It’s hard to say what dynamic really going to take hold in China, but it looks like the bust is well underway. Inflation in that country is spiraling out of control even as money authorities ‘ramp’ up a fake inflation- fighting campaign. China raises interest rates by piddling amounts.
According to Bloomberg there is a yuan cash crunch taking place right now:
PBOC Extending Biggest Cash Crunch Since Lehman: China CreditBorrowing costs for China’s banks will rise to the highest in more than two years in the first quarter as policy makers curb supplies of cash to fight inflation, according to a survey of bond analysts.
The seven-day repurchase rate, which measures interbank funding availability, may average 2.9 percent in the first quarter, compared with 2.75 percent in the previous three months, according to the median estimate in a Bloomberg survey of eight analysts. Both levels were the highest since the third quarter of 2008, when Lehman Brothers Holdings Inc.’s bankruptcy caused global credit markets to seize up.
Central bank Governor Zhou Xiaochuan’s tolerance of the funding shortage shows his determination to curb the fastest inflation in two years in a country where 150 million people live on less than $1 a day. The seven-day repo rate has doubled in the past year to 3.14 percent, as the one-week U.S. dollar Libor remained little changed at around 0.25 percent.
“The pool of liquidity is getting smaller, but corporate demand for funds hasn’t dropped as China is still an investment- driven economy,” said Sheng Nan, an analyst in Shanghai at UOB Kayhian Investment Co., a unit of Singapore’s United Overseas Bank Ltd. “That means higher borrowing costs for some companies, and for others there could be no funding available at all. That’s certainly not conducive to economic growth, but the government’s priority now is fighting inflation.”
The People’s Bank of China ordered lenders on Dec. 10 to set aside more deposits as reserves for a third time in five weeks. Governor Zhou pledged Dec. 31 to keep prices “basically stable” this year, after a second interest-rate increase in three months on Christmas Day. He said inflation pressures are rising, partly as a result of monetary easing in the U.S., according to an article posted on the website of the China Finance magazine on Jan. 4.
The issue is how much control Zhou Xiaochuan has over China’s money supply along with whether he is willing to stare a systemic real estate- and accompanying debt deflation in the eye. Zhou is in a dangerous box. China needs inflation the same way Bernanke does. Without a constant flow of new money the structure of bad debts becomes a cascade of defaults.
Clamping down on inflation means crimping cash flows: this results in unserviceable debts and lenders falling insolvent. Credit destruction ruins borrowers who must find instantly scarce and increasingly valuable funds to repay loans. When they cannot, collateral is forfeited and capital annihilated in currency traps. Deflation rewards the cautious, who hold cash. Among the ruined by deflation are the elites who used their connections to massively overleverage themselves and cannot meet margin calls.
The costs of inflation are balanced against the cost of having to bail the banking system, or, not bailing it out and letting the excesses self- liquidate. The lesson Lehman’s failure teaches is that the road that leads from economic growth and ‘good times’ to systemic collapse is very short.
At the same time, ramping hyperinflation ruins savers and liquidates investment capital while putting food prices out of the reach of the average Chinese citizen. Riots and worse follow when food is unavailable. Zhou is damned if the does and damned if he doesn’t.
When countries are experiencing very high rates of inflation, one effect is an apparent ‘shortage’ of cash, which ultimately compels money authorities to add more and more to the money supply. Right now, industries are clamoring for cash. These companies will turn to loan sharks to gain the funds they need if the authorities cannot satisfy them.
Zhou’s problem is that China’s money supply does not flow entirely through banks but also through a gigantic, informal black market of local government entities, developers, overseas traders and lending pools. China is increasingly tolerant of this informal economy because it is ‘backup liquidity’ @ no questions asked and because this shadow economy provides ‘services’ for the elites. No black market will survive only to provide goods for the proletariat, there simply isn’t enough margin.
Since these markets cannot create a money supply (Seigniorage) they trade whatever currencies can be had on any and all markets, which would includes the currencies found within the China banking sector. Buying dollars or euros from the back door is putatively illegal in China but certainly happens if the yuan ‘offer’ is high enough. This currency/yuan ‘spread’ is the inflation basis. Ironically, the increased demand for yuan also increases the yuan price for dollars and other currencies. It’s the gross demand for a sufficient supply of money that matters.
At any given time, there may be proportionately more dollars or euros and less yuan circulating on the street but the total value of the money supply as a whole will tend to increase. This is because the opportunity is far greater to profit on the street trading money with fewer barriers to entry than exist in the official economy. As with all other currency regimes, funds in circulation will tend to remain in circulation with increasing velocity which becomes self- reinforcing. Since one currency or another is in greater demand relative to another there is always incentive to sell whatever is in hand for an instant gain or to avoid an instant loss.
