China’s liquidity blockage

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The issues surrounding China’s foreign reserve accumulation, capital flow, and the liquidity of Chinese banking system has been one of the key themes that I have been following. It is only recently that we saw the first ever quarterly drop of foreign reserves (balance of payment basis, excluding foreign exchange revaluation) and, predictably, it was dismissed as a problem for China.

But there are some facts related to this that everyone should be aware of. First, the sources and destinations of the outflow are not relevant. US$100 million worth of outflow remains the same, whether it is fund transfer for emigration purposes or outbound direct investment. The impacts upon the liquidity in the Chinese banking system are equivalent.

Second, the impact on liquidity is already apparent, as reflected in the total lack of foreign reserve accumulation since last year, which translated into the lack of PBOC balance sheet expansion, as well as the frequent liquidity crunches affecting the banking system. Such occurrences are completely in-line with what I have been expecting.

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Finally, it is absolutely true that the size of China’s FX reserve is a lot of fire power, but what is all this fire power useful for? The short answer is to defend the currency in the even of massive selling pressure. But to defend the currency against massive outflow by spending FX reserves, liquidity within the country will be massively tightened. Only a few seem to realise this, and the majority continue to bang on the argument that it will be fine because China has a large FX reserve.

No, it will not be fine if capital outflow continues.

After the ECB announced OMT and the Fed announced QE-Infinity, the removal of tail risks in Europe and weakness of the dollar may reverse the trend of capital outflow for China (or at least reduce the size of outflow so that it is smaller than current account surplus). In that event, the PBOC should be able to restart the process of FX reserve accumulation, which will help liquidity within the Chinese banking system. The strongest evidence which suggests that this is possible is that Chinese yuan has once again appreciated against the US dollar. In fact, the yuan reached a multi-year high yesterday against the US dollar, while PBOC fixing continues to trend downward.

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However, something rather contradictory is also happening, which suggests that perhaps the pattern of funds flow has not improved much in favour of the Chinese economy. The Chinese banking system has been in a liquidity crunch almost every other week. It is true that the latest crunch comes ahead of the long Golden week holiday and quarter-end, which means that the liquidity crunch is not unexpected. However, the magnitude of the crunch seems to be unprecedented, as indicated by the amount of temporary liquidity which PBOC has to inject into the system.

Which brings us to the question of whether there actually is any inflow at all, and whether such inflow (if it exists) is enough to restart the process of FX reserve accumulation, or whether I have turned too optimistic about the reversal of capital flow after OMT and QE-Infinity. Simon Derrick of Bank of New York Mellon (via FT Alphaville) has the same problem in mind:

At first glance it could be argued that, while the USD 65 Bn decline in the value of China’s reserves seen in Q2 was the largest quarterly decline on record, this was only a 1.96% decline in the total amount. As such it could easily be argued that this represented no more than a shift in the mark-to-market value of the reserves rather than an actual reduction in holdings given that EUR/USD fell 5% quarter-on-quarter. However, it is when we look at the year-on-year change that it starts to become apparent that something rather more significant is happening. Between June of last year and June of this year China’s FX reserves grew by just 1.32%. In contrast, the average year-on-year growth rate since 2001 has been a little over 30% while the lowest numbers prior to last week’s were 8.5% in March, 11.7% in December 2011 and 12.1% way back in March 2001. Given how important the process of reserve diversification has proved over the past decade for the broader currency markets, we need to ask whether we are seeing a fundamental shift in the underlying pattern of reserve growth.

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It will, of course, be some time until the official reserve numbers are published so we must therefore look elsewhere for our evidence. One small piece of evidence may come from the news yesterday that the PBOC has apparently injected a net CNY 365 Bn into money markets this week, the largest weekly injection in history. The injection was intended to help stave off a potential short-term liquidity crunch at commercial banks over the quarter end and the week-long holiday to come. However, the very fact that the bank is having to make the move at all is a measure of the fact that inflows of foreign money remain scarce and that the PBOC has had to become the supplier of cash to the market instead.

We will not know about the size of Chinese FX reserve until they report it. For the time being, we can only guess. Liquidity crunches before long holiday and quarter-end is not unusual, but the magnitude of it is not. If there is any inflow which ease Chinese liquidity, it is obviously not big enough yet to offset the tightening.

To see this problem from another angle, if we extrapolate the old trend line of FX reserves and PBOC balance sheet accumulation (which was about RMB302 billion per month), the PBOC’s balance sheet should be about RMB3 trillion larger than it was by the end of July. The pace of balance sheet expansion before the current dramatic slowdown also happens to be roughly the rate of nominal GDP growth, thus keeping the size of PBOC’s balance sheet roughly constant relative to GDP. If this old trend line of PBOC balance sheet expansion is what’s necessary to maintain liquidity in the current environment, then obviously the monetary policy remains too tight.

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Even though the total net liquidity injections for the past 14 weeks are equivalent to 2 regular cuts of reserve requirement ratios (50bps each), RMB3 trillion base money “shortage” would require at least 6 or 7 cuts to offset the effect of the lack of PBOC balance sheet expansion. It also implies that ten 50-basis-point cuts of the reserve requirement ratio would probably be closer to what is actually necessary to actually ease monetary conditions, not 1 or 2 cuts before the year-end, as the market consensus is hoping for, and very clearly more than what PBOC appears to be willing to do at the moment.

For the time being, we still see the possibility that funds flow could become more favourable for the Chinese liquidity condition as ECB and Fed actions encourage risk-on. For the time being, however, the positive impact on liquidity from this source remains small, and obviously far from enough to provide lasting easing of liquidity condition. I remain sceptical as to how long such funds inflow may last, as the global economic slowdown seems to be gathering pace, and the Eurozone crisis is far from over. Any positive impact on domestic liquidity can only appear if large and consistent inflow is enough to get PBOC back into FX accumulation. Anything less than that will proved to be useless.