January 9, 2016
China’s increasingly erratic economic policy

There is little doubt that, even among veteran China watchers, what is going on now on economic and FX policy does not make a huge amount of sense – best reflected by Emerging Market Advisors’ Jonathan Anderson’s note titeld “The Renminbi – It’s Amateur Hour!”. One of the simplest explanations: that decisions are being made by a very small group at the top – mainly by Xi himself – that don’t have the same international sensitivities that others have traditionally had, such as PBOC Governor Zhou.

I had hoped to do a longer blog on China back in August but instead stuck to listing some basic facts that we know and don’t about China. What’s remarkable about the list is how little of it has changed, but some of the unknowns have become a bit clearer.

  • The labor market appears to be is doing fine, as is services activity
  • Capital outflows are impacting Treasuries but more via swap spreads than noticeably higher nominal yields (yields higher vs swap rates)
  • Capital outflows remain substantial and go beyond Chinese corps paying down FX debt: the valuation-adjusted $125 bln drop in FX reserves in Dec certainly suggests so, though we need to see the FX transactions data
  • Clearly there’s a *certain* consensus on allowing more CNY depreciation, though who’s making the final decision is very unclear – plenty of politics at play that go beyond the PBOC/SAFE 
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What about how policy decisions are being made? That is very unclear. And it’s still worth keeping the political backdrop in mind when looking at what’s going on. The corruption crackdown is the paramount achievement of Xi that has touched many facets of society – an attempt to restore the CCP’s credibility with the public that now seems to have morphed into its own inquisition – that is leading to the ongoing capital outflows. Yes, a depreciating CNY is certainly a factor, but the political factors are huge. Some of the below is largely a recap of recent events, so feel free to skip ahead.

The Xi/Li administration has its hands in many pies in ways that didn’t seem to happen with Hu/Wen. Under Hu/Wen, China’s financial/economic reform followed a relatively slow, deliberate path, and Hu largely deferred to Wen and the technocrats. That path began with the 2005 de-pegging of CNY from the USD (though not really a de-pegging then, just the start of a long process that led to ever-more freer trade onshore, the launch of the parallel CNH offshore market and up to today’s new post-SDR inclusion environment). Arguably, the pace of reform was too slow, so the bigger problems kept building: not just the well-aired ones of excess capacity and debt, but the lack of domestic financial development and restrictions on bank deposit rates led to overheated property markets and money seeking avenues of return in shadowy corners. This all then turned into something of a bonfire with the misguided mega-stimulus of early 2009 whose after-effects and excesses led fairly directly to the corruption crackdown and Xi’s consolidation of power, which have to be viewed as one and the same. One only needs to look at the 25% yr/yr drop in the gambling-revenue dependent GDP of Macau – formerly a prime gambling/shopping/offshoring getaway –  to see both the broad and narrow impact from the corruption crackdown (experiencing that heady Macau heyday from 2009-11 was good fun – even just stepping back to look across the vast main Venetian trading floor that stretched for what felt like 9 football fields/pitches).

The PBOC’s response to the economic problem has been fairly standard – cutting rates (which matter less given China’s less developed markets and lack of rate sensitivity) and cutting bank reserve requirements (RRR) to unlock liquidity sterilized in reserves for lending. But much else that has happened in Chinese policy over the past two years has been increasingly erratic and seat-of-the-pants.

The first big problem was deliberately inflating a mega stock market bubble and thinking that its undoing could be controlled. In full disclosure, I was among the naive to think officials could use tools at their disposal to do so. China has always kept relative control over ALL its markets, and fairly successfully before most of the world ever cared, and I’m sure officials felt confident that this time was no different. But clearly this market bubble was of a whole different beast than previous ones: the proliferation of margin accounts and retail participation (always the main driver of China’s equity markets given the fledgling nature of its institutional investor base) helped drive the combined Shanghai and Shenzhen market cap to nearly $12 trillion during the June 2015 peak, triple what it was a year earlier. Even after the volatility and this week’s sell-off, it remains $7 trillion. 

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Then came bungled response to the sell-off by CSRC and cultivation of the idea that the National Team could save the day. This was probably the best reflection of how China’s securities regulators/bureaucrats thought they could control the sell-off. But, alas, it struggled and faced withering criticism at home and abroad. (”Whenever the CSRC says it is going to protect us, I know there is going to be market turmoil,” said one elderly Beijing day trader just this week to the FT). Not only did it struggle, but it also dragged the PBOC and others into the effort. This was particularly odd: there’s really no need for the central bank to get directly involved in cleaning up the mess of the inflated stock market bursting. Which suggests that the leaders at the top wanted everyone to do their part in the National Team.