Within this constellation of currencies a preference for one or another takes hold which enforces an unofficial exchange rate that is never favorable to the local currency which is of course created by seigniorage in ever- expanding amounts. This preference rate is added to the ‘back door’ rate or yuan cost of buying the preferred currency. The two costs added together become the real rate of inflation which can be many times more than the official rate.
Like the OECD’s ‘shadow banking’ little is sure about the size of the Chinese currency black market. Increasing inflation @ the ‘Trans-China scale’ indicates it is massive and will be extraordinarily hard to throttle. Entire Chinese cities have sprung up empty: how much of this is the product of ‘informal finance’ run amok?
Arbitrage opportunities expand along with inflation which changes the relative values of ‘official’ and ‘street’ monies: interbank lending rates are creeping upward as the black markets seek cash regardless of the cost. Unlike rocketing LIBOR rates during the ’08 credit squeeze which was the result of liquidity collapse in the dollar- denominated shadow banking system, China’s rise is caused by a voracious black market demand for currency. The central bank must bid against the yuan black market for dollars. At the same time, it must add yuan so as to compete with China’s savers as liquidity providers.
We simply have the dude @ a mega-bank with the nose ring and Metallica tattoo sitting in a cubicle next to the loading dock who punches a few trillion into existence on his laptop between tokes.
Renting the cheaper ‘official’ funds to sell short to loan shark operations causes the cash drought at the bank level. You can read between the lines.
China Allows Exporters to Keep Foreign Earnings OverseasThe new measure signals loosening controls on foreign exchange
China said December 31 that exporters will be allowed to keep their foreign revenues overseas from January 1, in a move to expand a trial program effective since October 1.
The new measure signals loosening controls on foreign exchange and will help slow down the growing pace of China’s already massive foreign exchange reserves.
Under the new rule, it is up to qualified Chinese exporters to decide how long they park their revenues in foreign currencies in a foreign country and when to transfer the funds to China, according to the State Administration of Foreign Exchange.
In the past, exporters were required to convert their revenues in foreign currencies into Chinese yuan with commercial banks. Commercial banks in China sell the foreign currency to the central government. The People’s Bank of China has been forced to increase the monetary base in order to purchase foreign currency from commercial banks, which has increased the liquidity of the yuan in China.
Oops! it seems the black market cat is already out of the bag! By making this announcement, the money authorities are accepting a fact on the ground, that exporters are already holding dollars. The next step is for the Chinese to ‘allow’ dollars to circulate freely on the streets. The fact of the announcement itself reflects the new reality.
Of course, there is nothing authorities can do to keep the companies from putting their dollars into informal circulation within China if, as the articles suggest, exporters are reluctant to swap them at low ‘official’ rates for yuan. Chinese businesses appear to be already spurning the bank- level dollar- exchange and getting better yuan rates by peddling dollars in the black market. The higher the ‘street’ rate of exchange, the more yuan escape from savings and flow toward the loan sharks.
The more savings that escape into circulation, the higher the rate of hyperinflation.
This is why the Chinese money authorities are quietly adding to the supply of yuan. They do this while keeping rate rises very small and pimping ‘inflation fighting’ noise on television. This also takes F/X pressure off the yuan, which would otherwise fall in value against the dollar. How would it do otherwise? America’s yuan complaints are far away. The exchange of dollars/yuan that matters takes place on the sidewalk next to the Forbidden City. China can only offer more yuan for dollars at the banks to attract dollars away from the loan sharks.
Again, the central bank is in a box. If they could somehow push the yuan’s value upward, dollar- investments already made in China @ the lower rate would be claimed in more valuable yuan. This would represent a value loss to China and a gain for ‘evil’ dollar speculators. Avoiding this outcome was the reason for the dollar/yuan peg and increase in dollar surplus in the first place.
Conventional macroeconomics insists the yuan appreciate because of the current account surplus held by the Chinese in debtor countries’ currencies. The informal currency arbitrage within the Chinese local economy is pulling in the opposite direction. Rather than a cheap yuan stimulating Chinese exports, the Chinese cost advantage has allowed a cheap yuan. Now that costs are rising the cheap yuan advantage has morphed into hyperinflation. This in turn has created a vicious cycle where the informal dollar/yuan arbitrage is driving the yuan lower which next puts more and more yuan into circulation which sets off successive rounds of arbitrage. Each of these takes different forms such as food price hikes, wage hikes and changes in F/X policy.
