China’s currency had been on fire for seven months straight. Rising nearly in a straight line, from May 27 last year until very early January this year, CNY had gone from a certain plunge into the devastating monetary abyss (unintentional devaluation) to a significant basis for Xi Jinping’s global boasting. This was no ordinary turnaround.

The timing of it speaks initially to underlying fundamental economics: reopening globally which just got things moving again. Dollars that were denied via both the merchandise and financial (“hot money”) channels became available, or at least relatively more available than they had been in March and April 2020 (GFC2). Some have spoken of, and continue to talk about, a flood of currency worldwide.

Reopening and some stature of a rebound, sure, there has been a glaring omission so far as the Chinese part of it has been concerned; where did these inbound dollars end up?

The only thing we know for sure is where they didn’t materialize, which just so happens to be the one place they really should have. Dollars (or other foreign currency; primarily dollars, though) enter China and the PBOC scoops up a significant portion of them as soon as they do (managing the exchange rate’s float). Historically, it had been a near dependable, almost proportional relationship:

The more “dollars” the eurodollar market had to offer the Chinese – especially in the aftermath of GFC1, or Euro$ #1, when it was assumed EM’s like China would escape the lingering problems becoming more apparent in the DM world – the higher CNY traded (after being allowed to limited float) because they were plentiful to the point of competition to lend them. What the central bank didn’t need, the rest went on to China’s domestic banking sector.

Since the world runs on a (euro)dollar standard, these “dollars” get recycled back into the corporate sector for re-use in global trade (as well as other financial forms); through specific intermediaries such as the Import/Export bank, through offshore interbank markets, or as “dollar” loans taken out by China corporates from China domestic banks.

More importantly, so far as the central bank is concerned, these forex assets which had previously accumulated on the PBOC’s balance sheet formed the basis for internal RMB money. Essentially, the monetary authority “converted” those “dollars” (which it would invest in UST’s) into RMB bank reserves and physical currency. China money is significantly dollarized.

That transformation gave the PBOC further monetary control over the domestic banking system, including reserve requirements (RRR) acting as its margin for error when fine-tuning bank reserves (which before Euro$ #3 had been expected to only be in the one direction).

That all changed at the end of 2013; CNY started lower (along with UST yields) at the outset of 2014 when CNY (along with UST yields) was supposed to go only ever higher. Indeed, within a few months this shifting monetary condition was easily detected right on the PBOC’s balance sheet in the reverse of what’s described above: the eurodollar market makes “dollars” more restrictive, meaning relatively more expensive, increasing the dollar exchange rate against CNY (down).

To counteract this eurodollar drain (which can take the form of limited growth; tight money needn’t be a straight up contraction, it can simply be when not “enough” is available on reasonable terms rather than strictly “fewer”), China’s central bank did what nearly everyone else (Brazil a noted and notable exception) around the same time had: they “sold” their forex assets and (more) directly supplied China’s corporate sector its shortfall. 

The direct internal RMB consequence was simple accounting – fewer assets (forex assets sold and disbursed), fewer liabilities. Physical currency growth was choked off and bank reserves began to decline sharply (the RRR was reduced starting in late 2014 intended to counteract this illiquidity in bank reserves).

The Chinese economy barely escaped a “hard landing” in 2016 which brought about a clear shift in reserve policy (along with Party Politics). Authorities are absolutely determined to avoid repeating this Euro$ #3 situation; the PBOC is almost religiously adhering to the level of current foreign reserves.

One part of that is the missing forex of 2016-17; during Reflation #3, said to have been “globally synchronized growth”, like last year CNY had completely turned around and moved upward while at the same time the central bank’s forex reserves didn’t. Where were the “dollars?” Nowhere to be found.

These two seemingly contradictory outcomes hinted (strongly) at a backdoor; meaning, that CNY’s rise was being sort of engineered out of hidden US$ transactions carried out by the PBOC (off balance sheet) or on its behalf (forward cover provided to domestic banks operating in eurodollar markets). In other words, to put it in very simple terms, rather than “sell” UST assets and then deliver the dollars off its balance sheet to domestic banks (and on to desperate China corporates), the PBOC might have sold forward or even borrowed “dollars” directly in repo using (loosely) its UST’s as collateral.

