested in cutting rates and lowering bank reserve commitments was both part of its reform agenda but also functional; those measures tend to make the currency fall further, the direction Chinese authorities were seeking to counteract.

As if it isn't completely clear by now that the mainstream has a problem interpreting currency rates in this wholesale, eurodollar format, the shorthand is very simple to understand even if it strips out a great deal of complexity that is important. The currency is not a country's value, nor is it actually a price in the sense that gold has a price. It is a relative measure of what banks inside the country must pay for rolling over or obtaining "dollar" finance. The great "secret" of the wholesale evolution in global money is that everyone is short (synthetically) of "dollars", period. What the 2008 crisis exposed was just how short everyone was, and that it was a matter of international alarm (yet, absolutely nothing was done).

A large change in a currency rate directly affects the price at which banks source those "dollars." Therefore, when a currency is "devalued" it is really local banks paying more for "dollar" funding. The lower it goes, the more banks have to pay or withdraw, meaning less "dollars" for economic trade as well as less internal liquidity due to the "dollarization" framework. From this perspective, you can finally understand and appreciate why the PBOC at the very least is interested in a stable CNY if not an exchange rate that is once again rising.

The problem for Chinese banks is often the limitation for daily trading, the currency band. As in early 2014, China's central bank was not attempting to "drive out speculators" seeking to profit from a further upward move, it was acknowledging that Chinese banks were having so much trouble with "dollars" that the price they were being forced to pay would have violated the currency restriction, and thus caused all sorts of worse negative consequences ("dollar" defaults that would surely have turned into a total eurodollar blackout for China's banking system) were it not addressed as it was.

Of course, the most famous of these violent "dollar" disruptions was August 10, 2015. At the time, and even now, nobody knew what to make of it. It was shocking and unexpected and every other adjective that flew in the face of convention. It should not have been, however, as it was simply the same if much larger "dollar" shakeup as in early 2014. The "dollar" shortage had become so acute by that time the PBOC was forced to let Chinese banks pay an enormous premium (CNY went from 6.20 to 6.38 in one day) for "dollars" else a great many of them likely would have again defaulted (or been forced to call in dollar loans across China's corporate sector that couldn't have been repaid right at that moment) on eurodollar markets.

What the Chinese have done to try to combat this problem since early 2014 is really quite simple, though the how's and what's are not. Almost taking turns, the PBOC "supplies" "dollars" in derivative operations, either direct forwards or covered forwards (as well as a few other transactions and techniques like term repos), that show up in traditional accounting as "selling US treasuries." The problem of "selling US treasuries" is the currency "third law"; reducing "dollar" balances on the PBOC's balance sheet has the effect of reducing RMB for internal use in China. Therefore, we can indirectly detect PBOC "dollar" operations by when they also undertake RMB policies, even "targeted", to offset them (action/reaction).

The timing isn't always exact, but by and large because of the methods of intervention and counter-intervention the exchange rate swings almost like a pendulum. Forward cover comes with a maturity, an expiration that must be added to the "dollar" conditions at that time in the future. Owing to convention dating back centuries, three months is the typical tenor. It gives the deploying central bank just enough time, it hopes, for conditions to change, while at the same time being short enough so as to not elevate too far the very real costs of mediation.

What you will find on the chart for CNY in its descent since early 2014 are these nearly regular interruptions; though the first two in 2014 stray beyond what seems to be three months, partly because there is some difficulty in timing their start. After last August, however, it has been almost exact, regular as a ticking clock. From the day the PBOC almost certainly intervenes, meaning that CNY suddenly stops its downturn and either goes sideways or higher (with that direction telling us something about the intensity of that operational interruption), you can be sure that three months later CNY will be falling all over again.

The reason for this regularity is also quite simple, owing to the great mistaken assumption on the part of all central banks, even those that are actually aware of how the "dollar" world works. In other words, by writing huge forward "dollar" cover, as a central bank you expect that three months later the storm will have passed; that any "dollar" shortage will be over such that your local banks can easily source "dollars" again and you can cover what you had written. If it isn't over in three months, you have just made the situation that much worse because now your banks are still facing a desperate "dollar" gap at the same time you have to cover, adding that much more to the "dollar" deficit. The worse it gets for China, the more likely it spreads far beyond China.

The overall direction of the Chinese currency as well as the regular pendulum swings it takes on its way leave no doubt as to what is truly wrong - "dollars." Economists have tried to attribute these movements to all sorts of other factors, including, as noted above, declared war on speculators. By the end of 2015, however, the media was claiming that the PBOC was again on the warpath against "speculators", this time those betting in the opposite direction.

