China: Devaluation Or Much, Much Worse

Authored by Jeffrey Snider via Alhambra Investment Partners,

When the Chinese yuan suddenly plummeted in mid-August 2015, the world looked on in stunned confusion. It didn’t make sense. The global economy was about to take off, they thought, and it wouldn’t be doing that without China’s vast anticipated contributions. Such a large move in such a short time frame for a major currency was another big “unexpected.”

To try and make sense of it, every explanation for it was offered from the textbook perspective. Why devalue at any given time? Exports, of course.

But the move also comes as China’s important export sector has weakened – and overall economic growth looks sluggish. Over the weekend, Chinese customs officials said July exports fell 8.3% compared with a year ago. A weaker currency helps China’s exporters sell their goods abroad.

That was the Wall Street Journal’s main point in their 5 Things To Know About China’s Currency Devaluation published on August 10, 2015. But like “rate hikes”, “devaluation” deserves the quotation marks. That’s not even close to what it was.

Imagine you are a Chinese bank that works with the Chinese corporate sector. For various economic and some non-economic reasons, companies in China require dollars on a continuous basis. In the simplest terms, in order to do nothing more than import goods means having dollars in order to pay for them (chart below).

In truth, there is far more going on (chart below, which takes account of the first).

As a Chinese bank, where do you get these dollars? Even if you are doing nothing more than relending them to China’s corporate sector, they must be obtained from global (offshore) dollar markets. Like all banks you borrow them as cheaply as possible meaning in the shortest terms. Thus, you are now “short” the dollar; really eurodollar:

The “short” is not really dollars so much as funding liabilities. It’s the same way as other global banks are “short” the same things; the “short” relates to the funding mismatch (maturity) between short-term interbank borrowing (globally) on the liability side supporting and maintaining longer duration loan or security assets. Once you create those “dollar” assets, you are on the hook for funding them, in “dollars”, until they are disposed of – voluntarily or not.

It leaves the internal Chinese system with a further process mismatch, whereby the central bank is synthetically long “dollars” while the private banks are synthetically short them. The PBOC still accumulates the vast majority of “reserves” given its role in regulating internal versus external liquidity.

China’s currency, yuan, or CNY, is allowed to float but only on a narrow daily basis. The central bank, the PBOC, sets the range for that daily float.

But between March 2015 and August 10, there was practically no movement in CNY at all. In my mind, there was absolutely no way you could even venture a guess about “devaluation” without first explaining those five months. I wrote in late July 2015:

Trading has been confined, except for very brief, intraday outbursts, to an increasingly narrow range. Given its behavior particularly as a full part of the reform agenda to that point, this amounts to what can only be hidden and inorganic factors. Whether that means PBOC intervention is unclear, though suggested by even TIC, but this is the most important and unexplained dynamic in the “dollar” world at present.

 

Perhaps the June TIC updates will help shed some light on what has been going on with China’s “dollar short”, but I doubt it. The nature and especially the scale of what might be happening in the money markets has global implications, and may (conjecture on my part) start to explain the reversal in the Chinese stock bubble and ultimately even relate to the “dollar’s” renewed disruption in July so far.

From the perspective of Chinese banks and their synthetic “dollar short”, what really happened becomes clear. The exchange value of the currency is determined by the availability of eurodollar resources (in all forms, especially FX), meaning how generous those supplying “dollars” will be at any given time.

If there is an overflowing supply of eurodollar funding available and good competition among firms aiming to transact in that supply, the terms of funding will generally be favorable to those seeking funds (basic economics). In plain vanilla arrangements, that would be something like a discount on the interest rate; instead of, say, LIBOR + 150 bps, you, as the Chinese bank, might be able to get LIBOR + 145 or even better as eurodollar firms (including and especially those located in Tokyo) desperately compete for your business.

