China recreates the Mississippi Bubble

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Andrew Hunt argues that investors should be watching China's currency carefully as that will impact asset price inflation around the world.

Sunday, August 14th 2016, 4:19PM 1 Comment

by Andrew Hunt

At -3% in year on year terms, China’s published rate of reserve money growth (i.e. the amount of money circulating within the banking system) appears exceptionally weak and certainly far at odds with the ECB’s 40% rate of base money growth or even the Bank of Japan’s 26% YoY rate. Indeed, taken at first sight, the behaviour of the PBoC’s balance sheet would appear to represent that of a central bank that is in the midst of tightening and, when one also notes that interbank rates have tended to drift higher since March, one could easily come to the conclusion that the PBoC is indeed in a restrictive mode at present. 

We would argue, however, that to arrive at such a conclusion would be the result of having been conditioned by the behaviour of Western / developed world central banks which rarely intervene in the FOREX markets, and as a consequence have their rates of balance sheet growth determined almost solely by their domestic activities. In the case of China, in which the Foreign Reserves (still) account for around 80% of the total balance sheet, the decline in reported reserve money growth is simply the result of the country’s loss of exchange reserves and not, we would argue, the result of a policy objective and furthermore it is not particularly indicative of what is really going on within the financial system.

In theory, an emerging market that is operating any form of formal / informal currency target (as China does) should have its rate of reserve money growth determined solely by its rate of FOREX reserve accumulation or loss but we can calculate that, if China had abided by this rule and simply kept the other components of its central bank’s balance sheet constant while it was suffering the drawdown in its foreign reserves, then its rate of base money growth would have been around minus 11% over the last year, a ‘crisis-like’ number that would doubtless have sent interest rates soaring, the financial sector into a probable “death spiral” and the economy into an undoubtedly deep recession. 

Unsurprisingly, the domestic authorities have chosen not to allow this state of affairs to exist and they have instead attempted to sterilise the monetary effects of the loss of reserves by aggressively expanding the PBoC’s stock of domestic assets.

In the West, were such a sterilisation effort to occur, then it would probably occur via the central bank in question buying in large quantities of government paper, something which would now bring forth cries of “QEP”. China has however adopted a more circuitous route in that the PBoC has, over the last year, advanced nearly RMB3.5 trillion (equivalent to around US$500 billion) in new credit to its domestic banking system and, in particular, to its state-controlled policy banks. Intriguingly, roughly half of this lending has occurred since mid-April, which implies that on a pro-rata basis the PBoC is expanding its domestic balance sheet at an even faster absolute rate than the ECB and the BoJ.

This apparent massive expansion of the PBoC’s domestic assets would seem to represent a very obvious, and we might even suggest determined, form of domestic easing that should in theory both contain the pressure on interest rates and perhaps even encourage the commercial banks to expand their balance sheets. Certainly at first sight, this activity would seem to be supportive of domestic activity and asset prices in China, although as we shall see the situation is in fact a great deal more complicated than this seemingly obvious first glance conclusion.

Perhaps unfortunately, one of first things that we can see within the latest money and credit data is that this recent (i.e. post April) easing is not going into an increased rate of domestic lending by banks to the private sector. Over the last few months, the rate of annual lending to the private sector has declined from RMB24 trillion per annum to closer to RMB22 trillion, while in USD terms lending growth has slowed from $2.8 trillion to $2.1 trillion per annum (which may be the more important number from the point of view of the outlook for the global real economy). In percentage terms (measured in RMB), credit growth slowed to 20% YoY from 23% YoY during the first quarter.

We suspect that the slowdown in credit growth is the primary reason behind the still weak data trends in much of the real economy, the disappointing import data in June and even the clear ‘depression-like’ readings in many of the business confidence indices (and particularly in those concerned with corporate liquidity). It would certainly seem that China’s ‘easing’ has not improved credit conditions within the private sector and if anything they may be continuing to deteriorate judging by the recent bank lending and corporate bond issuance data.

Instead, we find that where the banks have made some considerable use of the PBoC’s extra funding has been in expanding their acquisitions of government bonds and muni bonds. In a sense, this situation, in which the PBoC has lent to the banks who have then used the funding to buy government bonds, can be thought of as representing almost a ‘QE by proxy’ but the monetary implications will have nevertheless been the same as they might have been had the PBoC purchased the bonds directly. Both routes result in an increase in ‘net bank credit to the government’ and if anything the PBoC’s route may have been a little more potent, since it will have been the banks, rather than the central bank, that captured any of the ‘carry’ associated with the increased level of bond holdings.

