Inelasticity Not Outflows

More and more the media are finally starting to get the message about Chinese liquidity and its tendency for or against “devaluation.” For their part, the PBOC has been quite clear about its intentions all along; it was only the impenetrable fog of orthodox economics that prevented more widespread acknowledgement and understanding. There are no “reserves” at least not in the sense that the word actually applies. Instead, there are only various forms of bank liabilities, not all of which are created equal.

The eurodollar in its most basic conceptualization is chained bank liabilities of all types. The designation of “dollar” only gives it a common framework by which to decode everything; it’s an encryption cypher for what is really an encoded financial system of dizzying complexity. Central banks enter only under certain circumstances and then provide at best tangentially relevant liabilities in the narrowest sense. For a particular bank to buy MBS, for example, they need much more than federal funds or eurodollars at LIBOR, they need to manage the rate curve as well as jump volatility and liquidity risks (and then they would model volatility of funding in federal funds and eurodollars!). The Fed might handle the first one, but the rest are far out of its hands.

China offers a bit more complexity but really that is only because the Chinese liquidity system is something of a hybrid. There are the complexities of eurodollar wholesale but also attached is an internally proportional banking system of the traditional format. If you were to diagnose in very simple terms China’s existential issue, it would be that it used the eurodollar as a basis for that traditional yuan banking internally. You can then see the problems the central bank would find, where it must figure itself in both wholesale eurodollars while trying simultaneously to reckon that in “normal” banking inwardly.

Since March 2015, that has no longer been possible. I still have yet to identify the specific or proximate cause (I have theories), but the eurodollar problem morphed to something else and forced the PBOC to abandon its more measured balancing act. That pressure has only increased over time even if the PBOC manages to “buy” periodic calm here and there.

Going back to August and the first really open outbreak of internal/external disorder (the break in March was, unfortunately, largely unnoticed or misunderstood), we find a now-familiar pattern emerging:

The authority earlier auctioned 150 billion yuan ($23.4 billion) of seven-day reverse-repurchase agreements, more than the 120 billion yuan that matured. In addition, it gauged appetite for loans under its Medium-term Lending Facility, after extending 110 billion yuan last week.

“The injections through open-market operations and MLF failed to bring borrowing costs lower,” said Kenix Lai, a foreign-exchange analyst at Bank of East Asia Ltd. “That’s why the PBOC has had to make such an aggressive move. It was unexpected to have them cutting both interest rates and RRR.”

What does the media tell us as the PBOC’s greatest concern?

China’s central bank poured the largest amount of cash into the financial system on a single day in almost 19 months, signaling Beijing’s growing concerns about capital flowing out of the country following the recent weakening of its currency.

It’s a really odd sequence to be used for interpreting what are really unfamiliar central bank actions. If there are “outflows” there, by definition, have to be “inflows” somewhere else. Yet, in August there were instead what looked a lot like concurrent “outflows” all over the world; “money” simply disappeared. As if to emphasize that point yet again, January is an exact replica of August, starting with the PBOC’s even larger liquidity emphasis:

The PBOC conducted 110 billion yuan of seven-day reverse-repos and 290 billion yuan of 28-day contracts, more than the 160 billion yuan that matured. It also injected 762.5 billion yuan into the banking system via three-, six- and 12-month loans under its Medium-Term Lending Facility this week, while Short-Term Liquidity Operations were used to add 55 billion yuan of three-day loans on Monday and a further 150 billion yuan of six-day funds on Wednesday. In addition, the monetary authority auctioned 80 billion yuan of nine-month treasury deposits on behalf of the Ministry of Finance, and its branches used the Standing Lending Facility to ensure liquidity supply.

They did all that once (that was recognized) already and we are still here trying to figure where and when the opposite “inflows” are to be recorded. Yet, the amount that supposedly left China is staggering:

An estimated $843 billion of capital flowed out of China in the 11 months through November, according to a Bloomberg estimate, and policy makers are having to add funds to the financial system to prevent interest rates rising as money exits. Standard Chartered Plc says lenders’ reserve-requirement ratios will need to be cut to free up funds, even with all the cash that’s being injected.

