Whistling Past the Crisis: Dollar Pressure Breaks PBoC In 3 Months

Back in September the PBoC announced a targeted RRR cut that took effect on January 25, 2018.

Reuters: China makes targeted reserve requirement cut to boost lending to small firms
China’s central bank on Saturday cut the amount of cash that some banks must hold as reserves for the first time since February 2016 in a bid to encourage more lending to struggling smaller firms and energize its lacklustre private sector.

The People’s Bank of China (PBOC) said on its website that it would cut the reserve requirement ratio (RRR) for some banks that meet certain requirements for lending to small business and the agricultural sector.
That date is important. China cuts the RRR because liquidity in the financial system is tightening amid deleveraging efforts and global disinflationary forces. The pressure became extreme back in 2015-2016 when U.S. dollars were flowing out of China. February 2016 was the bottom of the 2014-2016 deflationary wave. The best explanation for the end of that wave is China's decision to flood its financial system with new credit, increasing risk with every increase in leverage. Now that credit wave is over.

China may have hoped their targeted RRR cut would be the boost needed amid the "deleveraging" effort, thanks to "synchronized global growth." Global growth isn't so hot though, and neither is the Chinese economy. And so three months later, China makes a big 100 basis point cut in the RRR.

Reuters: China central bank announces surprise cut in bank reserve requirements
Reserve requirement ratios (RRRs) — currently 17 percent for large institutions and 15 percent for smaller banks — will be cut by 100 basis points (bps), the People’s Bank of China (PBOC) said.

The change will be made on April 25 and will apply to most banks with the exception of policy lenders such as China Development Bank.

But the banks must use most of the freed-up liquidity to pay back relatively costly loans obtained via the central bank’s medium-term lending facility (MLF). Based on first-quarter data, the PBOC said the MLF loans due to be repaid on April 25 will be about 900 billion yuan ($143 billion).

Whatever funds the banks have left after repaying their MLF loans must be used to provide loans to small businesses. The PBOC said there will be 400 billion yuan in excess funds after the MLF loan repayments.
Heisenberg Report: China Bails Out Flagging Stock Market As Bonds Stage Enormous Rally After RRR Cut
This is clearly a dovish move. The central bank has been avoiding using RRR and benchmark rate changes as both are widely viewed as tools with strong signaling effects. A RRR cut does not necessarily lead to lower interbank rates as the central bank might use other tools to make any changes rate neutral. However, it is likely that the interbank rate will be relatively lower because the RRR reflects a mild loosening bias.
PBoC turning dovish as the Federal Reserve turns hawkish.
Bloomberg: Down $1 Trillion, World’s Worst Stocks Near Make-or-Break Level
In a Chinese stock market infatuated with round numbers, 3,000 has emerged as the latest fixation for investors trying to gauge the government’s commitment to ending a nearly $1 trillion selloff.

That’s the next big line in the sand for the Shanghai Composite Index, whose 13 percent slump since Jan. 24 has been the steepest worldwide. The benchmark equity gauge came within 1.4 percent of the 3,000 threshold on Wednesday, before rallying in the afternoon amid speculation state-run funds had stepped in to support the market.
Jeffrey Snider connects the dots for us: China’s Monetary Shell Game
If the PBOC had been serious about tightening, it would have done a whole lot more than raise its reverse repo 5 bps at a time. I also wrote in December, “If economic and financial conditions were really improving, [RRR] is where monetary policy would respond (you know, like every other time in the past).” Today, they did – only not tightening.

Starting next week, the RRR for large firms will be cut by 100 bps. This isn’t going to be an isolated maneuver, however, as the PBOC is ordering those banks to use reserves freed up by the reduction to repay MLF borrowings!
The PBoC is caught between Scylla and Charybdis: the USD and the CNY.
We’ve seen this before, in the middle of 2015. This is different, though, and in several important ways.

At root, I continue to believe, is CNY. Beginning early last year, there was a clear choice made to prioritize the currency over every other consideration. Unlike the media, Chinese officials very early on realized the overriding factor in everything (globally) – the “dollar.” Thus, they knew CNY DOWN = BAD.

