Businesses Shun Innovation. They Just Want IOER.

On March 26, 2018, Chinese authorities began allowing seven different grades of crude oil to be traded on Shanghai’s International Energy Exchange. Since this specific marketplace fell under the rules of one of China’s larger Free Trade Zones, special areas within the Communist country which had been set up because even the Communists know that Communism doesn’t create wealth, domestic Chinese buyers and speculators would be able to directly transact with foreign speculators and sellers.

More importantly, the currency they’d begun to use for settlement was China’s renminbi (RMB), not dollars.

This “petroyuan” was purported to have been styled similarly to the so-called petrodollar, and thus was seen as more than simply a product of enterprise evolution inside the dense Chinese bubble. Graphic headlines populated the media both East and West, many of them predicting the dollar’s doom.

The day before the oil contract trading went live, on March 25, UBS published a white paper on the topic. In the rush to be first to extol its virtues, the Swiss bank researchers wrote:

“This will have two principal effects: increased demand for RMB assets and a switch out of the USD for trading purposes, which will likely undermine the United States' dominant role in the global economy and create a sea change in global asset allocation to China's financial markets.”

The theory goes like this: by talking up the incentives to doing business directly with China, including, perhaps, a little more soft extortion along the lines of its Belt and Road Initiative, oil producers would agree to be paid in local Chinese currency. That would allow them to buy more goods directly from China or leave the proceeds invested there without having to confront the difficulties presented by using the dollar.

For a time in 2018, there was so much salivating over China’s big move it had grown downright obnoxious. Even the venerable and usually dependable Mises Institute chimed in for another slap to poor old dollar’s reportedly tenuous fate. Writing in January 2018, in anticipation of the grand Chinese oil masterstroke (which had to be delayed several times and for several months), Alasdair Macleod piled on:

“This might seem a frivolous question, while the dollar still retains its might, and is universally accepted in preference to other, less stable fiat currencies. However, it is becoming clear, at least to independent monetary observers, that in 2018 the dollar’s primacy will be challenged by the yuan as the pricing medium for energy and other key industrial commodities.”

If anything, the dollar is as popular as ever - including for commodities – even as it continues to make the rest of the world miserable for it. 

Theories can be fine to work from if they are legitimately grounded in on-the-ground facts. Where money and finance has been concerned, there’s probably never been such a huge divide.

Right from the start, China’s currency isn’t fully convertible in the most comprehensive sense, which means that once you have RMB in your hands you don’t actually have RMB in your hands. The Chinese government is notoriously inviting for those who want to move cash or product in, but equally if not more stringent for anyone even thinking about taking cash out.

RMB is therefore of limited use, a fact of monetary life China isn’t going to change anytime soon (they certainly haven’t yet). Which, if you understand the nature of global reserve currencies, would definitively rule out RMB as one even if the PBOC’s involuntarily ultra-tight grip on supply hadn’t already done so a long time before.

Second, the dollar’s exchange value is, they say, unstable. And while that’s true, unstable in the post-GFC1 fashion actually has benefited greatly those who stick with it. Why would oil producers want RMB when they can continue demanding dollars and then gain further as the dollar “unexpectedly” grinds ever higher? It makes their future purchases of cheap Chinese goods that much cheaper, any future investments that much more investable.

What’s left of the petroyuan story, then, is essentially the extortion. Like it or not, this accounts for those Shanghai contracts’ popularity as well as the far more important fact that these things haven’t put the slightest dent in the dollar’s.

What everyone had taken for granted, before ever thinking seriously about the petroyuan, was how the dollar was assured to fall. It’s always going to fall. Money printing, political will, something. And up to early 2018, that seemed at least somewhat plausible.

March 2018 was a watershed period, though, for reasons that had little to do with Shanghai’s oil-for-RMB swap. At least not directly. There were all sorts of “weird” noises creaking out from the shadows, the kinds of cracks and bangs that if you heard them you had begun to worry about the status of the dollar system.

Not the sort, however, which were consistent with this universal convention convinced the dollar was going down. Way down. I wrote on April 12, 2018, having closely studied these somewhat arcane things (and written much about them in these pages and elsewhere):

“In other words, as you can plainly observe…liquidations in multiple markets, spread out globally, led to a rising LIBOR spread which indicates, surprise, rising liquidity risk. Budget deficits? Come on. Seriously.”