The problem is eurodollars, and therefore the problem for interpretation is not just rigid ideology, but even for those who are open-minded enough to realize the unsuitability of mainstream beliefs, it is that the eurodollar is not a thing. It's not as if we can go into the PBOC, the vaults of any of its banks, or even those in the global market claiming to have them and count stacks of eurodollars neatly piled and assayed in the corner. They don't exist, more a virtual currency than anything, and in reality, to my view, share far more similarities to a computer network than actual currency.

So what we are really talking about in terms of a "dollar" shortage are those "network" protocols that determine who gets what and ultimately at what price: bank balance sheet conditions and restrictions. The increasingly immutable truth of CNY in showing a global "dollar" shortage manifesting in a number of ways beyond the Chinese exchange rate and even far beyond China has finally, finally provoked some soul searching. It is, to this point, just baby steps and, as you would expect given such a radical departure from orthodox beliefs, limited, but slowly the orthodoxy is being forced to accept the fact that global money may not be or have been what they all thought. BIS Working Paper #592 published just recently admits:

"A stronger dollar goes hand-in-hand with bigger deviations from CIP [covered interest parity] and contractions of cross-border bank lending in dollars. Differential sensitivity of CIP deviations to the strength of the dollar can explain cross-sectional variations in CIP arbitrage profits. Underpinning the triangle is the role of the dollar as proxy for the shadow price of bank leverage...

"CIP is perhaps the best-established principle in international finance, and states that the interest rates implicit in foreign exchange swap markets coincide with the corresponding interest rates in cash markets. Otherwise, someone could make a riskless profit by borrowing at the low interest rate and lending at the higher interest rate with currency risk fully hedged. However, the principle broke down during the height of the 2008-2009 crisis. After the Great Financial Crisis (GFC), CIP deviations have persisted and have become more significant recently, especially since mid-2014."

In short, there is more to money than they all believed, especially in international settings where the eurodollar is and has been the (dying) king. The difference is banks, once an afterthought if ever considered at all, now realizing that their role is at least more relevant if not, as I have argued for years, the only thing relevant (more than suggesting it was the QE's, LTRO's, and all the rest as what was irrelevant).

This is not the only peak behind the ideological reckoning, of course. At Jackson Hole in August, central bankers gathered to essentially declare they had no clue, hoping that by getting enough of them into one room spontaneous new ideas would just arrive as if by osmosis. Earlier this year, Paul Krugman told a Japanese audience that "the linkages among major economies are strong" due to "capital flows" among them that, too, were written in every orthodox textbook as if immaterial. Economics (capital "E") had assumed a closed system for each currency, with each central bank as its lone center; the eurodollar obliterated that model long, long ago. The Great Financial Crisis, easily swallowing up every single monetary "answer", should have been enough proof of this.

It is obvious to project why this all matter s in its most immediate form; after years of global stagnation (depression) all these places subjected to the unending "dollar" shortage are in danger of being further destabilized. But we should not also set aside more selfish considerations. The Bloomberg article from November 2014 I quoted above made another crucial error of understanding, one that has become common again, writing, "The evidence underscores concern that, outside the U.S., the global economic outlook is deteriorating." In other words, Bloomberg offered that China's failed targeted "stimulus" was failing China and the rest of the world apart from the US.

The truth was, of course, far different, as China's struggles against the "dollar" shortage coincided with our own financial and economic problems with the very same, revealed quite directly also last August. It was all "unexpected" to the likes of Janet Yellen because she thought it was QE that had engineered a meaningful unemployment rate when it was instead the "dollar" that had been undermining it since 2007. I wrote last June that Americans were sheltered from the building "dollar" problem that was more than a looming threat even to America at "full employment." There was a great deal of domestic optimism then, not unlike now, determined to the textbook course of overlooking "foreign" money.

"To a great extent, Americans are both sheltered and wholly unaware, but the rest of the world is very much alerted to the continued downside of the eurodollar standard. Stocks may be at or near record highs (though broader stock indices, such as the NYSE composite, have gone nowhere since the "dollar" started to rise), but Brazil is in a state of total economic and financial chaos while China flirts with what was never thought possible...There was a "dollar" system somewhat in place, largely before the middle of 2013, which supported all those but no longer does."

CNY is falling again and right on schedule. When enough people are finally obliged to confront what that truly means, maybe then, finally, the pendulum can stop swinging, the clock having struck its final countdown.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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