I’m positive that if nearly $1 trillion (if you include from countries other than China, the figure would be larger than that level) was outflowing from China and landing somewhere else we would have noticed by now. Instead, again, it’s as if stock and credit markets in the developed world have been hit with similarly massive “outflows” and liquidations. Where is all this “money” going? More important, why is China and the rest of the world repeating this process yet again?

Clues to those questions are supplied in the very means the PBOC is using for liquidity in yuan. As noted two passages above, the central bank was forced to up its quotient in reverse repos to RMB400 billion because it also had to factor the maturity of an enormous RMB160 billion previously done. And when the MLF “injections” along with those from the SLF’s come due in the months ahead, they will only add to the PBOC’s burden. The direction of these liquidity interventions is only upward, something of a ratchet effect because the baseline remains unaltered by any of it.

From the perspective of China, it appears like outflows; from the perspective of the “dollar”, it appears like outflows – as if liabilities on both sides are canceling each other out. That description comes closer to recognizing the complications of having chained liabilities act as global currency, or what PBOC chief Zhou Xiaochuan recognized about the post-Bretton Woods system all the way back in 2009, “The acceptance of credit-based national currencies as major international reserve currencies, as is the case in the current system, is a rare special case in history.” Without any historical precedence, we don’t really know how it will unfold in the reverse. So far, however, there has been much that is recognizable even under more traditional views. From last week:

As I have written before, you would think economists would be all over this; it has all the classic symptoms that they would describe as “tightening” or shrinking “money supply.” The problem is that eurodollars totally invalidate economic theory as it is currently constituted on two major, foundational points.

The PBOC, for its part, is playing the traditional role of currency elasticity – and still failing. No matter how many hundreds of billions or even trillions in “liquidity” that are placed in the yuan market, the “dollar” hole swallows it up as if it were nothing much at all. Instead, the cycle repeats only with much bigger numbers (or lower, in the case of asset prices) each further iteration. I wrote all the way back in April 2014 about what was then only apparent in copper (and other commodities), not yet joined in oil, credit and so many of the rest of the “outflows”:

As much as the PBOC is sitting atop a multi-trillion dollar “reserve” excess, meaning that it seemingly should be easy for Chinese companies to obtain US dollars, there are enormous obstacles to mobilization, not the least of which is the daily currency band. Thinking about this in terms of eurodollars and global wholesale finance, the Journal’s theory about punishing speculators does not explain enough to be compelling, amounting to more of a latent PR backstory. Instead, Chinese banks “aggressively” purchasing dollars, in quantities sufficient to cause notice, might rather be indicative of a dollar shortage among Chinese companies (and banks that lend those dollars to the corporate sector).

Given the behavior in copper, and the foreign distance from default rumors, the dollar shortage actually makes more sense, and more complete sense. This liquidity shortage is bad enough that the PBOC has been forced to widen its currency band enough so that banks can rollover sufficient quantities to avoid dollar insolvency. Thus, the Chinese banks are not being directed to bid “aggressively” for dollars, but rather their own survival, and really the survival of China’s economically planned “miracle”, is driving them to desperation.

What counted for desperation in April 2014 actually seemed so; in today’s context, not nearly so. And that is precisely the point. The eurodollar had been eroding for some time, and each time it passed an acute financial threshold it forced the PBOC to act with inevitable failure. That failure only brought about the “need” for the next intervention, which would be larger and appear increasingly desperate; leading to inevitable failure and the next time; and the next time. The single line that connects all of these ratcheting failures is the eurodollar subtraction; “outflow” is that subtraction, a conspicuous decline in global “money supply” that looks more and more like waves in a run. The only difference, and what makes this more difficult to handle from a traditionalist vantage point, is that there is no convertibility of eurodollars. They just fade away into the ether, the complex mix of bank balance sheet liabilities like interest rate swaps, eurodollar curves and other FICC vagaries that used to put it altogether in something like a functioning whole. In other words, we know where all those “outflows” are.

The timing isn’t even all that suspicious, either. For one, there were ample warnings throughout 2013 that suggested what was to come, including and especially gold. From the orthodox perspective, however, the gold crash that year seemed so comfortable, that Bernanke had finally done enough QE to vanquish what was called the “pessimism bubble.” Now, with hindsight, we can see clearly something else; Bernanke wasn’t victorious, he was sealing the eurodollar’s fate. What gold suggested then was that there would be no “outflows”, only disappearing global “money.” And here we are.