While most have been complacently ignoring signs of tremors being felt in the global markets, one of the fascinating developments has been in China.
As I’ve previously noted, as the yuan wobbled, interbank lending rates in Hong Kong and China have been in turmoil. Ironically, these haven’t been a one off event. The week closed with hardly any significant improvements in interbank rates. Instead, most rates continue to lurch higher.
What makes the present developments riveting have been the actions underneath the proverbial hood.
Two charts from very astute China observers share the same story…China has been experiencing accelerating US dollar shortage from which its central bank has been substituting loss of (US dollar) liquidity with the yuan.
And as I’ve said here, the capital controls have been indications that the PBOC’s toolbox has effectively been depleted, thus the PBOC seem as losing control.
While the monetary liabilities (read: monetary base) of the bank have remained rather constant since late 2014, their composition has changed. The assets, which are the counterparts to the monetary liabilities, have changed dramatically. The net foreign assets have fallen and been replaced by net domestic assets. In consequence, the quality of the CNY has deteriorated. In this light, the recent tightening of China’s capital controls on outbound foreign investment is nothing more than an attempt to preserveforeign exchange and reverse the deterioration in the CNY’s quality. Over the past year, we have observed a depreciation of the CNY against the greenback, a reduction in the CNY’s quality, and the imposition of even more restrictive capital controls – an embarrassing state of affairs for a country that was beating its breast just two short months ago about joining the International Monetary Fund’s elite Special Drawing Rights (SDR) currency basket.
Eurodollar analyst Jeff Snider of Alhambra Investment Partners described in details how the US dollar shorts effectively represented a “drain on internal RMB liquidity”. And such has mechanically been countered by the PBOC as “something of a rule of thumb where we can discern the relative level of China’s “dollar” problem by how intensely the PBOC fights against it with RMB”.
Yet the intensity of the PBOC’s actions can be seen through a gargantuan infusion in October “The total reported amount run through the MLF, SLF, and whatever else Claims on Other Depository Corps was nearly RMB 1.1 trillion”. Although such infusion has mostly been soaked up by the government through government deposits.
And the PBOC’s actions have resulted to variable effects on the economy: (bold mine)
From this you can appreciate the PBOC’s dilemma and why it as part of the overall government structure would seek to alleviate its “dollar” pressure through even “capital controls” that aren’t what they might seem to be. To give the Chinese system full availability of RMB (which in October would have meant RMB 2 trillion, RMB 4 trillion?) risks turning China’s markets into copper, where an imbalance in real estate and other asset classes are already at the top of the official list for deflating (which is, I believe, one reason the PBOC in RMB sat out the monetary contraction of 2015). And in the case of October 2016, what they did do in size was just enough to keep the overall system from contracting due to seasonal factors of government influence.
That is why, I think, SHIBOR rates diverged from copper, especially since the “targeted” liquidity of Claims on Other Depository Corporations is channeled directly through China Development Bank and other state-owned behemoths like it. The general interbank market for RMB, on the other hand, was left with the effects of the government drain, leaving the PBOC’s overall addition not strictly as an addition, but rather a redistribution of RMB. This proves yet again that actual central bank programs are not so straight forward as they might ever appear to be, and that currency elasticity as a theory does not fit the real world mechanics of how things actually work.
In short, the PBOC has been caught in a quagmire of its making. They inflated a credit bubble, now they seem to be at a loss on how to address, contain or curtail it, hence the act of desperation—capital controls.
While the PBOC tries to offset balance sheet shrinkage from the decline in foreign assets with RMB liquidity injections, it has been afraid to further stoke febrile speculative episodes that would exacerbate on real economy imbalances, thereby the drain on these injections that has spurred surges in the SHIBOR curve.
Nevertheless, the massive credit creation, which has spawned a rotation in China’s grand asset bubbles, has now fomented massive punts on industrial commodities, including copper as indicated above.
From Bloomberg (November 29): “The Chinese speculators shaking up global commodity markets are switched-on, flush with cash and probably not getting enough sleep. For the second time this year, trading has exploded on the nation’s exchanges, pushing prices of everything from zinc to coal to multi-year highs and sending authorities scrambling to deflate the bubble before it bursts. Metals brokers described panic earlier this month as the frenzy spread to markets in London and New York, prompting wild swings in prices that show no signs of abating.”
