It seems increasingly to dawn on Chinese commentary that there is much more going on than “devaluation.” The latest has drawn in the Chinese hoard of UST assets, as it is clear that China is “selling” them though there is great confusion as to why or even what that actually means. The world of forex “reserves” is a bit more complex than bonds moving in and out of retail (or even institutional) brokerage accounts, but it is apparently more unintelligible when you add wholesale banking dynamics globally to the mix.

The buying and selling of US assets via “official” channels is not that at all, as no foreign government or central bank is making bets on the direction of US interest rates or creditworthiness. This is all about supply and demand. In a eurodollar world, that supply and demand is “dollars” not dollars; in other words short-term, especially overnight, credit extended between global banks that claim to have them in a positive net position against those that perpetually need to roll them over (the “short”). Rollover risk was paramount in 2007 and 2008 as a proximate trace to the crash, and here we are once more.

In Chinese terms, there is the added complexity of the PBOC which directly links external “dollar” availability with internal yuan liquidity. That is a remnant from the days where the yuan was pegged, with the “allowed” trading band on more volatile days not all that different. The only factor to contemplate about what happened on August 11 is that context; Chinese banks have to bid every morning for “dollars” from the general external supply of eurodollar bank balance sheets. If there is a “dollar” run, making the regular daily “dollar” rollover problematic, Chinese banks will have to bid up for them stretching the currency band in response.

Once that exchange pushes to the PBOC’s preset limit, the Chinese central bank has a choice of issuing “dollars” itself (from its UST hoard by “selling” treasuries), letting Chinese banks default on “dollar” rollovers or widening the band so that Chinese banks can bid for as much as they need at whatever price (when you are forced to bid at any price it is the definitive signal of wrongful systemic operation). The “devaluation” everyone keeps talking about was instead that third option.

We know, however, without much doubt that the PBOC has been supplying “dollars” all along, going back for some many months. The story and rumors about treasury selling emanating from some PBOC account has persisted from far before the events of a few weeks ago.

Just two days before “devaluation”, Bloomberg reported on this very issue with a typically wrongful focus. The article was clear about what China was doing with its treasuries, but the focal point was not on what that meant financially for China and the rest of the world but how nobody should worry about the domestic treasury market and US interest rates.

“China may be stepping away, but there is such a deep and broad buyer base for Treasuries, particularly when you have times of uncertainty,” Brandon Swensen, the co-head of U.S. fixed-income at RBC Global Asset Management, which oversees $35 billion, said from Minneapolis…

 

China’s holdings have fallen in two ways. First, active trades show $19.4 billion of net note and bond sales this year through May. Second, holdings data indicate China has opted not to reinvest the full proceeds of maturing securities back into Treasuries. Those measures combined to lower the country’s stake in the debt by about $180 billion from its apex.

Again, that was two days before the main event and during the recent-most period where the yuan-dollar cross had become a straight line sideways. Putting those two together should have been enough of a warning that “dollar” strain was seriously building (let alone oil, gold, eurodollars, LIBOR, other wholesale currencies, etc., etc.), and if it was enough to break the PBOC’s resolve it wasn’t going to stop there with just Chinese surfaces.

I think the biggest intellectual hurdle to overcome is that convention continues to demand these ideas about “reserves” as still physical piles of currencies where the central bank offers the only base supply. This is still the mistaken inference about the “dollar” as what replaced Bretton Woods’ destabilized (by the early mechanisms of wholesale eurodollars already working in the 1960’s) gold mechanics. When the US ended its final link to convertibility, Nixon “closing the gold window”, the replacement was a credit-based reserve currency – the eurodollar not the dollar or even petrodollar as the emphasis is on credit. The distinction is not trivial; it is everything.