Essentially, a backdoor bypass into and out of China where CNY rises somewhat because of reflationary eurodollars but also with this backdoor otherwise “supplying” “dollars” leaving fewer to be demanded at the front door. Authorities wanted to keep this in the dark so as to keep the CNY fiction going for as long as possible (hoping, eventually, the “dollars” would start flowing back in the front door on their own before too long).

Time ran out right around the end of 2017. By early February 2018, yuan was no longer rising (nor were many other currencies) and Euro$ #4 showed up instead. Already overextended from its 2017 activities, and with global “dollars” increasingly hard to come by for the entire world, CNY plummeted.

At that point the PBOC could have gone back to its original 2014-16 strategy of outright selling foreign reserve assets; central bankers blatantly chose not to, seemingly drawing a line in the sand where they’ve judged it the lesser evil of maintaining this level of reserves even to the point of allowing the currency exchange rate to decline sharply.

The more Euro$ #4 progressed, the more this proved to be the case; to the point that, from early 2019 onward, the PBOC is deliberately managing – to the point of almost openly targeting – the balance of foreign reserves again at the cost of internal RMB.

So, here we are back like late 2017, potentially, where CNY has been rising into a modest reflationary background, one that allegedly has been supported by a flood of dollars worldwide – and yet, like four years ago, none of them have ended up in the PBOC’s hands.

What some are further proposing is that the flood has indeed come in for China, except this time the PBOC has refrained from taking up any of it; the tsunami of “dollars” (merchandise surplus more than financial) is, supposedly, going right into the banking system which is either holding onto them offshore or being given permission to bring them onshore without PBOC recourse (and even if the former, that might also be an indication of more complications so far as dollar tightness is concerned).

But why would the PBOC do this? Why wouldn’t the central bank want, demand, a good chunk of this inflow?

To begin with, openly, publicly adding to foreign reserves would represent a turn toward normalcy if nothing else; “see, it’s just like the old days again!” More directly, an increase in foreign assets would take some of the pressure off downstream RMB constraints; like before 2014, more foreign assets mean more RMB currency and bank reserves.

And CNY would still rise while authorities replenished themselves, maybe just not as much as it has.

If the Chinese have learned anything, it’s been that it is far, far more preferable to deal with the inflationary consequences of too many dollars than the rampantly destructive, politically dangerous fallout from deflationary too few.

Furthermore, there is every outside reason to suspect there hasn’t been much eurodollar reflation to begin with. A survey of currency exchange rates (as a limited proxy for general eurodollar tightness) shows – especially for EM’s – that the rebound or reflationary case didn’t make it all that far given how other currencies have behaved outside of China. More of a slight trickle than flood following what had been an enormous interruption in global “dollar” flow (GFC2).

In short, it seems far more likely the “dollars” never showed up anywhere in China at all, and the PBOC is and has been very busy at its backdoor to make up the difference.

Now CNY’s rise has, at the very least, paused. This pause coincides with a whole bunch of other “tightening” indications, not the least of which has been T-bill rates. Are we seeing in CNY SIDEWAYS renewed eurodollar tightness more broadly which is making the PBOC’s backdoor efforts a little more difficult to carry out? The timing is certainly compelling. 

According to its latest balance sheet figures, central bank holdings of foreign assets barely budged yet again in January. Should the PBOC continue to prioritize reserves over exchange value any further tightening in the global dollar marketplace could bring CNY falling down hard like it had just three years ago. As we know from recent history, CNY DOWN = BAD.

This doesn’t mean immediate crash or any kind of crash; rather, a more defined turn at least in the wrong direction for whatever ultimate end.

Keep in mind, too, that China’s economic rebound overall from 2020 hasn’t really gone that well and since January (imagine that) there are growing indications it may have even reversed entirely. Such rising risks, perceived in dollar markets, would definitely cause enormous headaches for Chinese central bankers trying hard to keep engineering out of their backdoor what so far has been impossible.