In FX, it’s a little different but the same principle (and I am going to oversimply here). You could do a currency swap where the amount of dollars obtained today are equal to the spot exchange rate, but to sweeten the pot and close the deal one of the many competing global banks offers instead to close out the swap at the current exchange rate minus a discount.

If the exchange rate was 6.20, then on the other side you could close out (more likely rollover) at, say, 6.195. The direction of CNY is up.

But if eurodollar banks start to grow uneasy about Chinese banks, or even their own position in the eurodollar food chain, rather than being generous they are likely to become increasingly demanding. Now in order to fund, they might demand a premium on the back end. If you start at 6.20, then on rollover the close out might instead be 6.205. The direction of CNY is down.

And if you have fewer available options to rollover large existing “short” funding needs, you have no choice other than to pay what amounts to a penalty. CNY can go down much faster if competition for the supply of dollars dries up, too. Again, basic economics. If there are fewer firms willing to transact then the general direction of price will move in favor of those few – unless “somehow” Chinese banks who are more and more desperate find some alternate source of dollars.

This is where the PBOC’s synthetic long can come into it.

By offering “dollars” in place of some proportion of marginal funding supply, they can maintain the price of CNY even to the point of seemingly perfect stability. Doing so, however, would be incredibly expensive and inefficient to the point where if it didn’t work it would backfire (spectacularly). The point, from the central bank’s perspective, is to buy time so that whatever is causing heartburn out there among eurodollar banks can dissipate and they can get back to regular business at reasonable terms.

On the morning of August 10, however, the PBOC which had been offering significant dollar supply (likely not direct “selling UST’s, but more so borrowing on its own and redistributing using UST’s as collateral – which is why the big selling in China’s “reserves” didn’t happen until 2016 when instead of continuing the process they started to wind down these redistribution subsidies) suddenly pulled out of the market.

I wrote on August 11, 2015:

It may be that the PBOC intends to devalue as all the rest seem to claim, but in my view the yuan’s move is simply tied to the inability of the central bank to continue to artificially suppress financing volatility and disorder – they reached a moment of maximum pressure and decided, especially in light of yesterday’s very discouraging data, that it would be far too “expensive” or inefficiently stabilizing to continue. Thus, the yuan did as it had done in those prior two “dollar” versions and moved down against the rising “dollar.”

From the point of view of China’s banks now stranded, this PBOC decision left only two options neither of which were particularly appealing. It was a “least worst” kind of decision:

So if the PBOC was no longer able to supply sufficiently as pressure exceeded some grand threshold, assuming that is what kept the yuan suppressed those five months, they had only two choices at that point – let the fix drop significantly so that China’s banks could find their “dollars” at whatever price or face illiquidity to the point of default, “dollar” insolvency and all the rest of the nastiest consequences.

What else could they do? Again, basic economics. If eurodollar suppliers had been offering steady funding at a trickle and doing so reluctantly at that, what happens on the morning of August 10 when China’s banks abruptly shut out by the PBOC all come running for dollars at once? The price of CNY plummets as funding banks demand huge premiums where the counterparty “price” of the dollar skyrockets (squeeze), a reality fully acknowledged at official levels with the daily fix recognizing this “devaluation.”

It’s important to review all this because we are again doomed to repeat.

I don’t just mean “rising dollar” stuff, which is already bad enough in 2018, but even more frustrating is that CNY’s renewed flop is being once more cast as textbook devaluation; export stimulus to ward off Trump’s trade war. It’s like 2015 never happened. After falling last week, CNY is down big again today.

Like 2015, in 2018 we know that the PBOC and the rest of China’s various government authorities want nothing to do with CNY DOWN. On August 12, 2015, the PBOC issued a statement which read:

Looking at the international and domestic economic situation, currently there is no basis for a sustained depreciation trend for the yuan.

Yeah, they all lie when it suits them. There was every basis for CNY’s move, therefore a more honest declaration would have said, “a falling yuan is bad for everyone, so we hope that by admitting this isn’t us devaluing on purpose it’ll stop because we just spent a ton trying to make it stop and we couldn’t get it to.”