Under a credit-based reserve system bank balance sheets are the central axis of supply globally, and in the eurodollar version the Federal Reserve’s only role is and has been in delusion. China’s activities in supplying “dollars” from its treasury holdings were as a replacement for offshore bank balance sheet contraction. The following, published back in January at foreignpolicy.com under the unfortunate title of Why China’s U.S. Treasury Sell-off Is Good News, is perhaps the best explanation of this dynamic though still falling short (obviously, given the title) of adding the wholesale element:

So what does happen to with the money China receives from unloading U.S. Treasurys? A common misconception is that China is using the proceeds from selling U.S. Treasurys to prop up its own slowing economy — by funding infrastructure projects, for instance, or bailing out troubled banks. It’s true that after Japan’s bubble burst in the early 1990s, many Japanese companies sold off overseas assets and brought the money back to plug holes in their balance sheets. But selling private assets and selling central bank assets are two entirely different things. If a Chinese company sells a building it owns the United States, it trades the dollars it receives with China’s central bank (the People’s Bank of China, or PBOC) for yuan. By issuing more yuan, the PBOC adds to China’s money supply and credit.

 

But when the PBOC sells U.S. Treasurys, the opposite occurs. It can’t spend the dollars it receives in the Chinese economy, and if it exchanges them for yuan, it’s in effect taking money out of the Chinese economy. The PBOC can counter this tightening effect by injecting more yuan, on its own, but selling U.S. Treasurys does nothing to channel more funds into the domestic Chinese economy. Quite the contrary — it is buying reserves that expands a country’s money supply and credit; selling those reserves is (other things being equal) contractionary.

That last part has become more readily apparent, especially immediately after the “run” in mid-August as the PBOC has been engaged in massive yuan injections rather steadily. So by direct inference, the massive yuan injections alone add up to the other side of continuing and heavy treasury sales even after “devaluation.” Thus, the PBOC was selling UST prior to August 11 maintaining the outward appearance of placidity and order, doing the exact same since with now open and ongoing disorder – the “dollar” run only intensified into and past a systemic breaking point.

That much we knew given a broad set of interbank indications in “dollars” having nothing directly to do with China or UST. LIBOR rates, for example, surged in the early part of August while US repo rates, particularly MBS, jumped to multi-year (non-month or quarter-end) highs during the worst of it. While China took most of the attention due to size and the magnitude of the disturbance, it should not be forgotten that China was and has not been alone in that regard (Brazil may be in far worse relative “dollar” shape).

But because wholesale dynamics remain almost totally undiscovered, very few people get the implication. From the same article as quoted above:

When Chinese companies change their yuan for dollars (from the PBOC) to import goods or buy services from the United States, those dollars are earned back into the U.S. economy. When they buy existing assets (like a home or a factory) in the United States, the American seller gets the dollars. When they invest in new assets (like opening a new factory), the dollars go to pay contractors, suppliers, and workers, creating new demand in the United States. In each case, the dollars that exit U.S. Treasurys don’t disappear, they just change hands.

That is where this all goes wrong, namely that those “dollars” do disappear as they aren’t actual dollars but rather wholesale balance sheet ledgers; they had, in fact, already done so which is why this “run” was occurring in the first place.  The PBOC is supplying by default, in essence, “past” dollars in place of shrinking “current” and traded supply (flow),  acting in wholesale markets to make up for onshore banks with “dollars” that they could not themselves obtain easily without disturbing the yuan (before August 11) or at a stable price. In other words, what the Chinese episode demonstrates is the great truth behind everything going back to August 2007, that the “dollar” “supply” globally is shrinking taking on acute sensitivity the further into 2015 we traverse.

With such magnitude even offshore (from the US perspective) it was only a matter of time before it penetrated domestic markets including stocks. The corporate credit bubble had been warning of that for months, in perfect tandem with the yuan’s end of the run, so there is little “unexpected” here. More importantly, however, whatever calm has been the past few days is a further illusion, as the great “dollar” imbalance is clearly far from settled. In fact, the greater the volatility the more likely that wholesale supply shrinkage will accelerate, as that monetary math constraint is self-reinforcing absent exogenous interjection. That is the problem with all these perceptions about central banks riding to the rescue, particularly the PBOC this week which is exuding only more desperation, as central banks do not possess the tools for, or even sufficient awareness of, these wholesale dynamics.

It’s like August 2007 never happened, and economists and policymakers simply reverted back to their pre-crisis intellectual state of denial once the furor died down sufficiently. Now that it’s back, they still have no idea but “markets” expect them to act in time this time by actively forgetting how they quite similarly couldn’t last time.

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