In a world in which every nation is now part of the race to debase their currency, or as the Brazilian finance minister first dubbed it in 2010, a "global currency war", the first and foremost imperative on every central bank's agenda is to devalue its currency faster than its net exporting peers. But not too fast: indeed, there is a problem, when the threat of devaluation becomes too great and the risk resulting from a flood of capital outflow surpasses than that from the economic contraction that would persist should the currency not devalue fast enough.
This is precisely what is happening in China, where as we reported two weeks ago, the nation has, over the past 18 months, seen $1 trillion in capital quietly exiting the otherwise closed system which has terrified the Politburo that even its $3.5 trillion in foreign reserves (of which about $1.5 trillion are said to be liquid) won't be enough if the capital outflow accelerates.
This has in turn put the Chinese central bank in a very uncomfortable position: while the PBOC desperately needs to boost monetary stimulus to facilitate debt creation in a nation where company have to issue new debt just to pay their interest, or as Minsky called it, the endgame...
... any further stimulus will also lead to even greater currency debasement and devaluation, more capital outflows, more FX reserve spending, and ultimately the perception that Beijing is panicking and those $35 trillion in Chinese bank assets are about to the NPLed into oblivion as the rollover of bad debt becomes impossible.
This was confirmed earlier today when the South China Morning Post reported that according to a leaked document "the People’s Bank of China is reluctant to further reduce the required reserve ratio (or RRR) for fear of such a move resulting in the weakening of the yuan."
The information, reportedly leaked from minutes of Tuesday’s meeting between the central bank and commercial lenders, was shared widely after it was published on major mainland online portals including Sina.com and Netease.com.
As a reminder, the RRR along with the core interest rate, are the two "shotgun" methods that China's central bank has to easy (or tighten) monetary conditions. As such, every time Chinese economic indicators take another leg down, every one in the sellside screams for more PBOC stimulus, mostly in the form of a RRR cut.
However, that now appears won't be happening. SCMP explains why the PBOC is suddenly reluctant to ease aggressively over fears such a move can unleash another torrent of capital outflows:
The memo sheds light on the challenge the PBOC faces in trying to achieve two conflicting goals. It has to ease monetary supply to raise liquidity to boost the ailing economy. But it also has to stop the yuan from weakening too much, which could happen in the case of increased liquidity.
According to the memo, Zhang Xiaohui, an assistant central bank governor in charge of monetary policy, told commercial bankers that the PBOC had to be very careful in maintaining the renminbi’s exchange rate stability when managing liquidity.
A key lesson for the central bank was the aftermath of its move in late October to cut interest rates and the reserve ratio. The move greatly loosened liquidity conditions and “increased yuan depreciation expectations and added pressure on the yuan to weaken”, Zhang said.
The PBOC had to balance ensuring sufficient liquidity in the banking system and managing the stability of the yuan exchange rate, the official said.
“A too-loose liquidity situation may result in relatively big pressure on the yuan exchange rate,” Zhang was quoted as saying. “A cut in the required reserve ratio would be too strong a signal [to send to the market], and we can use other tools to provide the market with liquidity.”
Instead of the shotgun approach, the PBOC will therefore be expected to increase liquidity in the economy through open-market operations that were less drastic than cutting the reserve ratio, the memo said.
Indeed, we observed just that last week when the PBOC injected a whopping 400 billion yuan into the banking system - the most in three years - in an overnight operation using 7 and 28-day reverse repos, the same operations it was aggressively relying on in 2011 until 2013, when it resumed RRR and rate cuts once again, only to see a surge in capital outflows starting in mid-2014.
Furthermore, since the Lunar New Year period which falls in early February this year, is when cash demand peaks, it is likely that over the coming week the the PBOC will release an extra 1.6 trillion yuan, nearly a quarter trillion dollars, into the banking system to help banks cope with the increased cash demand.
However, and liquidity junkies expecting a flood of short-term funding may be disappointed: Zhang said banks had lent out money too rapidly in the first half of the month – over 1.7 trillion yuan – and that they had to slow down their lending process. The SCMP quotes Yi Gang, a vice-governor of the PBOC, who again warned banks not to repeat their mistake in the 2009 lending spree, during which many loans turned bad when they could not be collected back, according to the memo.
Of course, if China's growth contracts any further, and if the central bank is indeed precluded from RRR and interest rate cuts, then a lending spree is precisely what banks will engage in.
Meanwhile, the biggest threat facing China remains its porous capital controls, which despite a max quote of $50,000 in annual outflows, has seen hundreds of billions in funding exit the "closed" capital account system, which in retrospect is not only not closed but very much open.
The central bank was determined to keep the yuan stable, Yi said. “The personal annual quota of $50,000 has not changed. Some individual bank clients are sending messages to their clients, encouraging dollar buying ... If you spread false information to cause panic, relevant authorities will come after you,” he said.
As we said in September, when bitcoin was trading 40% lower than its current price, the big question is whether the Chinese population (which has over $20 trillion on deposit in the local banks) has realized that one of the best means of circumventing capital controls is with the digital currency, which however provides a window of opportunity which may not last too long, now that the PBOC is contemplating rolling out its own "digital currency."
Of course, since the particular "currency" will be nothing like bitcoin, and every transaction will be logged, absolutely nobody will use it voluntarily unless China does what it does so well, and threatens with arrest, bodily harm or worse, anyone who keeps using bitcoin in lieu of the government-mandated currency. Based on history, such an escalation would only make the "forbidden" alternative even more attractive.
The PBOC’s news division did not respond to requests for confirmation of the leaked memo.