These things have internal consequences, too. The amount of dollars on the PBOC’s balance sheet, the synthetic long, directly affects the level of RMB bank reserves available to the domestic Chinese banking system. It’s simple central bank accounting.

Over the weekend, the PBOC announced a second cut to the RRR rate this year (2018). The central bank had offered a targeted 100 bps reduction in April tied to repayments in the MLF. This latest one, slated for July 5, will be for 50 bps.

This flies in the face of pretty much every conventional assumption about China. In monetary policy terms, the PBOC is supposedly “tightening” because China’s economy is about to take off (sounds a lot like three years ago). Reducing the RRR is contrary to that narrative. Doing it twice is emphatically so.

As noted last week, Chinese bank reserves are contracting again like they were during the middle of 2015. Unsurprisingly, at least from the non-textbook perspective, a lower RRR corresponds to this particular circumstance. A reduction in the required rate for reserves means that private banks don’t have to hold back as much of them, meaning they can use proportionally more for monetary and financial purposes.

And if the overall level of reserves were to decline, then the lower RRR would offset much or all of the contraction in the general balance in the RMB marketplace (in theory). But that raises the important question, why doesn’t the PBOC just keep expanding bank reserves rather than risk upsetting internal RMB conditions by introducing complications and uncertainties? The experience in 2015 demonstrated the dangers.

I’ve already explained the straightforward answer, but here I want to put it in these same terms of China’s “dollar short.” Throughout 2016, the PBOC did do just that. Chinese central bankers “printed” RMB, raising the asset level on their balance sheet so that the liability side could expand somewhat, too, leaving a larger remainder (bank reserves).

But the balance of forex assets was declining sharply at the same time, meaning that Chinese money was in danger of becoming more and more unbacked by anything other than its secretive framework and unpredictable often political intrusions. This sort of risk becomes embedded in the rate eurodollar banks will charge Chinese banks to borrow dollars.

It is not a static charge, either, as the premium demanded to compensate for uncertainty rises and falls with perceptions about uncertainties. If eurodollar banks are already uneasy, then adding to their unease by more and more uncovering RMB money can only further pressure CNY. On the other hand, reassuring them by maintaining a predictable and steady monetary base could, potentially, offset some of that risk premium.

To stop the uncovering necessarily requires an end to the RMB “printing.” That’s exactly what’s been done over the last few months, repeating what had been done during the worst of 2015.

And repeating also 2015, the RRR cuts are meant to try and offset any RMB illiquidity arising from purposefully fewer bank reserves.

Will it work?

A terribly convoluted plan developed along unclear lines carried out across several dimensions including both offshore and onshore money centers where contradictory behavior is often determined by the same thing at the same time and in which the vast majority of conventional commentary is perpetually confused as to what’s taking place, what could go wrong?

The very fact that this is what they are up to tells you quite a lot about how things may be going over there. But if you think actual devaluation, it’s impossible to determine.

There are a few different elements to it this time around, though, which are important to point out.

First, I don’t think it was the PBOC starting in April who dumped Chinese banks all at once onto eurodollar markets like August 2015. Rather, I would guess that it was the tap out from Hong Kong banks that then (at the margins) unloaded China’s funding demands onto the global money market.

Second, it doesn’t seem like the PBOC is willing to expend resources directly as it was in early 2015 (and throughout CNY’s prior fall). At least not yet. The direct expense of forex is, again, tantamount to buying time. It doesn’t seem as if monetary authorities are even bothering with that this time around, suggesting a more definitive exercise. In eurodollar terms, that would amount to a starkly different interpretation.

In 2015, they may have been trying to ride out the “rising dollar” hoping that it would straighten itself out (at least as far as the Asian “dollar” might have been concerned) if given enough time. Now? Batten down another hatch. That’s the RRR. 

CNY is falling again and one thing is certain. It isn’t devaluation.