China Needs A White Swan to Absorb Excess Money Supply

The New York Fed: The Turnaround in Private and Public Financial Outflows from China

China lends to the rest of the world because it saves much more than it needs to fund its high level of physical investment spending.

China lends to America because China's currency policy required the purchase of U.S. dollars and it doesn't own a mattress large enough to store a couple trillion in Federal Reserve Notes. Although if the U.S. could send them a trillion dollar coin...

The easiest way to think of the flow is dollars came into China via exports and the dollars were swapped for renminbi, while the dollars went into U.S. treasuries that went into the PBoC's vault. It was a one way flow most of the time that led to a huge pile of Treasuries and massive money supply growth in China. The country not only outsourced monetary policy to the Federal Reserve, but it imported U.S. money creation, which led to lower inflation in China and the U.S.

The new flow is dollars out of the PBoC's vaults into the market to trade for dollars, which are bought by private Chinese citizens using renminbi and then finally sold abroad for investment assets. Renminbi is destroyed by the PBoC, reversing the prior monetary expansion, or it floats around the economy unbacked.

The high investment spending illustrates the current challenges facing China. Such spending will, at some point, yield diminishing returns. In fact, IMF data suggest that investment spending as a share of GDP fell in 2014 and 2015, consistent with declining returns on this spending. The country’s macroeconomic challenge is that additional reductions in investment spending as a share of GDP will be a drag on the economy, requiring higher consumption and/or exports to maintain growth.

Consumption and exports aren't rising enough, and they never will because there's excess money. The country created too much money and credit. Either the supply of money and credit will contract, literally destroying this excess money as credit instruments default, or all prices will adjust to fully account for the new money. This is why I referred to the stock market bubble last year, and housing this year, an incipient hyperinflation. A bit of hyperbole, but all prices in the economy either rise to meet the price increase in the latest asset du jour, or the bubble pops.

The central bank could theoretically wait for the economy to grow into its money supply, but the country probably tips into a deflationary depression because as Steve Keen showed, stall speed is much higher than most realize. As soon at the debt-to-GDP ratio stops growing, countries with debt levels as high as China (and most of the developed world) swing into recession. To combat deflationary pressure, there are intermittent monetary emissions to smooth the rough patches as the country waits for a "white swan" to deliver a positive growth shock. Meanwhile, the recent government messages have all had the same theme: no debt fueled growth. No "trees to the sky," aka forever rising debt. Trees that spring up get harvested. If you're a Chinese investor with 100 percent of your net worth in renminbi and Chinese assets valued in renminbi, it's a no brainer to buy foreign currency denominated assets.

As for the latest boomlet...

WSJ: Here Are the Cracks in China’s Steel Story

China’s steel net exports rose 8.8% in April from a year before and 9.4% between January and April from a year ago. That raises the question: Why are mills exporting more steel when Shanghai front-month futures prices for rebar steel rocketed 48% between January and April, and signaled a potential rise in demand? Shouldn’t mills be selling more of what they make at home? And steel production is weak, so it isn’t as if producers are churning out more steel available for exports.

...Real demand for steel in China dropped at least 7% in April from the year before, Citigroup’s Tracy Liao estimates, based on changes in exports and inventories. The drop was at least 5% between January and April from the year before.

Bloomberg: The World's Most Extreme Speculative Mania Unravels in China

“You have far too much credit, money sloshing about, money looking for higher returns,” said Fraser Howie, the co-author of “Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise.” “Even in commodities where you could have argued there is some reason for prices to rise, that gets quickly swamped by a nascent bull market and becomes an uncontrollable bubble.”

Christoper Balding hits the same notes in: Why China Is Prone to Bubbles

Money doesn’t sit still; all this increased liquidity is flooding into real estate and financial assets. Last summer, that led to the boom-and-bust of the Shanghai stock market. Now it’s driving up property prices in top cities -- Shenzhen real estate is up more than 50 percent in the past year -- to levels higher than in any U.S. metropolis other than New York.

Yet rather than retreating, the government is doubling down on its strategy. In January, soon after drafting a new five-year plan that focused in part on the need to shrink industries such as steel and coal, the government eased credit yet again, boosting loan growth by 67 percent in January and 43 percent through the first quarter. The money was meant to -- and did -- buy an uptick in GDP growth. But it's also gone into new loans to zombie companies as well as speculation in the commodity and bond markets.

Going back to Keen's simple debt model: the higher the debt-to-GDP ratio goes, the bigger will be the future adjustment. Increased money creation puts increased pressure on the exchange rate and that's the most likely avenue for a phase change. Timing is always tricky, but the end game is becoming more certain.