It's Important To Keep In Mind We May Never Know Why

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By Jeffrey P. Snider

At times like these, when it seems as if the world has been so simplified, it is useful to remind yourself that it is dangerous to think it will remain that way. That is the path that leads to orthodox economics, where ideology alone dictates that you know everything that is worth knowing. If there is one constant of the eurodollar system, it is the opposite - it doesn't stand so still. That warning even applies just when you think you have everything "clocked." What disturbs me most is that I don't know what I don't know.

It starts with the realization that everything is hidden, even when it seems on those rare occasions as if it is not. At best, we are dealing with what we hope, in the end, are reasonable guesses, but guesses nonetheless. There is so much undiscovered detail that it is unwise to ever be so confident.

At this moment, we have CNY acting predictably, and now the PBOC updates its own behavior in the same fashion. The most important piece of the latest balance sheet figures for April is that once again, bank reserves in China declined, just as we suspected it would related to the "ticking clock." Further, the proximate cause of the drop was a sharp increase in government deposits; that isn't the problem for Chinese liquidity, however, as it indicates, instead, the general illiquidity everywhere else that the PBOC did not expand its balance sheet elsewhere to accommodate the central government.

Not for lack of any effort, though, as there was an RMB 320 billion increase in the medium-term liquidity programs (claims on other depository corporations). However, just like last March, when the whole internal system of bank reserves suddenly turned around to where reserves would suddenly decline regularly, there is no indication as to why the PBOC didn't expend more effort to head off harmful liability-side redistribution. It is that part that worries me the most, as it suggests that though we might have found some assumed degree of predictability and comfort with understanding, there is "something" else missing - perhaps very big and important.

The most logical supposition as to what that might be is politics. The idea of reform and the (perhaps) growing consensus within China that they are truly going to experience a paradigm shift is a powerful impulse. It leads to a position where the PBOC will not, and should not, just respond in blanket monetary fashion, therefore explaining what surely looks to be PBOC hesitation. The central bank has undertaken some modest effort to divert any "dollar" problem, including the dollar deposits that it demanded starting last October, but that is nowhere near what would be necessary to keep internal imbalance from being further harmful.

If that is a conscious choice, then it would propose serious consequences. I wrote in March 2014, just as these kinds of unusual CNY and Chinese behaviors were starting, that:

What we can take away from all this is that China is one massive mess of dollar entanglements, cornered by an export focus that won't recycle to the previous peak, further wrapped inside a credit bubble beginning to show signs of cracking. The "usual" remedy for such a system is to try to "export your way out of it." And that may be the forward intent if it doesn't get too complicated by eurodollar mechanisms ahead, but it also may signal a far darker worst case (that may be more probable than anyone admits now) - China in 2014 is Japan in 1989. There are enormous similarities that make such a comparison compelling, enough to further study how that analogy might work out alongside their differences.

My dates were off, as we are now in 2016 without Japan 1989 yet being replayed, but maybe that simply meant China in 2014 was Japan in 1987 (or, far more likely, that China then was on a slower Japanese trajectory, as to this point, the Chinese have been moderately successful at least on these terms). My thesis at the time was that Chinese officials, through "reform", had prioritized managing imbalances rather than growth at all costs so as not to make the same mistakes as the Bank of Japan - managed decline rather than devastating and permanent crash.

The history of the PBOC balance sheet over the past year does seem to suggest just that kind of intent. There has been this seemingly determined restraint to just follow the forex assets at the base of the asset side, no matter what it does to the liability side (internal money). And if that is correct, then it can only mean that Chinese officials are deathly afraid of the alternative. Their focus, as the "ticking clock", would then be on the short run alone: to manage any disruption as its own problem, rather than seeking full monetary absolution on the same terms as had been done up to 2012 (flooding).

The implications are enormous, not the least of which is a more realistic picture for the global and US economy. The Chinese government, again if this is correct, is actively betting against Janet Yellen's economic outlook. You don't go into this kind of "emergency" mode if six months from now, the world is a bright and beautiful place again. It might also propose that in light of that stance, the PBOC could, in one of these "dollar waves", go do too much on the short run, so that the "ticking clock" following it becomes utterly unmanageable from any effort. The pendulum swings too far.

There are, of course, many other possibilities that could, in theory, account for what we find in China and Chinese money. That is again the problem that bothers me the most even here, where it seems as if correlations have been durably established to the point of actual predictability (including why 2% O/N SHIBOR is so damn important; there is no obvious reason - none - as to why that number is meaningful, but it clearly is, and has been, to the PBOC that it acts as a very useful guide; not knowing the actual reasoning behind it leaves us vulnerable to when it might not be). It would be nice, though probably unrealistic, to have a better understanding as to "why." Even though we don't have any hard evidence on that point, it is still quite relevant to analysis to keep it under as much consideration as possible - to not fall into the trap of orthodox economics and think that we know everything worth knowing. We don't, and likely never will.

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