2019 Rate Cuts Are Being Priced As Far, Far More Likely
When the Chinese currency (CNY) suddenly plunged in the middle of August 2015, a stunned world conditioned by decades of econometrics condemned China for its brazenness. Currency exchange rates are set, we are told, by learned experts conducting predetermined policies. Therefore, an abrupt devaluation like that one must have been an intentional change in strategy.
In the face of growing economic weakness, the masters of CNY were purportedly undertaking export stimulus. Lower the currency, make the goods you produce a bit cheaper on global markets, voila, economic acceleration. It’s in all the textbooks.
At the time, though, even those proposing this sort of explanation were unusually shy about it. Something just didn’t seem right, starting with why China was in such an economic fix to begin with. The global economy of 2014 was a total boom, they said, nowhere more so than the Chinese’s arguably most important trading partner.
The US had just experienced what was widely described as the best jobs market in decades. And yet, US consumers weren’t buying up a lot of what China could manufacture. Imports were falling not rising. In fact, a “manufacturing recession” worldwide was perfectly clear in 2015 by the time August came around.
Then, just two weeks after CNY’s “devaluation”, Wall Street crashed. Much confusion.
We are taught that none of these things can be related. Individual economies are, well, individual economies. Trade is good and all, but hardly a major connection between them. That’s why “devaluation” is explained the way it is in the Economics textbook.
The 2015 case didn’t work out like that. After a few months further on, even the mainstream media, most of it, stopped referring to CNY’s plight as intentional policy. In this age of Economists and their complex equations, even the most stubbornly orthodox among them had to note the only equation which seemed to matter was, CNY DOWN = BAD.
Bad for much more than China. Bad for everywhere.
It’s not that China’s falling currency itself destroys economic growth in other places. This is no beggar-thy-neighbor outcome. When CNY drops, it is a signal for something else which does the dirty work behind the scenes. In the shadows. China’s currency is a proxy, perhaps the best one for the thing that really does matter.
China needs dollars in the same way Europe, India, and every country of Africa does. The dollar denomination is a middle currency, the means to intermediate global trade that accomplishes and connects much, much more than the standard Economics textbooks say. It is the grease for the wheel of the global economy and global finance, and not just any old grease but the most efficient economic/financial lubricant ever invented.
These are not dollars, however, as most people understand them. There are no shipments of stacks of Federal Reserve Notes. More like promises made by banks that if another bank on the receiving end ever chose to, the first bank could obtain those kinds of dollars on the spot. The second bank never does, using instead the IOU as the relevant currency unto itself. Nobody wants the actual dollars; these virtual ones are so much better.
The fact that these long chains of bank liabilities take place offshore, that’s why the name eurodollar most closely applies to them. The world needs the eurodollar system else things really start to get weird.
For the Chinese, local banks must have access to eurodollar markets so that Chinese companies can participate in vital economic and financial activities outside of China’s borders. In many cases, they need this middle currency to do things inside China, too.
When the world was seemingly unstoppable in its globalizing before 2007, eurodollars were more than plentiful on the Chinese side. There was, in fact, too much. As a result, China’s official pockets were filled with what seemed like US$’s but were in fact eurodollar-based financial connections. Classified as foreign reserves anyway, they formed the basis for China’s central bank and its internal monetary conditions.
But what happens if China’s local banks start to have trouble with eurodollar markets? China’s corporates still need these “dollars” to do the same things they’ve done for decades. To deprive the corporates of them would mean the Chinese economy grinding to a halt, further consequences spreading around the world from there.
Having built up so many reserves, the country’s central bank, the People’s Bank of China (PBOC), which has been entrusted with the vast majority of them, can mobilize these reserve balances and give them back to the local banks for use by local companies. Simply, if the system can’t source eurodollars, then the central bank can supply them dollar-lending-of-last-resort.
It sounds easy enough, so what’s the big deal?
It’s actually very complicated. Having absorbed all those eurodollars onto its balance sheet prior, the central bank removing them even in an emergency removes the central building block of domestic currency.
