The Decade Ends In the Same Place As It Began

What a way to end one decade and begin another – in the same place. Though they are separated by a whole lot more than just the Pacific Ocean, they are institutions caught up in the same noose spaced over an enormous amount of time as well as distance. On the surface, they couldn’t seem more different and yet they find themselves a common cause for a common purpose because of a common deficiency.

For the one in China, the People’s Bank, Rénmín Yínháng, it is attempting as best it can to look after the People’s Currency, Rénmínbi. Every so often, however, the same PBOC keeps having to add massive amounts of what we are told is additional liquidity.

It has happened again just recently; or, more specifically, this week it was announced by Yi Gang’s central bank that on January 6 the reserve requirement ratio (RRR) for Chinese banks will be reduced by 50 bps. Another 50 bps.

The Chinese have a seasonal calendar bottleneck to contend with in the weeks ahead. Every January or February the country shuts down for a weeklong celebration. The Spring Festival had been designated as the first of the country’s two “golden weeks”, government-mandated holidays where workers are given a full week off.

The people as consumers use it to good effect, especially traveling and shopping. But with banks closed for an entire week, the result for the financial system is a seasonal low point as it pertains to spare currency. Banks stock up, leaving less for each other, knowing that there will be a huge spike in demand for currency and payments from the public.

The PBOC typically manages this predictable currency jam by flooding the system with actual currency. For example, in anticipation of last year’s Lunar New Year, the other name for China’s Spring Festival, the central bank increased its currency float (liability) by 21% in January 2019 from December 2018. Going from RMB 7.9 trillion to RMB 9.6 trillion, the currency gets issued to the banking system so that enough of it is on hand for the enormous withdrawals that take place before the holiday.

That currency, however, isn’t of much use in the interbank market. This is the wholesale money market where banks seek refuge from overdrafts as well as seek out funding on the shortest terms for balance sheet positions.  Physical currency issue has no place here where virtual ledger money is the currency.

As such, Chinese banks tend to hoard that form of liquidity ahead of each Lunar New Year. Most years, this is an uneventful process because, again, it is entirely predictable. There are rarely any surprises, and even rarer still are liquidity problems.

Or were.

For the last several Spring Festivals, some of them have been preceded by these RRR cuts. Each policy reduction is celebrated in the West, particularly, heralded as more very welcome “stimulus.” Another flood of liquidity on top of prior floods.

In addition to January 2020, the RRR was reduced in January 2019 but not January 2018 nor January 2017. But it had been in February 2015 - since the Golden Week fell as late in the calendar as it possibly could - and again in February 2016 a few weeks after that holiday had ended.

Some seasonal bottlenecks, it seems, are different than others. What makes them different is not the bottlenecks nor the seasons, but the monetary conditions over top of them each time.

The Federal Reserve should have taken notice because despite so much distance and perceived differences it begins 2020 in the same boat as the PBOC – afflicted by the calendar. At least that’s what it will have the public think.

Like September, for December in one US$ wholesale money market, repo, the Federal Reserve was forced into heavy action by what we are led to believe is another quarterly problem.  In addition to ongoing responses to that prior one, the not-QE T-bill buying, Jay Powell’s group would auction another “flood” of liquidity so that 2019’s calendar “turn” would not turn out like last September or last year’s (you might recall a huge jump in repo rates at the end of 2018, too).

While one prominent Credit Suisse “expert” jumped the gun predicting all sorts of hugely negative consequences for last month’s repo condition (if for no other reason, I presume, than to use it as another way to reverse engineer a path toward his unflinching position for how interest rates have nowhere to go but up), they never materialized in one part because of the Fed’s actions.

Kudos to Mr. Powell, right?

No. Like Yi Gang, Jay Powell is fixated on the wrong side of the issue. Unlike Powell, Yi has little choice. To see why, for both men, you have to go back a little way and appreciate how this was all supposed to have unfolded.

It was arguably the most studied and anticipated policy change in the entire history of the Federal Reserve. In (belated) response to the Global Financial Crisis it did not foresee (nor stop), the US central bank engaged in four doses of quantitative easing throughout the years (because it didn’t work, the program had to be repeated). As a large-scale asset purchase (LSAP), the net effect of all that purchasing of assets (MBS and US Treasuries) was a radical expansion in its balance sheet.

