By Russell Napier of ERIC
The PBOC – How to fail in business without really flying
"Terrain seems a bit unstable...and there seems to be no sign of intelegent life anywhere"
- Buzz Lightyear (Toy Story)
"That wasn't flying...that was falling with style"
- Woody (Toy Story)
Another day, another central bank failure. In a world of currencies backed only by confidence, every failure is masqueraded as success. Like the ballet dancer who transforms the stumble into a pirouette, central bankers, knocked to the ground by market forces, smile and pretend that this was all part of the routine. Financial market participants, having bet everything on the promised omnipotence of central bankers, do indeed seem happy to see genius in every stumble. However a fall is a fall regardless of the style of the descent. So when will investors see that the earth is rapidly approaching and that style is just style?
The key for investors today is to see behind the masquerade and the mask, the façade of those putting up a front behind a public face, and be able to tell the difference between the soaring flight of reflation and the perilous fall of deflation. The more attitude you hear from policy makers, the more you can be sure it’s style compensating for the lack of real substance and that this is falling and not flying. And as the attitude becomes more high-handed, the lower the altitude gets. The attitude quotient is rising rapidly.
Two weeks ago we noted the ‘flying’ undertaken by the Swiss National Bank as the market forced them to abandon their exchange-rate target. Deposit rates in Swiss Banks are now at such a low level that investors are better off converting deposits into bank notes and placing them under the bed. The Danish Central Bank has also instituted negative interest rates with the consequence that deposits in Denmark might also fly into paper. As the central bank managed to create over DKK106bn (US$16.3bn) in bank reserves, trying to stop a revaluation of their exchange rate last month, there will be no shortage of banknotes to go round should a ‘bank run’ from deposits to banknotes begin.
Taking interest rates so negative that they threaten a run on bank deposits should not be seen as success --- it is failure. Creating bank reserves at that pace should not be seen as success --- it is failure. The next failure may well be some government-inspired restriction on capital inflows. Well, you could call such restrictions, and risking the liquidity of banks, monetary success if you like, but then you probably also think it’s a success to throw the ball one yard from the touchline.
Last week the Monetary Authority of Singapore was apparently "flying", definitely not falling, when it cut interest rates and tried to devalue the SGD to defeat deflation. The Central Bank of Russia reduced interest rates while defending its exchange rate and, guess what, the currency fell. Most people, of course, would recognize that as simply falling, but as it was Russia you do have to ask did it just fall, or was it pushed ?
You may even have missed the news, that the Costa Rican central bank has just announced that they will be floating the Colon. Those of a squeamish disposition should certainly not try googling "floating colon" but, just take their word for it, the Colon will float. Elsewhere there were examples of more conventional falling, disguised as controlled flying, in the form of cuts in interest rates from Australia, Canada, Egypt, India, Pakistan, Peru and Turkey. The Turkish President has the perfect style for this sport and declared that interest rates had to fall as they were the cause and not the cure for inflation. As our hero himself remarked, ‘Buzz Lightyear to star command, I have an AWOL space ranger.’
So, will failure ever be seen as failure? Well, it will if the PBOC also fails. For we must remember that the most dangerous thing in finance is the thing that never ever moves --- until it moves. A generation of investors has grown up to believe that China can have whatever monetary policy it wants and simultaneously maintain a stable exchange rate. That generation now believes it will see a monetary reflation in China and a stable exchange rate and thus economic gravity defied. There is more evidence every day that China cannot achieve both goals.
Such a dual target might be possible if China ran a large external surplus and had effective capital controls. However, with China reporting a US$91.2bn deficit on its capital account in 4Q 2014 it is fairly clear that China’s capital control regime is not working. In 4Q 2014 the capital account deficit was larger than the current account surplus. Indeed, the total reported value of Chinese holdings of US Treasuries has been declining for over a year, despite regular steady rises in the price of Treasuries, suggesting that China’s current account surplus is at least offset by its capital account deficit. This is a huge change as China’s external surplus, a seeming economic certainty for two decades, has ceased to be.
Easing monetary policy and maintaining a stable exchange rate without an external surplus would be flying indeed. Other symptoms of the nature of this failure are also visible, with the offshore and onshore exchange rate to the USD declining and the price of Dim Sum bonds falling 4% from their November 2014 levels. This combination of a falling exchange rate and rising interest rates are compatible with the lack of an external surplus but entirely incompatible with consensus expectations for monetary reflation combined with a stable exchange rate. Since the PBOC cut interest rates in November 2014 and then yesterday reduced the banks reserve ratio the 12 month deposit rate has risen from 300bp to 465bp! Is this falling or flying? Sources familiar with the PBOC’s plans report to Bloomberg News that a further widening of the trading bands for the Yuan is being considered. Monetary policy is tightening, not easing and the PBOC will respond by jettisoning its exchange rate target. How much style they can muster for the fall only time will tell but this will be falling and not flying.
The PBOC are preparing to fall because of their failure to generate sufficient reflation while simultaneously maintaining the exchange rate with the USD. Something has to give and the result won’t be the exhilarating flight of reflation but instead an initial global deflationary shock that will see exports pour out of China at ever lower USD prices as the Yuan declines. Few will then believe in the omnipotence of central bankers: style over substance may still not have gone out of fashion, but style will just be style and falling, well, that will very much be seen as just falling. Ignoring the rapidly approaching ground and seeing falling as flying brings tranquility of mind but is that what they pay you for?
‘The test of the machine is the satisfaction it gives you. There isn't any other test. If the machine produces tranquility it's right. If it disturbs you it's wrong until either the machine or your mind is changed.”
Robert M. Pirsig, Zen and the Art of Motorcycle Maintenance: An Inquiry Into Values