Just one week later, the dollar began to rise precipitously. It hasn’t really stopped. To that point, and for quite a long while thereafter, Federal Reserve officials would blame December 2017’s tax reform for the rising problems in federal funds, eurodollars (LIBOR), and most of all repo. This neatly dovetailed into the dollar-is-done theory, too.

To put it simply, they all claimed there were “too many” Treasuries. Wild government borrowing had begun to overtax the banking system which threatened the Treasury market and thereby the US currency. And at the perfect time, in swooped the wise Communists in China to deftly take advantage of America’s greatest moment of financial madness.

It made for one hell of a great story; it’s just that very little of it was true – starting with the petroyuan.

To begin with, you don’t hear much about it these days. In fact, the yuan-mongering didn’t really make it out of 2018. As the year turned 2019, and the “too many” Treasuries theory tumbled along with Treasury yields once demand for these instruments predictably skyrocketed, suddenly the grand Chinese oil play, the pivotal reveal of the long-game the super-patient government of China is allegedly playing, looked downright inconsequential.

We’ve seen this countless times over the last dozen years. In reality, the Shanghai oil contracts are doing quite well, you might even say they’re thriving. China has been able to develop a decent (though questions persist) market for this financial product.

It was never meant as even a small piece, let alone the key piece, which would have allowed the world to dethrone the dollar, RMB first. That’s just other commentators hyping up another innocuous method the Chinese have to come up with in order to try and alleviate the ever-present (euro)dollar pressures they continuously face.

The hype is easy and easily packaged for sale; understanding what’s really behind the dollar obviously isn’t.

If you have to pay for oil, indeed most goods available on the global marketplace, using the dollar as the required medium and you continuously run into trouble getting your hands on it (almost $1 trillion in Chinese reserves “disappeared” 2015-16), then it makes sense to reduce your dollar need as much as possible by convincing as many trade partners as you can to take your own or even other forms of currency that aren’t so difficult (these are equally mythical).

Reducing the dollar’s burden is not the same thing as gunning to replace it in the global currency system with your own (and Chinese monetary officials like current PBOC Governor Yi Gang as well as his predecessor Zhou Xiaochuan have instead pushed for SDRs because that’s how short the list of alternatives really is). The latter is ascribing political motives (and abilities) to what is first and foremost extremely different monetary and economic reality.

Like US Treasuries, though, the dollar mostly goes in the other direction. I assure you this is not some display of instinctive patriotic chauvinism nor the emotional chest-thumping of some excessively proud American. Quite the contrary, the very fact that Treasury prices tend to go higher (therefore yields lower) no matter how many of them get issued and that this corresponds very closely to the dollar’s ascent can only mean bad things.

For China, Russia, Europe, and, yes, America. Everyone.

The petroyuan was hardly the first attempt. If the Chinese have to come up with increasingly creative ways just trying to lower their dollar burden, and that they’ve been forced to do this near constantly for more than a decade, what does that really tell you?

The dollar’s exchange value, looking at it from a very high level, is pretty simple and follows basic economics (small “e”). Like any commodity, when it becomes scarce the price goes up. Relative scarcity can mean different things at times (demand rises but supply doesn’t; supply falls faster than demand; etc.) but in general the supply of dollars hasn’t adequately matched the demand for them (for all purposes) really since August 9, 2007.

And that raises the question of who actually controls that supply. The textbooks say the Treasury Department can, assuming, of course, it convenes a top-level meeting of similarly-ranked officials from enough nations at the poshest hotel in New York City to raise some accord. By and large, though, convention fingers the printing press; the central bank; the Federal Reserve.

It isn’t something we are supposed to be thinking about not after having completed the QE decade. The Fed printed trillions the end. But it also spent those dozen years (the only thing QE inflated was how many years fit under the same label) researching one excuse after another for why so much monetary magnificence never produced the intended results. From inflation to growth, everything was undershot.

And that was just inside America. Outside, well, you get the picture just from what’s really going on with the petroyuan.

A little over a week ago, the father of modern finance (no, not Louis Bachelier) Eugene Fama caused quite the stir when he declared that, “Inflation is totally out of the control of central banks.” He further characterized modern monetary policy as, “it’s just entertainment and it doesn’t have any real effects” equating it to pornography.