The second big problem was the surprise August mini-devaluation and adjustment to the PBOC’s daily USD/CNY fixing for onshore trade that came out of the blue. Chinese equity markets had only just started to settle down when this shock reverberated around the world and, given the total lack of transparency, prompted many to assume the worst about the state of the Chinese economy. Ironically, it came at a time when the economy was showing signs of picking up some steam. To the PBOC’s credit, it was quick to host press conferences and post statements in English on its web site - a rarity for the secretive institution that still makes monetary policy changes by surprise (partly because the entire Chinese government operates that way to be inline with the State Council). And in fairness, it looks like much of what happened in August was a shift in the USD/CNY fix tied to technical suggestions the IMF had made for SDR inclusion to work more smoothly. Still, the timing and poor communication only made things worse and caused fears about China to remain elevated for several more weeks before eventually settling down. As we noted on FX Buzz at the time, the many U-turns showed Chinese policymaking had become more erratic and was likely to stay that way.

After the initial move, the PBOC was quick to reassert control, even intervening in size in the USD/CNH for probably the first time beyond USD/CNY to bring some calm. Capital outflows subsided to about $30-50 billion in October after a record $150-200 billion in September. USD/CNY was guided lower all through October. The IMF’s board then on Nov. 1 announced RMB would be included as part of SDR as of October 2016. Yay! It was an important victory for China’s market reformists because the SDR stamp of approval would seemingly lock China into a path of capital account opening up given that it is being allowed to join such an elite global club while still having such stringent capital controls, some of which have been suspended for other central banks and sovereign funds for SDR purposes.

Then the USD/CNY fix started to rise steadily all through November. Fine, the new fix was supposed to be more market-determined rather than being at the whim of the PBOC, and if that’s on the weaker side for CNY, so be it. But then the decline accelerated in December for no discernible reason, just as USD itself was actually steadying against major FX following the EUR short-squeeze after the ECB, right into the announcement by CFETS (China’s FX and money market exchange) that the focus would be on a RMB trade-weighted basket of its own design rather than USD/CNY alone. That was fine too: it was pretty clear since August that it was being managed more as a TWI. Viewed that way, this wasn’t really a devaluation or the start of something more sinister (currency wars blah blah). CNY depreciation mostly stopped going into 2016 except for a further, small late-December drop. 

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Then the sudden, sharp CNY depreciation of the past week that really doesn’t make any economic sense, except that someone somewhere wanted to give it a little extra shove lower on hopes it would help the economy in some vague way and got the approval to do so, whatever the PBOC thought. As Anderson said, the CNY drop is “not nearly big enough to yield any positive economic impact but still big enough (and, equally important, opaque enough) to destabilise markets.” Hence it only added fuel to the messy stock market sell-off on the first trading day of the year, itself exacerbated by the ridiculous circuit breakers that were jettisoned just a few days later. 

How to explain it? Well, let’s go back to Xi. As the Wall Street Journal’s Andy Browne (formerly at Reuters and a longtime China hand):

Part of the problem, it seems, is a policy-making bottleneck. Mr. Xi has reversed a collective-type leadership process inherited from Mr. Deng and concentrated decision-making authority in his own hands. But he’s thinly stretched. On his plate already: reorganizing the armed forces, leading the charge against endemic corruption (while defining a new Confucian-style morality to chasten his bureaucracy,) confronting America in the South China Sea and worrying about Taiwan elections coming up next week.He personally chairs all the committees and commissions directly responsible for these areas.

Naturally, he also commands the economy. His platform is the “Leading Group for Overall Reform,” which he set up and chairs. Traditionally, the “Central Finance and Economy Leading Group” has coordinated financial and economic issues; it has now been eclipsed by Mr. Xi’s outfit.

As a consequence, Premier Li Keqiang’s job has shrunk. His immediate predecessors ran the economy; he doesn’t enjoy the same autonomy. If things go seriously wrong, though, he might end up as a convenient scapegoat. Other highly competent economic leaders look less like decision makers and more like cheerleaders for policy concocted above their heads.

It’s probably worth pointing out here that back in April 2015 Li gave a rare interview to the FT in Beijing in which he didn’t rule out CNY depreciation but said:

We don’t want to see further devaluation of the Chinese currency because we can’t rely on devaluing our currency to boost exports…We don’t want to see a scenario in which major economies trip over each other to devalue their currencies. That would lead to a currency war. And if China feels compelled to devalue the renminbi in this process we don’t think this will be something good for the international financial system.

