There are three letters you never want to see hit the Chinese news. Actually, it’s the same letter just repeated three times. If the People’s Bank of China (PBOC), the country’s central bank and top bank regulator, ever decides to reduce or cut their RRR you know things are getting serious.
And not in a good way.
This, of course, won’t stop the mainstream media from printing countless stories extolling the virtuous accommodation a lower RRR brings with it – in theory. Actually, it’s the same story just repeated so many times the public can easily be forgiven for thinking there is the slightest truth in them. There isn’t; every last bit of historic and empirical observation refuting the whole idea.
Nothing good happens when the PBOC finds itself cornered (by that dollar system) into crossing its fingers and hoping China’s banks step up.
They haven’t yet.
Earlier today, the Chinese central bank/monetary authority did just this; the RRR for all banks is to be reduced by 50 bps, for the largest banks lowering their reserve requirement (that’s what RRR references) to 12% from the current 12.5%.
At one time, all the way back in 2011, the RRR for large banks was an unbelievable 21.5%. Over the decade in between, according to the accepted conventional theory by reducing the RRR this must’ve flooded China with trillions upon trillions of RMB banks were allowed to incrementally use to stimulate the Chinese economy.
Only, the Chinese economy has gone in the opposite direction during those ten years. The money must instead be “missing” as is the economy. So much for the theory.
The problem begins where everything begins; in the eurodollar system. The background is complicated in the details, specific transactions and whatnot, yet really simple as a conceptual framework. Before 2011, eurodollar expansion (between 2009 and 2011 there was limited dollar expansion pouring into Asia) into China meant an actual flood of effective and useful money forms much of what by policy ended up in official hands – forming the basis for the PBOC’s balance sheet (asset side).
This external monetary expansion was the basis for internal RMB expansion; more assets for the central bank, even forex assets, more space for liability (money) growth especially in bank reserves (which in China, unlike the US$, actually have a place and use).
To limit the monetary/inflationary impact of this actual flood of digital dollars downstream, monetary policy was biased toward restraining these bank reserves by raising the reserve requirement particularly large banks had to hold. They end up with more RMB reserves at the end of this expansionary eurodollar process, but a greater proportion of them get “locked up” by the higher reserve standard (RRR).
So, more dollars go in, many/most end up in the PBOC’s hands, RMB in bank reserves rise as a result, and the RRR increases to constrain that rise before inflation gets out of hand (spoiler: it didn’t work all that well; inflation was high). And one final immutable correlation with all these things: the yuan’s exchange value against the dollar goes up (“weak” dollar consistent with global money increase).
As you can see above, since 2011 the opposite has developed across all these dimensions, particularly after February 2015 when the eurodollar retreat really targeted China and Emerging Markets. Whereas before it had been an interruption, from 2014 onward it really deprived them of the same dollar “inflows” they had long before come to depend upon (leading to several mitigation approaches, including straight selling of reserves or using something I call the Brazil strategy).
Here’s the thing, all these correlations hold for everything in reverse, too: eurodollar tightness (regardless of the level of US$ bank reserves, of course) directly impacts the PBOC’s balance sheet, limiting if not reducing forex assets (when the central bank pursues the selling reserves approach) therefore leaving less balance sheet space on its liability side for bank reserves (and currency growth), all while the yuan’s exchange value falls often precipitously against the dollar (CNY DOWN = BAD).
While the central bank attempts to deal with the growing eurodollar deficiency by “selling reserves”, meaning supplying dollars into the local marketplace, the PBOC has tried to offset the connected RMB drain in bank reserves by reducing the RRR. In theory, banks end up with fewer bank reserves as they decline, but are able to use a higher proportion of what remains.
This is uniformly described as “stimulus” when, as noted above, it doesn’t end up stimulating anything. The reason is that these correlations, and the causal chain behind them, are nothing but unfixable trouble. Thus, whenever the RRR is reduced, rather than view it as “stimulus” you need to see it as a warning – that this causal reverse is becoming such a serious problem that the PBOC figures it has few other alternatives (because, in truth, it doesn’t).
In fact, I did just that in early October 2018 when the third RRR cut in only a few months not only refuted the Inflation Hysteria of the time it directly indicated an escalation of the negative money situation which had been developing all year before it. The timing was near perfect; the landmine, as we call it, exploded (globally) barely weeks afterward.
I wrote then:
The RRR cut signals that the reserve problem therefore dollar problem is anticipated to grow worse. The PBOC is actually telling us that they expect in the months ahead the same or perhaps bigger commitment to “stepped up support.” CNY doesn’t need support if there is no worsening “capital outflow” situation of retreating eurodollar funding.
This will require more monetary contraction in bank reserves than we’ve already seen. The central bank is forecasting more problems ahead.
The same had been true throughout 2015-16 (Euro$ #3) as one RRR cut after another led only to more trouble, more weakness, more CNY DOWN, and serious fears about the overall situation (going all the way to the top and Xi Jinping). Again, warnings not “stimulus.”
We’ve been writing pretty much all year (2021), particularly the past several months, the situation in China truly seems to have turned a corner only toward a more serious and negative direction rather than displaying the strength every mainstream media “analysis” has claimed. Not only that, the ridiculous and absurd engineering on the PBOC’s balance sheet has basically confirmed the lack of dollar inflows as should have been the case if reflation (let alone Jay Powell’s claimed flood) had been real reflation.
In other words, economic risks of rolling over combined with a dollar situation or constraint much more serious than otherwise believed, both have led China to an increasingly precarious shape only-too-similar to those experienced in 2015 (Euro$ #3) and 2018 (Euro$ #4). This July 2021 RRR cut is entirely consistent, even predictable, again as a warning.
In theory, officials are hoping the banking system will be able to absorb the coming acceleration of anti-reflation conditions. In past practice, it never happens that way.
That’s because we know for certain what RRR reduction truly means; it is the last in the line of correlation in the chain of eurodollar causation. Eurodollar constraint leading to PBOC balance sheet problems therefore RMB restraint the central bank only hopes can be partially offset by a lower RRR.
CNY pushed downward by all of that. And we know what CNY DOWN equals.
These eurodollar squeezes or global dollar shortages are never one-off or short run situations. They are long and involved processes that play out over a prolonged period of time, each time their earliest days or initial phase is marked and described by a series of escalating warnings: curve distortions, rising dollar, falling yields, etc. In all four thus far, going back to 2008, RRR cuts have been just that; part of the chain of warnings indicating the monetary and economic situation going further and further the wrong way.
Is this time different?
Perhaps, but not likely at all. As I just wrote, we’ve seen this coming, and not just with global bond yields falling more precipitously in recent weeks. This latest RRR maneuver is absolutely consistent with what we’ve observed time and again throughout this era of eurodollar constraint.
China’s RRR actually stands for: Escalating.