China Spins the Dollar Wheel of Suffering, Cuts RRR Again

Rueters: As trade war looms, China cuts some banks' reserve requirements to boost lending
China’s central bank said on Sunday it would cut the amount of cash that some banks must hold as reserves by 50 basis points (bps), releasing $108 billion in liquidity, to accelerate the pace of debt-for-equity swaps and spur lending to smaller firms.

The reserve reduction, the third by the central bank this year, had been widely anticipated by investors amid concerns over market liquidity and a potential economic drag from a trade dispute with the United States.

But the 700 billion yuan ($107.65 billion) in liquidity that the central bank said will result from the reduction in reserves was bigger than expected.
The pain is worse than understood by financial markets.

Xinhua: China cuts RRR by 50 basis points
Funds released by the cut were about 700 billion yuan (about 108 billion U.S. dollars), with 200 billion yuan set for easing credit strain for small and micro businesses.
The cut for small businesses was expected. The larger cut for "debt-to-equity" swaps was not.

The quick take from financial media is: China is easing. They are not. They are filling a hole left by the contraction in shadow banking and unwillingness of banks to make uneconomic, risky loans. China's SMEs Cannot Obtain Low Cost Credit.

Some banks can't lend. From March: China Eases NPL Rules as Lending Constrained
China is making it easier for banks to lend if they declare their bad loans as non-performing. Regulations require a higher reserve ratio because its feared banks are hiding losses. Under the new rules, banks can lower their required reserves by reporting an accurate NPL accurately.

The shift is a regulatory step forward, but indicates banks are capital constrained amid deleveraging efforts. It is unlikely to boost lending when the credit market is in the contracting/disinflationary stage of the cycle.

China's financial system is still based on the U.S. dollar. As dollars came in from exporters, the banks buy them and send them to the PBoC. This creates base money. China creates far more credit that it has in reserves and no one cares when the system is expanding, anymore than they care that U.S. money supply roared ahead in the 2000s. When dollar liquidity tightens and there's outflow pressure, China's financial system risks collapsing like a house of cards. Even if the dollars are kept in the country, if the banking system wants to expand, it is creating "unbacked" credit. If China expands money and credit while the dollar is "deflating" it increases depreciation pressure on the yuan.

Meanwhile, credit keeps pouring into real estate through credit cards and consumer loans. There was a wild frenzy in Shenzhen over the past couple of days as wealthy people rushed to get divorced and qualify for a housing lottery. The winners of the lottery qualify can buy homes priced at least 2 million yuan below market prices.
Housing Lottery Frenzy in Shenzhen

In sum, Chinese banks either can't or do not want to make riskier loans. Sentiment is shifting. This second RRR cut follows changes in NPL rules, expansion of MLF, an April RRR cut. Deflationary pressure is building. The U.S. dollar (or eurodollar or "dollar" as Jeffrey Snider at Alhambra calls it) can blow everything up by itself and reflexivity is dangerously close to kicking in. Rising dollar causes China pain that spreads to EMs and causes rising dollar. Rinse and repeat all the way up to 120 on the DXY if all hell breaks loose.

Back in 2015 the PBoC was cutting the RRR heading into the peak of a stock market bubble. Today, the stock market is in a bear market. Real estate may be coming under control. It looks like restrictions are starting to finally have an impact, but the lottery behavior in Shenzhen and elsewhere shows sentiment remains bullish. The latest PBoC quarterly survey showed 23 percent of depositors say they intend to buy a home in the next 3 months, way above the 14.2 percent at this time in 2014 when the real estate market was already turning. Back in February 2014 I posted: China Real Estate Rage Is Back; Ghost Cities Everywhere; Offshore Yuan Plunges; Talk of Falling Real Estate Prices Across China. By 2015, China was already trying to rescue the housing market: MoH and PBOC Plan More Housing Bailout Measures, Cut Down Payments and Reduce Mortgage Rates. After the April RRR cut in 2015 I posted: Chinese Regulators Panic, Era of Tight Money Is Over.

I don't think there's any panic or reversal in monetary policy yet. Stocks are down, but have been for some time and are nowhere near as important as real estate. The real estate market hasn't slowed yet, but that is likely because credit restrictions haven't made their full impact yet. Local government policies such as lotteries are increasing speculative sentiment rather than quashing it. Comparing to the last cycle, I think the Chinese economy is much earlier in the cycle, but the PBoC is already behaving as if its moving into mid-cycle because three years of torrid credit growth has created a much larger problem.

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