The Money View

Liquidity, Down the Drain

China released quarterly GDP figures this week. Wen Jiabao emphasized the parts of the release that pointed toward stabilization, and one can certainly find some logic to that view. Stabilized or not, China's target of 7.5% growth marks a steep slowdown over recent growth rates.

Other major economies, facing weak demand, currency crisis, and high unemployment, have pushed monetary policy to the hilt with various forms of central-bank balance sheet expansion—QE3 in the US, OMT (announced, not yet used) in the euro zone, and maintenance of a currency peg in Switzerland. What about China?

The PBoC has certainly not been sitting still. Earlier this week it lent RMB 30bn ($5bn) to the money market, on the heels of a near-record injection of RMB 265bn ($42bn) into the Chinese money market earlier this month. This has come in the form of reverse repo operations:

It is worth remembering what is the immediate effect of such injections on the financial system. In a contracting economy, borrowers are coming up short, unable to meet their maturing obligations as they come due (in China as in any financial capitalist economy). The strain falls onto the banks, who can absorb it when the shortfalls are small. When the shortfalls become too large to be absorbed by any one bank, the biggest bank around, the PBoC, can create new money to meet the strain, which is the economic substance of these short-term liquidity operations.

They have been successful in pulling down overnight interest rates, but not at even slightly longer tenors, including the normal measure of Chinese interbank conditions, the seven-day repo rate. The RMB 265bn ($42bn) injection was enough to bring down the seven-day rate by just 3bp. One problem is that the reverse repo operations themselves have a fairly short term, and so they will have to be refinanced or unwound over the next few weeks, depending on whether the PBoC continues accommodation.

The context of all of this is the question of whether China will be able to rebalance incomes in its economy away from investment and toward domestic consumption. If the current high level of investment is unsustainable, it will surely come to an end. Coming to an end means, practically speaking, that producers of capital goods (and inputs to those goods) will be coming up short at the end of the month.

There is evidence, albeit anecdotal, on this score. In his latest newsletter, Michael Pettis points us to Bloomberg:

Copper inventories at bonded warehouses in Shanghai probably climbed to a record as import premiums dropped to a four-month low, signaling demand in China may not be improving as much as expected after a summer lull.

Other similar stories can be found. Simply put, as investment spending falls, industrial inputs like copper will go unsold. Inventories will pile up, and producers will find it hard to pay their bills. This will in turn bubble up as unmet obligations and, ultimately, liquidity strains in the banking system.

There are two ways out: either chronic shortfalls leading to bankruptcies in the capital-goods sector and contraction of investment, or sufficiently rapid growth of consumption to rebalance the economy without allowing capital-good production to contract.

The trouble for the PBoC is that, in the first case, the shortfalls are not going to go away in seven days or even in three months, so liquidity is no help; and in the second case, a major structural change needs to play out, so liquidity is still no help.

China has avoided large-scale stimulus in the current cycle, perhaps looking ahead to the Party Congress and leadership change in November. So perhaps the PBoC, not entirely unlike the Fed, feels that monetary policy must be used, even if fiscal policy would be more appropriate under the circumstances.

The Fed, the ECB, the SNB, and the PBoC have taken stock, and each has decided that large amounts of liquidity are called for. Rough seas ahead seems a safe prediction.

Comments

0

Daniel, great to see your piece on China!

I definitely agree that liquidity is no help for structural change of the economy, but I am not too sure about another thing. You are saying that the PBOC was doing reverse-repos because the commercial banks need liquidities as many borrowers cannot repay their debts on time. It could be true, but I am a little bit skeptical. Short-term reverse-repo is not a radical liquidity injection in China and it is more like a very usual day-to-day operation to me. What's more, the near-record high RMB 265Bn reverse-repo was due to the national holidays, and actually the net injection amount was much smaller as some earlier operations matured. Most analysts expected a reverse requirement cut in the summer but it has not materalized. I guess it could indicate that the economic slowdown might not be that serious. If there are massive overdues, why doesn't the PBOC just cut reserve requirement which is more preferred by the banks?

Btw I really want to ask you a technical question about the central bank's balance sheet. As you pointed out, doing reverse-repo would increase both asset and liability of the PBOC, but what about the RRR cut? Many people are arguing that commercial banks have more capitals to lend as a result of RRR cut, but is it true? Can banks really withdraw their reserve savings from the central bank to make loans?A RRR cut would lead to a decrease of reserves on the PBOC's liability side, but something else has to change to keep it even.

0

Hi Long Chen,

I did not mean to suggest that there was an acute liquidity crisis.

If all payments in the economy were always made on time, then banks could predict their cash flow perfectly and would never need to borrow reserves. Even in normal times, this is not even approximately the case. For example, in the US pre-2008, the Fed intervened in the Fed Funds market nearly every day.

When a sector starts to contract, one symptom will be that that sector will be unable to make promised payments, and that will show up as increased liquidity needs for the banks. This is how macroeconomic difficulties can make an appearance as liquidity difficulties. If the macroeconomic difficulties are small, then providing liquidity to the banks can buy enough time for them to be resolved. If they are large, then liquidity will probably not be enough.

You are of course correct about the national holiday, but net cash injections by the PBoC are quite elevated in recent weeks relative to months prior, so I think the basic point of my post stands.

As for the RRR change: in the abstract, the logic must be as follows. A fall in the RRR means that banks can expand deposits while holding reserves constant. They do this by expanding their balance sheets, increasing lending and deposits until their reserves. In practice, one must also believe that there are plenty of projects out there to fund and that the RRR is what is holding do wn lending.

In a rapidly expanding economy, as China has been in recent years, this is not a bad assumption, and RRR cuts could be quite expansionary (and RRR increases quite contractionary). It is not clear to me whether the effect would be the same now. If the overall economy is contracting, or growing much more slowly, banks may not want to use the extra reserves to support increased deposits, so an RRR cut may not be expansionary. It would make it easier to meet liquidity requirements, but if there is worry about overall contraction or slowdown, bank solvency may be the bigger worry, which argues for keeping the RRR high.

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