And to aggravate on the commodity pump, last week’s OPEC deal have spurred oil prices to soar by 12% (CNBC December 2, 2016)!
And many have come to interpret soaring industrial commodities as signaling G-R-O-W-T-H mostly via infrastructure spending or even signs of price inflation—when much of these have been part of China’s rotational credit financed speculative binges.
Rampant asset speculations are, of course, symptoms of chronic monetary inflationism.
And as the yuan lose value, this has prompted the public to increase demand to hold assets.
From the Austrian economics point of view, this represents increases in “reservation demand”. Reservation demand, according to Austrian economist Murray N. Rothbard signifies “a demand to hold stock. Thus, the concept of a “demand to hold a stock of goods” will always include both demand-factors; it will include the demand for the good in exchange by nonpossessors, plus the demand to hold the stock by the possessors.” (Rothbard, MAN, ECONOMY, AND STATE p 138)
And magnified reservation demand could highlight initial manifestations of a crack-up boom.
The crack-up boom as explained by the great Ludwig von Mises. [Ludwig von Mises, 6. The Gross Market Rate of Interest as Affected by Inflation and Credit Expansion XX. INTEREST, CREDIT EXPANSION, AND THE TRADE CYCLE Human Action]
Neither could the boom last endlessly if the banks were to cling stubbornly to their expansionist policies. Any attempt to substitute additional fiduciary media for nonexisting capital goods (namely, the quantities p3 and p4) is doomed to failure. If the credit expansion is not stopped in time, the boom turns into the crack-up boom; the flight into real values begins, and the whole monetary system founders. However, as a rule, the banks in the past have not pushed things to extremes. They have become alarmed at a date when the final catastrophe was still far away.
In short, crack-up boom means loss of confidence on paper currency from which commodities are seen as substitute store of value.
And it would appear China’s conditions could reflect on what I call the Mises moment—a decisive turning point where the political choice will either be to inflate even more and see the yuan crushed via hyperinflation, or put on the brake on credit, and consequently, see a deflationary bust.
The PBOC’s dilemma underscores this.
Yet it’s also interesting to see China’s 10 year sovereign yield surge along with global sovereign bond markets.
This means monetary dilemma has not only been spreading but exacerbating.
And even more interesting has been that soaring global bond yields have translated to a staggering $1.7 trillion loss for global bonds in November, according to the Bloomberg. This compared to the $635 billion gains by global equity markets.
Of course, that’s just volatility from stocks and bonds which excludes the currency markets. And there are yet trillions of derivatives (credit default swaps, repos, interest rate and currency swaps, securitizations and etc…) that underpin these markets.
Even more important has been that the surge in the yields of 10 year notes has real economic effects. Yieldsof 10 year treasury notes serve as a “benchmark that guides almost all other interest rates. The exception is adjustable rate mortgages, which follow the Fed funds rate” notes The Balance.com.
This means that if yields of US treasuries stay at present levels or even scale upwards, then interest rates for credit instruments that track these yields will move in tandem with them. And as feedback mechanism, these would compel a reaction by the FED to track such upside moves in terms of policy interest rates.
And the recent surge in yields of US Treasuries backed by soaring inflation expectations heralds to a FED rate hike in mid-December. The question is how big will the rate hike be? Could it be 50 bps or even more?
This also means that given the US dollar standard, many nations will also be impelled to realign their respective interest rates with that of the US—which means higher rates and the end of QE and ZIRP
Something, which China’s credit markets, has already been showing us.
And given the $152 trillion global debt pile in 2015 as estimated by the IMF (left chart from Bloomberg)—which should be definitely a lot larger today—that has pillared massive speculation on real estate bubbles globally, where housing prices around the world have almost reached 2007 highs (right chart from Bloomberg’s Tracy Alloway), just how will a global financial system almost entirely DEPENDENT on zero bound rates, cope with higher rates??????????????
And the economic weakness and huge debt would amplify the US dollar shorts.
The unfolding bidirectional amplified volatility across financial assets worldwide has been a testament to this.
Something is bound to give in…soon
It’s why breakthrough history is in motion.
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