That these forms have manifested themselves indicates the arbitrage is taking place. No other indicators are necessary.
Meanwhile, China also faces the dilemma of using dollars, euros and yen to buy petroleum and other commodities. China does not trade its currency freely. America can ‘manufacture’ dollars at the cost of a few pennies. America essentially pays for petroleum with ‘nothing in particular’. China’s fuel inputs are paid for with real output that has been shipped ‘paid for’: in other words goods that have been made out of real materials and labor then traded to America, also for … ‘nothing in particular’! The US’s dollars have more worth to China as they have been earned with work than the same dollars are worth to America. We simply have the dude @ a mega-bank with the nose ring and Metallica tattoo sitting in a cubicle next to the loading dock who punches a few trillion into existence on his laptop between tokes.
The term ‘lending into existence’ does not do the process justice; ‘peeing dollars into existence’ makes more sense.
China buys oil with dollars and sells the oil and products within the country for yuan. These are presumably earned with sweaty brows. Buying @ increasing volumes pushes up the input cost in dollars. The dollars must be ‘bought’ with yuan/labor in the first place. Then the yuan spent by fuel users must be ‘bought’ with labor and more yuan. The yuan themselves are priced by yuan/currency arbitrage on the streets in the Chinese black market. The foreign exchange costs are paid thrice by China in yuan. As she buys more fuel overseas — including coal — with foreign exchange the yuan costs multiply at every point of the transactions.
The foreign exchange costs of the dollars spent of fuel are added to the yuan value of wages and to the foreign exchange costs of yuan again in China. Add bid- offer spreads at every level and it is easy to see how fuel and other commodity consumption rapidly amplifies hyperinflation.
Pundits suggest that China and other developing countries can afford to pay higher dollar costs for fuel. This does not take into account the internal costs associated with F/X and black market pricing of currencies used to pay for the fuel.
Keep in mind that any dollar devaluation for whatever reason also adds to China’s F/X costs in yuan. Any fuel subsidies are also strictly zero- sum; given to one sector and taken from another.
Inflation is a wage- price spiral. Increased costs without increased wages to pay them is simply bankruptcy deferred. Wages are increasing dramatically in China: sez Financial Times:
Beijing city to raise minimum wage 21%Jamil Anderlini and Rahul Jacob
Beijing city is to raise its minimum wage 21 per cent next year, the second such rise in barely six months, amid rising inflationary pressure and growing concern over China’s widening wealth gap.
The increase, which will come into effect on New Year’s day, raises the statutory minimum monthly wage in the Chinese capital to Rmb1,160 ($175) and the hourly rate to Rmb6.7. It follows a 20 per cent rise in June.
China cash purchases are effecting markets as seen from these chartz by estimable TFC Charts. Here’s the NYMEX front month crude:
Here’s the July contract:
Nymex crude is back into contango with open interest starting to increase in distant contracts.
Here’s the COMEX gold contracts for Feb, 2011:
Here’s the December contract:
Gold has also slipped back into contango which means less intense demand for gold — and crude — in hand.
My personal opinion is that China will continue with more stimulus and ignore inflation while it engages in an inflation- fighting PR campaign. China’s elites — which own the Chinese government and Communist party — need hyperinflation so that they may repay massive (gambling) debts with worthless yuan.
What about an anti- deflationary bailout of private interests as was attempted in the US?
The bailout which started in 2008 is the reason for the hyperinflation in the first place. That bolt is shot.
The danger is that China will find herself unable to control hyperinflation with any interest rate tools. The endgame from this vantage point is a completely dollarized Chinese economy, like Zimbabwe’s or Ecuador’s. Should China shift to a gold standard, the most likely outcome would be trading inflationary collapse for massive deflationary contraction with one crisis following hard on the heels of the other.
China embodies steve’s ‘First Law of Economics’: that the costs of managing any surplus increase along with the surplus until the costs are greater than the value of the thing itself. Here, the cost of managing China’s F/X surplus is hyperinflation that destroys the Chinese economy. What China MUST do is cut the dollar/euro surplus down to size and do so immediately.
Of course, doing so will make it more difficult for Chinese cash flow to service its yuan- denominated debts or to buy fuel. It may indeed be too late for China. Its bad choices are those given by the waste- based economic model it imported from the US. It can continue to accept hyperinflation or gamble with debt deflation … or a combination of both.
Wow! Happy fricking new year …