One important feature of China’s “QE by proxy” that stands out is that the banks’ acquisitions of bonds has, by far exceeded the central government’s borrowing requirement. Indeed, we could argue that the banks are buying fully twice as much government debt as the would be required to simply fully monetise the existing budget deficit and this we suspect hints at there being another agenda behind the activity.

One of the most obvious and apparent features of the Chinese banking system at present is its rising loan to deposit ratios and growing signs of fundamental illiquidity. However, with the banks’ ability to issue bonds, (bearer) bills and in particular wealth management products now under threat, the banks’ need (or even requirement) for ‘vanilla’ type deposits must be intense. Therefore, if the policy banks are buying in more government bonds than the government is issuing at present, then by definition some of the bonds are being purchased by existing bondholders who will receive deposits in exchange. Presumably, the hope is that these former bondholders will then deposit the proceeds of their sales in the banks, thereby providing the banking system with new deposit-based funding. This, we suspect, is the plan that the authorities are adopting, at least implicitly.

Unfortunately for the Chinese authorities, but so far not for the rest of the world, we find that when these former bondholders sell their bonds, they are not simply depositing the money in the local banking system. They are instead increasingly looking abroad, it seems, with the result that China’s outflows of private sector capital seem to be picking up strongly once again. 

Of course, in the first instance these increased outflows are incredibly expansionary for global (asset market) liquidity trends. Certainly, we calculate that China is contributing an awful lot more to the current global liquidity boom than any other country within the Global System at present. Indeed, in what we regard as being an eerily direct re-run of the 1710-1720 Mississippi Bubble, a massive liquidity expansion in a significant global economic power (then France, today China) has unleashed what amounted to a tidal wave of liquidity that is inflating asset markets in the countries in which it arrives (while only exerting a relatively modest impact on the donor economy). Certainly, we would trade China’s current ‘QE’ as being the primary source of the liquidity that is powering the global asset price melt up at present.

Ultimately, the French monetary experiment of the 1710s that led to the Mississippi and South China Sea Bubbles did create (hyper) inflation in France but only when the Franc collapsed and it was at this point that the global asset price bubble also ended.

Economists such as the now unfortunately largely forgotten Richard Cantillon, who successfully managed to play ‘both’ the inflation and the deflation sides of the trade, made their fortunes while those that remained long the asset price boom as the French currency declined lost virtually all of their notional wealth.

The key to Richard Cantillon’s success in speculation at that time (although he was subsequently assassinated, rumours have it by the French state) was in appreciating when the pressure on France’s foreign exchange reserves had become so intense that the government would have to let the currency fall sharply relative to metal prices and foreign currencies, so as to choke off the huge capital outflows. Readers might also like to know that the collapse in the Franc occurred in the 1720s despite France running a substantial trade surplus, as indeed does China today – the collapse in the franc was very much a capital account driven affair.

Returning to China, it seems clear that around late April / early May of this year the authorities dramatically stepped up the rate of growth of the PBoC’s domestic assets in an overt attempt to both support domestic liquidity and we suspect sterilise the monetary effects of what might otherwise have become a very painful and destructive decline in banking system liquidity caused by the ongoing drawdown in the FOREX reserves.

Unfortunately, economic theory tells us that sterilised FOREX intervention is unlikely to provide long-term support to a currency – in the near term sterilised intervention might secure tactical victories in the markets via squeezes on speculative positions but in the longer term, the act of sterilisation simply implies that there will be yet more of the currency that is under pressure in existence and the laws of supply and demand tend to take over at that point, with the result that the currency will fall by even more than it might otherwise have done so.

In the near term, China’s easing of domestic policy may not have led to an improvement in domestic credit conditions (hence we expect China’s economy to remain essentially weak) but has undoubtedly unleashed a near tidal wave of inflationary liquidity into global markets but ultimately China will have to either tighten or accept that the RMB must fall to whatever level is necessary to curtail (or at least reduce) its capital account deficit. Such an event would be deflationary for both the global economy and – by definition - those asset markets that have been buoyed by China’s capital outflows, be they US and Australasian property or EUR assets.

We would therefore advocate that those participating in the current global bull market, or wishing to bet against it, should by very close attention to the trajectory of the RMB. Now that China has eased / sterilised its intervention, the RMB should fall further with deflationary consequences for the world but until the RMB’s decline accelerates, it may be able to squeeze a little more asset price inflation from China’s new capital outflows boom.

Andrew Hunt International Economist London

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