At some point, there would have to be a radical shrinking. Once the US economy was healthy and recovered, it had always been official intention to normalize the central bank’s footprint; to go back to the way things were. For several “autonomous” reasons authorities realized they couldn’t go all the way back to zero like it had been before 2008. Still, all their studies and game planning showed in all likelihood they would get close.

That’s all quantitative tightening had ever been. QT, as it has been called, was another term for “normalizing”, another way of saying the Fed was attempting to go back to the way it was.

Think, for a moment, about what that would have meant. As I’ve stated too many times before, there were practically no bank reserves prior to the Fed’s crisis interventions. The system didn’t need them, it had created, supplied, and redistributed its own forms of “currency” – and not just across the zoo-like landscape of domestic US$ wholesale, but all across the offshore world flooding the entire globe with virtual money (the eurodollar system).

What QT was supposed to have been, then, was the Fed handing liquidity responsibilities back to that private and global US$ system.

All monetary officials had to do was let those ample reserves do their work (in expectations), give them enough time so that first the financial system would be rebuilt and restored and then the economy which would follow the same way. Once it did, once the declaration was made that full employment and stable inflation (meaning a rise in the rate to the Fed’s 2% target) had been reached, that was the moment the Fed would hand back the liquidity function to the private markets.

The balance sheet would shrink (QT) and no one would notice because everyone would be too busy celebrating and taking advantage of the global recovery. For the public, who would care where liquidity was coming from during boomtimes? The central bank or the private system, so long as the good times kept rolling quantitative tightening would be a minor historical footnote, at most an academic quirk Economists and central bankers would use in the future as a means to pat themselves on the back.

It never worked out that way, of course. The word “boom” was used frequently enough though it didn’t actually mean even what those who used it were trying to convey. In terms of US$ liquidity, there were problems evident from the very start.  

Jay Powell’s Fed had been forced to tinker with IOER all way back in June 2018. It has only gone downhill since. By the middle of 2019, the Fed began to rethink QT, figuring it might have to end it far earlier than planned. By the end of July, on the eve of the first rate cut in a decade, QT, quite abruptly, was scrapped altogether.

Again, think about what that must mean underneath the surface. As a practical matter, policymakers were saying they, too, finally saw the illiquid behavior taking place in US$ markets. Not only that, they judged them to be serious enough that their answer to them was to leave the level of bank reserves far higher than they had ever planned.

Another way of saying that is bank reserves would never get close to normal. Or, the system wasn’t going to be normalized. Something was creating such a problem that in the official mind only an ongoing surplus of public reserves would let the system function minimally.

Where are the private reserves?

In attempting to return the liquidity function back to the private system, the Fed was stopped well short of doing so. In realizing that, what does the level of bank reserves actually tell you?

When there were no bank reserves before 2008, there must have been a whole lot of private reserves because, well, the world went monetarily insane. And when the Fed swelled its balance sheet it was because there was must have been an enormous deficit of them (thus, global crisis). Had QT been successful, it would have meant more like the latter (absent the bubble behavior) than the former.

And in this other condition where QT cannot be completed, suddenly predictable seasonal bottlenecks which exist in every calendar year must be met with enormous injections of, well, something. It can’t be liquidity because those very injections demonstrate the distinct lack of it.

It had been 2013 and 2014 when the Fed tested and studied and over-studied its crisis exit. Given the direction its models thought the economy was heading, all eyes were on 2015 as a possible start for potentially the full gamut: rate hikes, normalization, and even possibly QT. And it never happened that way, either.

In many ways, the aborted normalization of 2015 was every bit as instructive as the spoiled launch of it in 2018. Just ask the Chinese.

The reason why there had been RRR cuts in 2015 and 2016, but not 2017 and early 2018, was that same private dollar system. Yes, dollars.

When those hidden offshore US$ reserves aren’t causing trouble, they tend to find their way around the world into the most desirable (risk vs. reward) locations. That’s what a reserve currency does; it is the more than sufficient supply that allows for what we call “capital flows.” You have to have the (euro)dollars first else the “capital” will not “flow.”

For a place like China, that used to mean big things. Big money. So many “dollars” would end up there and because of the way the local money system was engineered they would find their way onto the PBOC’s balance sheet. It was as if the eurodollar system put China into a constant state of QE (where the “Q” stood for unlimited-Quantity).