For the central bank, it is faced with an unappealing choice: give “dollars” to the local banks and corporate sector to keep up vital global activity but at the same time robbing the domestic economy of its monetary base; or, leave the monetary base alone and deprive the local banks and corporate sector of the “dollars” the economy needs right where growth comes from.
If you had the ability, you would choose both if you could. But how can you supply dollars and at the same time preserve the monetary base? Fudge with derivatives.
In 2013, Brazil’s central bank, Banco do Brasil, published a study purporting to show the benefits of straddling this middle.
“A well known advantage of issuing such contingent liabilities as currency swaps is that authorities become able to intervene in the exchange market indirectly, without affecting the money supply or varying the stock of foreign exchange reserves.”
The exact way this works, purports to work, is far beyond my scope here. To oversimplify, central banks subsidize their local banks in many different ways, from forward cover to other forms of derivative supports. You get “the market” to work in your favor. As the Banco paper put it:
“We posited that, even though these contracts do not directly affect the supply of foreign currency in the market, they are likely to affect exchange rates as they alter the demand for foreign exchange – particularly if traders extrapolate exchange rate trends at short-term horizons.”
The Brazilians in 2013 when the study was published were up against a very similar currency challenge. The real was falling and Brazil, for these reasons specified, was unwilling to directly mobilize its reserves. It used swap-like instruments which subsidized Brazilian banks in their dollar activities; they could then more easily afford to pay the higher premium the dry eurodollar market was demanding for increasingly scarce offshore, dollar-denominated funding.
It was a disaster. This scheme can only work if the problem confronting the country is a temporary one. As a central bank, you can bankroll local banks for only so long. Eventually, the costs pile up as do unintended consequences. The point of such a program is to buy time so that “whatever” is causing difficulties for your banks clears up and everything can get back to normal.
At that point, you settle out all these subsidies which has the effect of increasing the strain. By that time you expect everything including the market is back to business as usual, it can then easily absorb the additional costs of winding down the prior interventions. This is nothing more than a maturity transformation; you intend to push the problem, push the increased dollar funding costs far enough into the future so that when they are unwound hardly anyone notices for everything back to booming normal.
A typical short-term swap instrument or the like has a standard maturity of three months.
For China in 2015, we could see and observe very clear three-month intervals. From them, we could infer the PBOC undertaking part Brazil-like intervention in CNY, part more direct lending via its reserves. To support the currency meant subsidizing China’s local banks in their increasingly harsh eurodollar market funding at the same time lending to them outright by “selling” reserve assets.
Throughout 2015 and 2016, the tally of China’s official reserve plummeted. It was not uniform, however, suggesting that during the worst months of the period China was also “selling forward” these same reserves – partly the Brazil option.
By early 2016, even the IMF had spotted it. At the very bottom of the global downturn caused by Euro$ #3, in March 2016 the Wall Street Journal reported:
“The International Monetary Fund is pressing China to disclose more information about its currency operations based on standards the Chinese central bank had pledged to follow, people familiar with the matter said, as Chinese authorities resort to more-discreet ways to support the yuan.
“In recent months, the People’s Bank of China has turned to the derivatives market to help prop up the currency—a shift from its traditional approach of dipping into its dollar pile to buy yuan.”
I call it, simply, the ticking clock.
To oversimplify again, let’s assume you need to borrow $100 every day in short-term eurodollar markets just to keep doing the vital economic and financial things you do. One day, the eurodollar market demands $110 for whatever reasons including problems on its own end. As the central bank, I promise to help you by giving you the extra $10 because you not having that $10 means you don’t get all of the $100 and therefore all sorts of bad things for you as well as the economy.
I can sell $10 in assets I already own, which, as noted above, means that’s $10 subtracted from the domestic monetary base. Or, the Brazil option, I can give you $10 today by promising to obtain $11 three months in the future. It sounds absurd, but that’s really what happens and it keeps the $10 in place for the domestic base while simultaneously giving you an acceptable liability covering your $10 shortfall.
