2015-11-24

Money Creation and Currency Collapse in China

FT Alphaville: Pettis on the tragedy of China’s common private central banks
At the extreme, he pointed out, much of the short-term paper issued in China was, in the eyes of investors, a lot like PBoC bills. They were liquid, short-term money substitutes with little to no credit risk. Did it make sense, he wondered, to think of China as an economy with potentially thousands of mini-central banks, all issuing nearmoney instruments, and if so, how might we model the monetary and economic impact?
Is this substantially different from the situation in the U.S. with FDIC insured bank deposits and implicit backing of Fannie and Freddie, or today, the explicit/implicit backing of student loan debt?

The private economy creates new money in the form of credit and it circulates as money until the crisis hits, and like Cinderella's carriage turning back into a pumpkin, it turns into debt. The central bank steps in and buys up the debt, placing it on the central bank's balance sheet, turning it back into money. Hence QE1, QE2, and QE3, and exploding Fed balance sheet and near zero inflation.

The post, which relies heavily on a note by Michael Pettis, focuses on moral hazard and removing it. This is not really the main problem though. It doesn't matter if there is moral hazard or not, except for answering the question of how big does the credit bubble get before it bursts? In a country with no moral hazard, zero implicit guarantees and even private credit insurance is banned, credit growth will be restrained. In an economy with not only an implicit guarantee from the central government and central bank (USA), but also an actively interventionist government working to ensure not even a slip-up in credit growth (PRC), credit growth can reach enormous proportions.
If this revaluation occurred very quickly and forcefully, and if it happened in such a way that investors found it difficult to distinguish between borrowers that might continue to be covered by moral hazard and those that weren’t, they might dump debt as rapidly as possible in favor of credible money, except for debt issued by borrowers whose solvency and liquidity is fully credible (which might only be the PBoC).
Except the PBoC isn't fully solvent, liquid or credible. Only the Federal Reserve is fully solvent, liquid and credible because only the Federal Reserve prints the reserve currency, to which the PBoC has pegged the value of its circulating medium.

The PBoC can choose to buy up the bad debt, devalue the currency and restart the credit system. Or the defaults will begin and Chinese will race down Exeter's pyramid. In which case, US dollars and gold are superior to Chinese renminbi.

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