Perhaps not quite in the loop of policy thinking. Then take a look at the almost carbon copy Reuters stories from two days ago on PBOC facing internal pressure for a weaker CNY and one from August just days after the mini-deval, both referencing calls from the hitherto weak Commerce Ministry. Clearly there’s a cacophony of voices getting a say and sometimes swaying decisions that almost seem to contradict previous signals or decisions. It would be one thing if there was some element of communication around these various decisions or even consistency to them. But often there’s nothing but the market itself. So we’re left guessing with each 9:15 am Beijing/Shanghai USD/CNY fix what’s going on. This week that fix took on almost comical global importance. Sadly, it may continue to do so. 

Browne’s comment about the cheerleading is an important one, which is why the National Team moniker is so apt. As anyone working in a big corporation is very familiar with, sometimes absurd and contradictory decisions are being implemented almost precisely because no dissenting voice can rise up to question them. It’s a system where already centralized power is even more concentrated at the top. So the haphazard decisions are happening with greater frequency, giving the appearance of a Keystone Cops approach to economic/markets/reform policy that China never really had before when it used to be a “feeling the stones to cross the river” approach. 

China still appears to want to open up. Plans for greater convertibility are still being aired, and the Shanghai Free Trade Zone looks to be a prime spot for that to happen in limited ways. But it is ironic to see what had been China’s big 2014/15 market opening up drowned out in the absurdity of this drama: the Hong Kong-Shanghai Connect of share trading that was launched just as the stock bubble deterred many international investors from taking part in the mainland markets. Restoring that credibility is going to be a pretty arduous process (hello MSCI). 

In the meantime, the reserve decline from capital outflows may threaten some of the very underpinning of monetary policy: a tricky balance between sterilizing reserves and using that liquidity to balance interbank needs and help serve the economy. The Swiss cheese-like capital account and now onshore demand for dollars is putting pressure on FX reserves that make one think that this big insurance policy on future capital opening up may not be enough. January’s USD/CNY surge is almost certain to add to the outlook and reserve pressure. At $3.3 trillion (down $700 billion from the highs) China has scope still to manage the transition. But assuming (huge guesstimation here) $1.5 trillion of reserves are already tied up in other ways (SWF or other asset/old NPL support), suddenly $1.8 trillion of reserves doesn’t sound like a lot in an economy still capable of seeing $150 billion or so of outflows in a given month and accounting for the usual import coverage needs. The still-large current account surplus should help and certainly suggests CNY shouldn’t weaken substantially on a fundamental basis. Nonetheless, if USD demand really picks up onshore at the same time as outflows remain large, this could start to look like something one would expect from Latin America. I’ve always been a relative China optimist bordering on apologist, but this gross mishandling of policy threatens bigger repercussions that may be hard to bottle up.

Xi’s concentration of power and modern-day nationalism has worked so far. He has also staked himself to further economic growth and prosperity, which remains the CCP’s ultimate success and claim to legitimacy. The economy may not be the ultimate problem here. But the obviously bad decisions and ham-handed policy meddling are starting to threaten that credibility in ways that may spill into other policy areas. 

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Filed under: China economics markets 
August 30, 2015
What we know and don’t know about China’s economy

I’ve written about China pretty extensively even before the current mini-panic about what’s going on. There are loads of questions about what is unfolding with China’s economic growth, capital outflows, falling FX reserves, Treasury holdings and what it all means. I was planning to use a bank holiday weekend to jot down more thoughts and put some order to them. But before doing so, perhaps first it’s worth sketching out what we do and don’t know about China’s economy right now as the basis for a future post. 

Please send along suggestions if you think something is missing or incorrect.

