China recreates the Mississippi Bubble

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.