Like the Fed’s balance sheet would experience much later, the PBOC’s swelled from the 1990’s into the 2000’s, especially the middle 2000’s, but not from asset purchases rather from eurodollar arrivals. Different intentions, same effect. As the PBOC’s asset side increased, its liability side did, too, meaning bank reserves (and currency).

But it had gotten out of hand. In order to tamp down inflationary currency conditions which were getting destructive by 2005 or so, China’s central bank raised the RRR. The PBOC, as the Communist government, didn’t want to stop the flow of “dollars” – why would they? – they would keep inviting them in and instead try to deal with their fallout locally. A very good problem to have.

By raising the RRR, officials were hoping that by locking up this byproduct of RMB reserves at private banks they couldn’t be used in liquidity and therefore the creation of private Chinese balance sheet credit. The more (euro)dollars that ended up in China, the higher the RRR went.

No one in China had ever envisioned a time when the (euro)dollars would stop flowing. But that’s just what happened between 2011 and the start of 2014. What, apart from 2008, had always been a flood from that private global dollar system slowed to a trickle. And then in early 2014 an actual reverse.

Without the rising tide of these “capital flows” it had left the RMB system dealing with the equivalent of a Chinese QT. Again, not an intentional policy but the same in terms of central bank balance sheet mechanics. The asset side slowed and even shrank, therefore the liability side would have to. Less bank reserves (I mean a lot less) at the central bank and physical currency growth down to practically nothing.

To try to handle that dearth of liquidity, the PBOC simply put the RRR in reverse. The fewer (euro)dollars that end up in China, the lower the RRR must go.

The first run of RRR cuts hit during 2015-16, Euro$ #3 (meaning the third global dollar shortage of the last decade), Janet Yellen’s aborted first shot at normalization. The second run of RRR cuts has been over the past two years, those coincident to a very confused US$ liquidity situation and its unexplained, misunderstood central bank responses.

Not just coincident timing, both the aborted US normalization and ongoing repo interventions as well as the PBOC’s RRR’s derive from the same issue. When private US$ reserves were plentiful, the PBOC experienced a form of hands-off QE-like expansion while at the same time the global system required little to nothing from the Federal Reserve. Conversely, when private US$ reserves stopped growing (at a sufficient rate), the PBOC experienced something like involuntary QT, leading to the RRR’s, while the Fed engaged in its own intentional act of QE.

Ironically, both the latter set of central bank actions have been uniformly characterized as stimulus – even though bank reserves rise for the one and fall for the other - rather than more properly as a reaction to a huge monetary hole that had already opened up far more importantly in the private system reaching out in both directions.

If public US$ reserves are rising it can only be because private US$ reserves are insufficient. And from China’s end of them we know just how dangerous of a situation this ongoing problem can create. Not in terms of an abrupt crash just around the corner, but far more of the slow and intractable strangulation which the entire global economy must experience only starting with the Chinese.

Xi Jinping has spent the entirety of this Euro$ #4 tightening his grip, realizing that there is no global growth in this kind of situation and what that could do as far as unsettling China. All the prohibitions that were put in place after Mao Zedong’s death to ensure there would never be another terrifying strongman tyrant like Mao have been unwound and undone. Never let a crisis go to waste, or something.

In the last days of the decade, in December 2019 while the PBOC was finalizing its latest RRR and the Federal Reserve was allotting out “repo” “liquidity” programs that are not QE, China’s Politburo very ominously awarded Xi the honorific of Rénmín Lingxiu last given to…Mao Zedong.

They call it Rénmínbi, the People’s Currency, a false notion because it is actually dollarized. And the People’s Bank, Rénmín Yínháng, is stuck on constant stimulus that never stimulates. The less dollars, the fewer the currency, the lower the economy. And because this dynamic had taken up the majority of the 2010’s, at the end of the decade it leaves China’s Communists to resurrect the terrifying prospect of Rénmín Lingxiu – the People’s Leader.

The issue is not really about the PBOC nor the Fed, but why they are stuck in the same condition where neither can get its act together. It is what lies in between them, the private reserve system that was supposed to have been fixed long before now – but obviously is not. As the twenties dawn, we can only hope the People of either country wake up and demand more than QE’s and QT’s - while they can.