What we know:

  • Growth is slowing
  • Growth emphasis is transitioning towards consumption and away from fixed investment
  • CPI is low but stable, export prices mildly negative; PPI and import prices falling sharply on commodity inputs
  • Real rates remain relatively high
  • Trade surplus remains high, mainly due to weak imports
  • Current account surplus remains high
  • But capital/financial surplus is negative as capital flows out 
  • FX reserves are falling
  • Bank RRRs and interest rates have been cut to offset liquidity drains from declining reserves and reduce real rates
  • USD/CNY has been de-pegged from USD but now with heavy intervention to limit volatility
  • Bank lending is rising but remains restrained
  • Shadow banking activity has been curtailed but remains large
  • Fake trade invoicing to hide capital flows is ongoing but has been curtailed
  • State policy banks (China Development Bank) are receiving capital injections from the PBOC to play a more active role in financing growth
  • Spending by indebted local govts remains restrained but is being encouraged
  • Local govts are shifting old loans into long-term bonds to lower funding costs and open up scope for spending
  • Stock market interventions have mostly subsided since July/early Aug

What we don’t know:

  • How sharply growth has slowed or what the current rate may be
  • How much the stock market sell-off may impact growth
  • What is driving the capital outflows or their composition
  • What the balance of payment “errors and omissions” really mean
  • How much declining FX reserves will impact the US Treasuries market
  • How concerned officials might be and what they are looking at
  • What the PBOC may be considering for unconventional policy
  • How much more CNY may be “devalued” or allowed to weaken
  • How policy decisions are being made (all coming from State Council? technocrats overridden?)
  • How much the commodity sell-off is based on fears over China o reflects weaker demand/commodity-financing troubles
  • What level of growth the govt is willing to tolerate in its reform drive
  • What is happening to China’s labour market in the slowdown
  • Where leverage problems are most acute in the economy

As always, the RBA’s SOMP is a good place to get a snapshot on what’s happening in China and the IMF’s Article IV on China is a very good summary of policy challenges and reform needs. 

This all needs to be kept in the context of a China slowdown that has been underway for four years and has been underestimated, especially by commodity producers who had over-extrapolated growth rates at the peak.

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August 30, 2015
China’s muni bond market and why it matters

Experimented with Medium for this one. I like the clean design and I’m sure it looks great on all devices. but still prefer Tumblr for writing/layout.

https://medium.com/@ericbeebo/why-china-s-big-muni-bond-market-move-matters-5d992a698579 

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July 27, 2015
Commodities reflect China’s big & ongoing econ shift

(Originally on Reuters FX Buzz July 24)

China’s renewed PMI slide and the latest commodities sell-off help illustrate the big global economic shift a few years in the making: China’s reorientation away from investment and manufacturing that is creating big waves to be felt for months and years to come (the “new normal” as its dubbed locally). This shift also has political significance as some of these measures are tied to the Xi/Li corruption crackdown, responding to the land seizures and heavy pollution that was sapping support for the Communist Party. The weakness in exports of commodities may still be in the early stages, while the China import side of the equation is more complicated as consumption gets prioritised. The latter factor is why the govt was so aggressive in propping up the stock market (even while ensuring margin debt was slashed) and helping reinvigorate the property market. Commodity prices are another headache for EMs already facing Fed policy normalisation, which is unlikely to be derailed thanks to the self-sustaining expansions in the US & UK.

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May 11, 2015
Look beyond PBOC rate cut to credit channel eforts

(Originally on Reuters FX Buzz May 10, 2015)

China’s 25-bp rate cut over the weekend was widely expected and, if anything, on the low side of expectations and more focused on keeping real rates less positive. Further rate and RRR cuts are almost certain, with the size of the latter depending on whether capital outflows remain as sharp as seen in Jan-April. While rate cuts help on the margin to reduce corporate/household borrowing costs, the State Council’s bigger challenge is reviving the credit channel via local govt spending on infrastructure. That has taken the form of its effort to launch a muni bond market to turn existing local govt bank loans into longer-term bonds. Even if the state-owned banks baulk at seeing high-returning loans morphed into lower-yielding bonds, the PBOC is readying plans for state policy banks to become the ultimate buyer. Getting this credit channel going is the bigger policy imperative now. In China’s quantitative credit system, the policy banks are starting to play a bigger role.

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April 17, 2015
Remember, China’s stock boom is officially sanctioned

(Originally on Reuters FX Buzz April 17)

China’s stock market boom has been a fairly micromanaged affair. Officials want a stock market rally to support consumption while spurring the Shanghai-HK Stock Connect launched last year. Official media have given many signals to retail investors, whose trading makes up the vast majority of mainland market volume, that it was time to buy. That message worked wonders: the opening of stock accounts topping 6 mln in the past month, almost as many as were started all of last year. Today’s crackdown on shadow margin trade financing (umbrella trusts) is more meant to bring margin trading into the open rather than stop it. Allowing funds to lend shares for short selling is more about maturing the market. China has many levers to guide the market: IPO issuance to cool it, Central Huijin buying to bolster it. Monday’s A-H share sell-off will likely be rough. But this remains an officially sanctioned boom, even if more such steps will be taken to let off a little steam. 