Three months later, you are still borrowing the $100 on eurodollar markets as you always do, but now I have to borrow $11 on top of it, to close out that prior intervention. If the eurodollar market has gone back to normal, great. If the eurodollar market still demands $110 from you, then we have double the problem.
At that point, I can choose to subsidize you again: promise to borrow $22 another three months further in the future (meaning now 6 months from the original start date) so that you can still obtain your $100 at the starting costs.
Every three months, the cycle or clock merely repeats.
Last year, 2018, proved yet again the validity of our big equation: CNY DOWN = BAD. China’s currency plummeted against the dollar beginning last April. A few tried, like 2015, to call it export stimulus. As 2015, China’s export engine has increasingly sputtered.
By October 31, CNY was back down near 7 to the dollar. October was a particularly bad month around the world. Economic stats since have grown more seriously negative and even recessionary in many key nations (Germany, South Korea, Japan, and yes China). Global trade is being held back and not by Xi vs. Trump.
Contrarily, during November and December which continued October’s market and economic disruption, CNY was on the rise. Either our equation had failed, or, pace the IMF, “someone” was out there supporting the currency via clandestine means.
And it wasn’t actually all that hidden and sneaky. The PBOC wasn’t directly admitting to what it was likely up to, but the central bank gave off several indirect warnings which if you understood the mechanics would only trace back to those shadowy efforts. The RRR cuts, for example, were the visible offsets to what the consequences of opting for the unseen Brazil option might mean.
October 31 plus three months was January 31. CNY stopped rising on that date, exactly three months after it started. The currency didn’t immediately plunge again, however, it changed pattern to sideways. The level and/or type of intervention probably changed with it, altering the cost/benefit equation for whoever was doing this.
January 31 plus three months was April 30. On that latter date, the exchange value was 6.7347 to the dollar. A little on the low side but very much in the same range and about where it was at the end of January. So far in May, however, it looks like everything has changed; CNY DOWN. As of this writing, now 6.83.
Not only that, more indications of “someone” out there borrowing heavily in eurodollar markets the past few weeks. Even domestic dollar markets, things like repo and federal funds, a noticeable increase in illiquidity spreading a little too uniformly. Rather than intervene a third time by promising to obtain $44 three more months into the future, maybe I’ve spent the past few weeks trying to close out the $22 I had already promised starting six months ago?
And with the eurodollar market still in a bad way, as it has been for more than year now, you are left to pay the whole $110 on your own for the $100 you always need. Given heightened risks, today you might be asked for $115. Another way of saying that is 6.83 yuan to the dollar instead of 6.73.
The ripple of effects are why CNY DOWN leads to so much bad. Extra competition for scarce resources, even monetary resources, drives up the price of them for everyone. A central bank coming in and closing out is an added burden a malfunctioning eurodollar market cannot easily handle – which may be why even something like federal funds going back to mid-April starts showing up on the front pages of the financial press. The sparest of spare pocket change suddenly in high demand.
It’s not like things have gotten better two ticking clocks later. Maybe the PBOC was hoping Jay Powell and Mario Draghi would get it together in the meantime.
On the contrary, risks have risen with economic data more and more confirming the unease. A global slowdown is already in the books, a downturn more completely emerging. Though the PBOC may have managed to pull CNY out of the mess, the mess is still there and much more widespread as a consequence of the same process which forced CNY lower a year ago.
In the US, rate cuts in 2019 are today being priced as far, far more likely than they ever were back in October. There is nothing good to associate with rate cuts, especially a renewed and further amplified global dollar shortage. CNY DOWN would only add to factors piling up on that scenario. It could actually be the most important one.
The global economy is not a patchwork of limited connections between robustly individual, closed systems. It may be China’s currency exchange, and it has nothing to do with exports, this is why CNY DOWN = BAD is so much more than just China. After a curiously exact six-month hiatus, it just might be back.