Izzy wrote in May how China’s Rmb exodus is a huge (and still little-explored) story for the world economy, and it’s one that won’t be going away as China recorded a net capital account deficit in Q2. We’re wondering now how this might collide with risks to domestic liquidity — specifically, whether a combination of Rmb exodus and local banking problems might affect the People’s Bank of China’s ability to maintain financial stability?
A very brief recap on the Chinese foreign reserves-domestic liquidity nexus:
– Demand from US dollar holders (domestic or foreign) to convert their holdings to yuan has typically been strong, because China’s currency peg means the PBoC pays a favourable rate.
– This creates a lot of Rmb inside China’s economy, which is sterilised by raising China’s required reserve ratios (RRR).
– However, that demand has been falling of late as preferences switch from Rmb to USD.
– We’ve already seen the PBoC respond to liquidity shortfalls by reversing its normal ‘repo’ operations.
In the second quarter of this year, the declining popularity of the yuan was enough to turn China’s balance of payments negative for the first time since 1998:
So, why might this be a problem for China? The country has masses of foreign reserves, including that famed $3tn worth of Treasuries, so why would some small flows in the other direction be a problem?
Firstly, China can’t just start casually selling its Treasuries because the waves from such a move would risk the value of its holdings.
Second, as we noted above, China’s forex reserves are tied up with its domestic bank liquidity. The PBoC uses changes in the required reserve ratio not just as an easing or tightening lever, but also to soak up the Rmb issued in the course of its efforts to keep the Rmb within its trading band. When there’s a net inflow of foreign currency being converted to Rmb, the PBoC requests banks raise their RRR in order to avoid the inflationary effects of all the extra Rmb it’s printing.
Of course, now the PBoC no longer has to raise RRR because it’s not having to make much if any net new Rmb issuance, due to falling net capital inflows.
Does this mean China’s authorities now have less room to inject liquidity into the country’s banking system? Sort of. There are still several other mechanisms it can use: open market operations, repo operations, and government deposits. But these all have limits.
Victor Shih of Northwestern University estimates that when capital outflows total about $1tn, these other mechanisms will begin to be exhausted:
As Shih explains in this INET video:
The majority of loans are long-term loans, because a lot of China are in reality not performing — they just get rolled over time and again, so they don’t ever get paid back and they’re long term loans. So as you have the deposit base shrinking and then on the asset side the loans are still there, after a while you have illiquid banks. But that doesn’t happen for a while because China now has the world’s highest RRR and they can lower it from the current level which is 20 per cent down to 6 per cent, 5 per cent and it still wouldn’t be that unusual. But that gives you a cushion of roughly $1tn.
The other part is the central bank has issued a large amount of bonds to counteract inflows, foreign exchange inflows, and so the central bank is obviously currently already redeeming a lot of these bonds and unwinding them, and if there were more sizeable outflows the central bank can redeem all of these bonds and lower reserve ratios. That gives China a cushion of roughly $1tn but the banking system begins to get into trouble after the first $1tn of outflow.
But the banking system begins to get into trouble after the first $1tn of outflow. That’s kind of hard to imagine, $1tn of outflow, but I would say that poeple didn’t think that capital flights in the billions of dollars was possible back in the early 1980s from Latin America.
So what could the PBoC do if outflows began to approach such a level? It could redeem all of its bonds outstanding, wind back its repo operations, and it still has plenty of room to further cut required reserve ratio (RRR) which remains at a high level after two big cuts this year.
However, says Shih, it would hit a wall eventually:
Even with this wide array of tools, an outflow of 1 trillion USD, roughly 30% or less of the wealth of the top 1%, would see the PBOC redeeming all of its bonds and bringing down RRR to the 6-7% range. Any additional outflow would completely deplete banks’ reserves and force banks to halt credit expansion and even to recall loans, which would drastically increase bankruptcies and slow economic growth. To support continual credit expansion, the PBOC can also print money on a large scale, as it did in the 1980s and 1990s (Shih 2004). This likely would trigger very high inflation rates. Inflation above 20%, however, provides strong incentive for the top 1% of households to reallocate their savings overseas.
In sum, once capital flight takes hold, the Chinese government will have few ways of forestalling it without either making the situation worse or without suffering massive economic costs.