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April 7, 2015
Five reasons why Fed lift-off can happen in June

In the current spirit of having five things in your ‘splainer, thought I would take advantage of the market mood of the moment that has all but ruled out a Fed lift-off in June to talk about some reasons why it may still happen. Clearly the market view has pushed back to lift-off in Sept or later. But it’s not all that hard to make a case for why June is still a likely window, even when parsing the latest statements from Yellen and other Fed officials closer to the center of the debate. On a certain level, I’m talking my book – or at least fiercely defending views of the past few months – because the broader evidence does not really point to a need to reassess as much as US rate markets would suggest.

1) Inflation is below but near target

Energy prices are clearly biasing the headline and even core gauges downward at the moment. Which is why the regional Fed trimmed mean measures are a better reflection of the underlying trend. And those measures show inflation fairly stable around 1.5-1.8%, certainly close enough to target for the Fed to take comfort. A lot of the energy/USD impact has filtered through by now. And what matters more is the labor market. In fact, the trimmed mean measures have already showed signs of bottoming out. Similar to the ECB’s official mandate, the Fed can comfortably start the normalization process as long as inflation is “below but near” its 2% target, with a reasonable likelihood of getting there in the medium term (3-4 years).

As Yellen said not long ago:

“A significant pickup in incoming readings on core inflation will not be a precondition for me to judge that an initial increase in the federal funds rate would be warranted.”

*emphasis on initial in my book*

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2) Labor market is doing just fine, even heating up in corners

The March payrolls data was a disappointment but almost an inevitable one given the string of strong data. Three-month averages matter more than ever, and while the private payrolls drop to 198k is slightly disappointing, it still puts it in the middle of the range seen over the past five years during which time a lot of slack has been clawed back. More importantly, as smarter folks on the Twittersphere have pointed out (see Matt Busigin, borrowed from below), some signs of the labor market show things tightening up a fair bit and approaching the point where the wages kick will be harder: private sector unfilled job vacancies reaching highs seen before the dot-come crash, the unemployment rate of college graduates 25 years and older (hello grad school) falling to a mere 2.5% and dropping sharply in the past five months. There’s only so much the Fed can help unskilled workers in this economy. So if anything, the Fed will have a hard time saying it hasn’t done all it can with zero-bound rates/QE to get the economy back to a relatively more normal state.

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3) Lift-off is not tightening

NY Fed’s Dudley made this point yet again today in statements that don’t seem to get enough broad market attention for the Fed’s communication purposes:

“Whenever the data support a decision to lift off, I think it is important to recognize what this would signify.  It does not mean that monetary policy will be tight.  We will simply be moving from an extremely accommodative monetary policy to one that is slightly less so.  It also will be a positive signal about the progress we have made in restoring the economy to health.  In my view, it would be a cause for celebration, because it would signal that the FOMC believes that slightly higher short-term interest rates are consistent with its objectives of maximum employment and price stability.  Near-zero short-term interest rates and a larger Federal Reserve balance sheet were designed to be a temporary extraordinary treatment to help the economy regain its vitality, and not a permanent palliative.”

Yellen made a similar point in the speech cited above. 

4) The FRBNY is still figuring out RRP-IOER

This is not a normal “tightening” cycle by a long-shot. For starters, the Fed is now instituting policy in a very different way from in the past because of the huge amount of excess reserves its QE purchases have caused. The back-and-forth on the new overnight, fixed-rate reverse repurchase facility (RRP for our purposes) underscores how the Fed is still figuring out how to 1) control the fed funds rate (FFR) in an environment where fed funds trading is very diminished and 2) bring in other non-bank money market parties to make its operations more effective and set a solid floor for its new corridor between ON RRP and the cap at interest on excess reserves. But as can been seen, the weighted-average fed funds rate (effective) tends to settle much more closely to the bottom of this range. In prime time, the Fed is still going to have to figure out how to manage this new corridor. The Jan FOMC minutes make clear that policy credibility is on the line, so this new corridor has to work. Which means that June or July makes sense to ensure the new facility is working properly through one quarter-end before the big year-end one when the flows tied to RRP will become even more important. If lift-off is not tightening and, given the current pricing, won’t make much different when it comes to market pricing of the future rate path, why not get things going sooner? The Fed’s core policymakers seem to be making this argument without the market listening. 