Anyone interested in honest study and analysis can see this is true. But why?

In Fama’s view, the QE decade was also the one which introduced IOER. According to money theory in the tradition of 1970’s Modigliani–Miller, when the Fed started paying interest on the reserves created as Ben Bernanke’s Fed bought assets from banks, that rendered what was supposed to be money printing, the creation of currency from thin air, into instead a neutral asset swap of long-term debt for short-term.

From this classic money view, what else could explain that while bank reserves have consistently been theorized as base money, from 2008 forward it has been proved time and again they are not? For classicists like Fama, and he hasn’t been alone in fixating on IOER, they can easily observe the effects, all these negative effects, as well as when in history the breakdown seems to have occurred.

Yet, they struggle mightily for the reason behind all of it. That’s how far gone classic money theory is even when it’s being practiced honestly. Without realizing the gross degradation in the study of the monetary system which long predated 2008, and the dereliction committed by the Federal Reserve and other central banks in encouraging this, we’re being asked to believe that the reason the banking system has gone backward despite QE is that banks have been signing up to get paid essentially an unlimited annuity at 25 bps from the Fed rather than hold debt paying them hundreds of basis points more.

The problem, therefore, is entirely unrelated with any stipend (noting that since 2015 IOER has been raised and now lowered again). Banks are refusing to do what monetary policy asks of them because they can get paid a trivially small amount on reserves? It doesn’t even pass the smell test.

As we’ve seen in Europe, the level paid by the central bank on excess anything is immaterial. The ECB via NIRP has been since 2014 essentially charging European banks now up to 40 bps for the “privilege” of holding liquidity in its account. Bank lending is still stuck below 2007 levels, while the yields on especially the most liquid European government bonds have likewise been driven down into the deep negatives.

The problem isn’t IOER or some equivalent, it is quite clearly the banking system itself. It is choosing to hold all the most liquid forms of even the worst-paying assets – so long as they are safe (and continue to be perceived that way).

Any cursory study of the monetary system since Economists and classicists like Eugene Fama stopped paying attention to it shows how it has been this very same banking system which grew to be the ultimate factor, and factory, of a world increasingly dollar-ized. Banks had made a lot of money by literally making their own money.

And it worked...until it didn't.

The textbook says money is one thing, and that thing includes bank reserves, even though for decades these other eurodollar forms were just what China had been using to transform itself from being in danger of suffering the same fate as the next Soviet Union to zooming closer to the modern industrial state Karl Marx had long ago demanded Communists to start from.

While that monetary transformation was taking place, there were practically no bank reserves in it. The eurodollar system was instead, in many ways, reserve-less. It evolved with its own forms of (useful) liquidity, dynamic stuff including off-balance sheet derivatives.

In other words, IOER hadn’t changed the nature of bank reserves in 2008, the idea of money itself had dramatically changed and therefore the very place for bank reserves in the banking system had been largely eliminated (or grossly downgraded) decades before. No one had noticed.

And because Economists hadn’t been paying attention, they were rudely awakened at that time and only then began to search for answers seeing how the Fed wasn’t providing any, confusing, once again, correlation (2008: introduction of IOER and bank reserves no longer work) for causation.

Again, simple scarcity and the Fed’s detachment from it which Jay Powell appears intent on proving in 2020 all over again.

The term global dollar shortage is only a euphemism in its middle word.

Follow the dollar as it is in the eurodollar sense. Like Treasury yields, it will reveal for you a realistic picture of how things are really going (liquidity preferences) where classic money theory and the mainstream textbooks still won’t even after thirteen years.

The petroyuan actually was a huge deal but not because it was ever a serious challenge to destroy the dollar; quite the contrary. Ironically, to its headline-grabbing 2018 proponents, anyway, its very existence is another significant factor in the long-term dollar “bull” landscape. The Chinese are showing you that they (still) can’t get the dollars they need no matter how many bank reserves the Fed creates, while also demonstrating that there’s no way to get around that need and the banking system which steadfastly refuses to fill it.

There are massive profits to be made supplying the world with “dollars”, but everyone would rather leave them on the table in order to get paid IOER or even less – so long as the thing paying is free of liquidity risk. As that fact holds true, the dollar, unlike interest rates, has got nowhere to go but further up.