But how does one reverse that devastating equation? It’s not an easy thing, as it turns out. Authorities tried several times throughout the “rising dollar” period with little success (as noted last week). As a result, they blew through a huge chunk of so-called reserves and the currency dropped anyway as it became self-reinforcing (a run).
If CNY goes up, deflation, economy slows, capital flows out of China, CNY goes down. "All roads" point to CNY going down amid dollar deflation.
That would mean great(er) attention to the asset side of the PBOC balance sheet which continues to bleed forex “reserves.” In other words, increases in RMB lending to the market via the MLF or anything else absent an actual increase in forex leaves Chinese RMB more and more unbacked on the money side. Unless forex starts to rise again, which appears very unlikely (CNY rose for months, and they still bled), there is only so much the PBOC can do through these RMB windows without breaking what sure looks like an imposed (policy?) limit (shown above).
This is the most important chart in the world. It doesn't matter today and it may never matter, but if it ever matters, watch out. China's forex reserves only cover 11.4 percent of M2 money supply. Put another way, at current exchange rates there are 55 RMB circulating in M2 for every USD of reserves. The claims on reserves are rising faster than China can add reserves in a slow-growth world. There are periods of relief such as the reflationary wave kicked off in February 2016, but that month reserves backed 14.7 percent of M2 and there were 44 RMB for every dollar of reserves. Today, even if USDCNY moved back to 6.9, reserves would only cover 12.5 percent of M2. China can't risk rapid credit growth because capital controls can only do so much. Increased credit growth increases the claims on reserves and intensifies any outflow pressure.
So, you don’t want to destabilize CNY by leaving RMB (bank reserves) more and more unbacked, so why not then make big banks pay down the MLF? That would create more margin for the central bank to deal with the prospects for further forex drawdowns in the months ahead.

The obvious downside to withdrawing bank reserves is immediate liquidity. To address what would otherwise be an acute shortfall, shift the burden onto large bank private balance sheets by cutting the RRR. They’ve been hoarding it anyway. The central bank reduces its RMB footprint to better align with “dollar” levels, leaving the private banking system to pick up the liquidity slack in a way that doesn’t endanger CNY. Since you just hiked the reverse repo rate for a fourth time last month, it will leave the “experts” wholly confused.

I believe that’s the theory, anyway. It’s a further lesson in how to continue to loosen RMB while making the rest of the world think you’re doing something else (at worst neutral). China has a sustained money problem it cannot by definition fix. Next best thing? Hide it. Why?

There is no recovery coming.
China had lots of time to reform over the past decade. Instead, they went in the opposite direction, increasing the risk in the existing economic model and monetary system.

I have been writing for years that the yuan will devalue because China is running out of room. Not only financial and economic room, but political room as the odds of a trade conflict increased amid negative social mood and a weak global economy. In May 2016 I wrote: SocGen Estimates Bank Losses 60 pc of Capital
If China is successful, it will take much longer than expected. If it takes upwards of a decade, the country is going to be slamming headfirst into the demographic wall. By 2025, the 20-24 age cohort will be almost 30% smaller than the 35-39 cohort, which is the cohort currently engaged in family formation. In markets such as housing, China will have turned Japanese.

...Finally, while China could use a white swan, the world is creating new problems, such as a potential trade conflict with the United States.
Back in 2011 I wrote: Chinese yuan depreciation coming soon?
I don't expect yuan depreciation will be slight because it will happen when hot money flows out of the renminbi and economic indicators, most importantly the trade surplus, reverse. It seems like every time there is a bubble, there are people explaining how it will be limited, the impact will be concentrated in housing/stocks/Greece and so on, and this is almost always wrong. Also important to watch is the political angle. If the renminbi doesn't continue to appreciate, U.S. politicians will become more open to the idea of retaliatory tariffs. This is why China's policy makers are in a bind. What happens if the yuan needs to depreciate in the midst of a crisis? U.S. politicians will be open to extreme policy choices during a crisis, such as the TARP plan that many were cajoled into voting for. Conversely, if the Chinese do not depreciate the yuan in a deflationary crisis, the economy will experience crushing deflation. This is why Liu Jun Luo warns that hyperinflation may be on the way if the Chinese do not inflate now.
I was wrong to expect something much earlier (although I don't think I was wrong from a policy perspective, they should have realized by 2011 that something was wrong), but not in the analysis. Here we are 8 years later and China is in a far worse position with respect to leverage, outstanding credit, reserves, trade relations, economic growth and the U.S. dollar bull/bear cycle (still bullish).

Even if China avoids a trade conflict with the U.S., that will mean a smaller trade balance. If global growth remains slow, that could be enough to swing reserve accumulation back to depletion, ceteris paribus. It would also mean slowed GDP growth in China that would have to be offset with bigger reforms or faster credit growth. The latter would weaken CNY and increase outflow/depreciation pressure. The policy options are fading fast and only hope remains. Hope for a global economic recovery and a restart of the U.S. dollar (eurodollar) system. Right now, I don't see a restart. I see another bear market peak as in 2011 and 2014. The yuan depreciation in both of those previous deflationary waves. The next one will be larger and China will be starting from a weaker position.

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