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5) Better sooner than later

Yellen, Dudley and the FOMC minutes have consistently talked about financial conditions being a factor in this tightening cycle. OK, not the simplistic reflection as seen in the Chicago Fed’s index below. But the Fed 1) is dead set on not doing a Greenspan-style job of predictable rate moves to avoid leverage building up in the financial system and 2) is taking financial conditions, mainly via the 10-year Treasury yield, into its policy mix. So if conditions are seen as loose, the Fed has been clear that it may tighten more quickly. This seems to be a change of discourse that has not really resonated to a market so used to QE and Fed predictability. Assuming that the key variables – growth, labor market improvement and inflation – hold up, then lift-off is even more likely to happen sooner rather than later. The Fed is more worried about leverage and financial balances building up more than the market seems to assume. Just look at that Dudley quote above, his speech from December (”The second major implication is to be cautious about overreliance on simple monetary policy rules, such as the Taylor Rule, that do not include measures of financial market conditions in their formulation” for those wanting a quote). The Fed wants to get this going and isn’t communicating it as well as it should. But if the ISM services data earlier today is as solid as suggested, that jobless claims are a better measure of labor market strength than other indicators, that the economy is coming out of a rough-winter soft patch and that financial conditions remain pretty loose (even with the odd shake-out in high-yield or tech shares), then there are plenty of reasons for the Fed to prefer June and its updated forecast and press conference time than July or even September when Q4 starts to loom large. 

The Fed is much closer to normalization than many market players seem to realize.

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April 4, 2015
Why China and EM FX reserves are dwindling

A few Twitter conversations and Ben Bernanke’s excellent launch of his Brookings blog have made me realize there is still plenty of confusion about what is going on in China and the role it has played entering the global economy in the past 15 years. So a few thoughts here on China’s huge and dwindling reserves, as well as those of Asia ex-Japan (AXJ). More to come on this. (And I won’t get into the asset/liability side of global capital flows the way Mr. Sankaran does far more intelligently here in refuting GSG.) 

Bernanke’s Global Savings Glut (GSG) hypothesis is useful in terms of showing how Asia, especially China, built up massive reserves that reduced the nominal long-term bond yields in the US and led to what Greenspan called the conundrum. The only problem is that this sucking up of dollars coming into economies seeking higher returns (and in return providing local currency, partially sterilized) was not, strictly speaking, savings. The build-up of reserves was very conscious and, as Bernanke has acknowledged, a response to the ‘97-98 Asia Crisis to create a bulwark against a future crisis. But this is not savings in the traditional sense – higher economic growth leading to higher household/corporate incomes and thus higher disposable savings, some of which is channeled into investments with different shades of risk. No, this was a very deliberate government action of central banks taking advantage of renewed capital inflows to build up a reserve buffer in case currencies came under attack again. This roughly describes the Asia ex Japan China situation. South Korea, Thailand, Indonesia and India certainly had reasons to play by this script, and did. (As an aside, it’s funny to see the US push back so aggressively against China’s AIIB when it had done the same with the Chiang-Mai initiative coordinated by Asian countries to pool their reserves together and create a common defense against another such crisis – Fortress Asia it was called.) 

Japan’s motives were more transparent: it was nakedly intervening to buy dollars and sell yen to weaken its currency in 2003-04, with the tacit approval of the Bush administration to do so given its weak state, struggles with deflation and attempt to clean up its banking system. That led to what was then considered a huge increase in its reserves that took them to around $1 trillion, most of which was ploughed straight back into US Treasuries and also agency bonds. In some ways, Japan’s aggressive intervention set the spark for even bigger interventions across Asia, none of which had to do with savings in the traditional sense – these were government actions taken for explicit reasons that meant their domestic currency was being used to absorb these USD inflows, parking the USDs into reserves and using money market operations to sterilize the newly printed local currency as necessary. 

The sheer size of capital inflows into EM markets from about 2003 until the tapering tantrum of 2013 is still quite staggering, registering into the trillion dollar range or higher. Some of this was understandable: much higher growth rates meant much higher returns in equities, while the still-high risk premium on these currencies meant much higher nominal bond yields and carry. Especially after the 2008 shock wore off, the appeal for some of these countries – such as once crisis poster-child Indonesia – was too hard to ignore. Just look at those returns from the start of 2009 in USD terms, with Indonesia easily taking the cake. 

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But China is a very different story. I’m still surprised at how the world wants to see China through the lens of major economies when it still has all the edifices of a command economy and one where financial markets are far from the likes of its freewheeling Western counterparts, instead controlled very closely by the state. China’s rise has been such a deliberate, five-year-plan driven one that it’s easy to forget how deliberate it has been: slightly unleash the currency (2005), gradually allow more open trade, aggressively promote the use of CNY via CNH (offshore yuan/renminbi – 2011) for trade settlement to make it more international, open up foreign investment (2014) but, by all means, keep as complete control as possible over CNY. And thus Beijing has. 

China’s monetary policy is constrained by the Impossible Trinity: a country cannot control its exchange rate, have capital controls and an independent monetary policy. Clearly China runs variations on all of those. The exchange rate has been largely loosened, but as seen with the recent interventions, the PBOC will push back against any kind of speculation on a weaker currency when it doesn’t suit its interests. The focus of monetary policy depends on the ever-changing conditions. Often it is purely about managing liquidity conditions to keep credit flowing via the banks. But in the current situation, the shift in hot money (funds that manage to get beyond China’s capital walls to seek carry and go back-and-forth very quickly) to outflows means the monetary focus is much more on the FX side of the equation. 

What is clear is that the China, once a near one-way currency bet with a carry bonus to boot, is seeing money head out. That poses risk to a monetary policy balancing FX and liquidity control: money leaving China (hot or otherwise, its capital controls are hardly iron-clad) leads to a drain of domestic liquidity, just as the inflows had previously inflated domestic liquidity and were thus sterilized. China’s open market operations have only grown more complex (and secretive) in the past few years, but it’s worth keeping in mind that much of the sterilization took the form of bank reserve requirement increases. Now money is heading out of the country, putting pressure on a weaker CNY and testing the PBOC’s current 1% daily trading band onshore. More on that below. But what it means is that China’s reserves are now shrinking as it intervenes to supply those stored-up dollars, mostly sitting into short-term Treasuries, to a market no long enamored with the renminbi. And that’s fine: those reserves were amassed for this occasion, supplying the local money market with CNY that otherwise might disappear as money is converted back into USD and heads offshore. No probs. 

So there are two really, really important points to make here:

1) This is negative for Treasuries and EUR

While China’s reduced role as a buyer of T-bills and two-year notes may not be a huge factor, there’s no doubt that seeing this once reliable buyer not roll over as much will affect the Treasuries market and will COINCIDE with the Fed almost certainly reducing its balance sheet and Treasury holdings. China is by no means the only game in town: other EM countries are reducing reserves and thus Treasury holdings as well(apart from India where the positive reform story and inflows have allowed INR to strengthen and let the RBI rebuild some reserves lost in the tapering tantrum). Don’t be confused by the latest spike in UST custody holdings: almost certainly that is a custody reallocation rather than a purchase, perhaps to move some holdings to the more-liquid US to make it easier to sell when necessary. The turn in Chinese FX reserves, UST holdings and even overall Fed Treasury custody holdings for central banks is pretty clear, though it depends on further capital outflows from China and the US economic rebound/stronger USD story falling apart.

EUR is more about its role as a USD alternative. China and other central banks have very deliberately diversified their reserves so that ~20-30% are held in EUR and much of the rest in USD, with commodity-related currencies such as AUD and CAD making a minor appearance depending on the reserve country’s trade make-up and risk desire. The simple fact is that a reduction in overall reserves means that those reserve holders need to sell EUR to keep their relative reserve allocations in line with targets. Of course the broad USD strength works in the opposite direction, so valuation factors may limit some of this need to sell EUR (a lower-valued EUR would require more to keep allocations equal). But all the talk of Asian central bank selling of euros on any bounce in EUR/USD ties into the idea that they need to sell EUR. Certainly we will see that come to the test in coming days/weeks as the EUR short position has become historically large and very lopsided relative to other currencies, but also because the behavior of ACBs has long frustrated any kind of fair value analysis and forecasts. Having long kept EUR far stronger than it should have been and finally forcing the ECB into something like negative deposit rates, not the tide is quickly running in the other direction. Given the scale of these forces, EUR is very likely to overshoot on the downside – especially as overseas investors snap up European equities but hedge out the FX risks Nikkei/JPY style. But I digress. 

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2) China does not want CNY to weaken that much and will not bow to outside market pressures

China doesn’t do currency wars. In fact, China prizes policy stability above all else. In a QE and currency war world, that fact is sometimes hard to fathom. But because of the reasons laid out above, China’s FX policy is a core part of monetary policy. Lazy predictions of a devaluation (or those even lazier predictions saying there’s a “30% chance” of a devaluation – the intellectually lazy but save-your-ass way of making it) typically do not understand how this would work AGAINST Chinese monetary policy: by encouraging further capital outflows via a weaker currency, the PBOC would face tightening of policy over which it wouldn’t have the control it would like, potentially being forced into a series of liquidity pumping measures (bank RRR cuts for sure) and potentially giving fuel to the bad behaviors it has worked so hard to crack down on. Better instead to intervene and sell USD, run down your obviously unwieldy reserves and push back against those foreign speculators who are hoping you’ll widen your trading band and devalue your currency to make a quick buck. If there’s any class of market participants that China/PBOC has little time for, it’s “speculators”. The PBOC is more than happen to wait until the market, especially offshore, is least expecting a daily FX band widening than given what those specs any easy money – so likely once USD/CNY has settled comfortably below the daily fix. Stability matters above all else. Just as it succeeded in deterring speculation on CNY appreciation last year, it’s probably not advisable to bet against the PBOC in this circumstance. The sharp drop in USD/CNY vols speak to positions betting on a sharper spot move up and higher vol finally giving up. So once those vols get back to more historically low levels, the PBOC is more likely to act.

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And this has to do with the GSG hypothesis because….

China is a decent bellwether of EM behavior, and EM reserve amassing was the chief reason Bernanke talked about a Global Savings Glut in the first place. We need only look at the reserve drawdown in Turkey and Russia for signs of how this process can work in reverse much more quickly that these countries/central banks imagined. Clearly a big part of the picture is Middle Eastern oil-based reserve managers who will need to: 1) sell USDs to keep their respective currency pegs in place, while 2) not getting the kind of USD windfalls from high oil prices that they are used to. Which isn’t to say these ME oil reserve funds still won’t be buying property around the world or investing in silly skyscrapers, but they may start to think twice as the oil inflow is not going to be what it used to be – and they do have certain claims to meet for their populations over a longer term horizon. 

All of which is a long-winded way of saying EM reserves were never a global savings to be deployed in “attractive investment opportunities” elsewhere in the world. This is where the macroeconomic theories fail relative to the basic politics of global finance. Apart from the sponsorship of certain Premier League teams or helping position certain airlines for bigger global ambitions, this capital was not really a global return-seeking type as much as a status-seeking one (or as my partner likes to call them, safety deposit boxes in the sky). 

Plus we have that problem of the US-driven job-destroying innovation called the Internet. Or so many seem to think. It’s easy to extrapolate too much from what the rise of globalization/computer power means for workforces, but if history is any guide, we get way too pessimistic in these moments of major transformation and don’t realize the opportunities to come – and may even be around the corner. So while the Bernanke/Summers debate on secular stagnation and GSG is useful, it also seems a bit antiquated. The simple fact is that Moore’s Law is still fundamentally reshaping human communication/interaction and innovation in ways we can’t yet fully comprehend. In many ways, the GSG was an economic anachronism that had nothing to do with either savings or investment: it was about liquidity – creating a liquid cash reserve and buffer for large and growing EM economies to help limit the damage from the very turbulence they are now facing as the USD reasserts itself. More important is that key revenue-generating innovations can happen without much investment or even bank loans – think VC or angels. The entire edifice of lending/investment is being turned on its head with today’s web-driven innovations. So rather than engage in tired macroeconomic debates based on a fuzzy understanding of the past, it would be more worthwhile to focus on the seismic changes that are setting the stage for a new era of human connectedness and prosperity. 

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January 18, 2015
The follies of markets

“…In the decade after the fall of the Berlin Wall, the most vigorous advocates of the market economy proved to be its worst enemies. They understood neither the genius of markets, nor their limits…On both sides of the demolished wall, there will now be a time of sober reappraisal. But the losers from the follows of markets will not just be the failed oligarchs, fraudulent chief executives and financiers. They will include many ordinary people who suffer in 1990s Russia as their grandparents had suffered earlier; workers in America who lost jobs as businesses were expensively acquired, or slimmed down in the pursuit of shareholder value; savers who believed those confident reassurances that the New Economy would provide for their pensions. Markets will continue to display their genius, test their limits and display their follies.”

John Kay, 2002, The Truth About Markets: Their Genius, Their Limits, Their Follies

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January 11, 2015
Economists as dentists and plumbers

Keynes once wished that economists would be treated as plumbers and dentists: technicians with specific skills, no co-venturers on an ideological crusade. This chapter is written in the spirit of economics as dentistry.
– Chapter 30, The Truth About Markets, John Kay (2004)

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