Here’s a bit more on what is going on in China. The upheaval in the rest of the world is leaking into that country. It’s gambled on hyper-massive industrialization and embrace of the ‘waste- based’ USA- model economy. China finds itself with a desperate need to gobble natural resources as fast as possible so as to maintain the ‘prestigious’ appearance of growth. This ‘race to waste’ causes distortions, including ‘virtual’ liquidity shortages.
This has been discussed previously, noting a bolt upward in the interbank lending rates, the Chinese equivalent of the Libor or London Interbank Offered Rate:
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.
Here’s Michael Pettis making a parallel argument:
…the month-on-month increase in prices suggests that inflation is running at just under 13% annually, although month-on-month numbers are always suspect because they don’t correct for seasonality and one or two big numbers can have a disproportionate effect. Still, although the CPI inflation number was below market expectations it is nonetheless well above the PBoC’s comfort level, which is officially 4%. In December the year-on-year rise in prices was 4.6%.This stubbornly high inflation number, coupled with good growth numbers and a surge in exports will, I suspect, give Beijing the sense that it has room to tighten, so I expect that we will continue to see measures such as interest-rate and minimum-reserve-requirement hikes to slow down economic growth. In keeping with this on Friday the PBoC announced yet another 50-basis-point hike in minimum reserves (making it the fifth hike in five months).
But will these measures bite? My guess is that they will at first, but that when they do they will be quickly reversed. Any real attempt to reduce the sources of overheating will cause economic growth to slow too quickly, and Beijing will change its mind, especially if, as I expect, inflation peaks soon and starts to decline.
Let’s face it – most Chinese growth is the result of overheated investment, and removing the sources of overheating without eliminating growth is going to prove impossible. I have been making the same argument for at least two or three years, and so far we have seen how Beijing veers between stomping on the gas when the economy slows precipitously and stomping on the brakes when it then grows too quickly. I don’t believe anything has changed.
And deposits were down
The most interesting number in the NBS (China) release, perhaps, was January the level of bank deposits. They were down. Dong Tao at Credit Suisse says that this is the first time this has happened since January 2002:
What was more concerning was that it was corporate deposits that went backwards, not household deposits, as may have been expected around Chinese New Year. This gives us reason to believe that the fall in deposits is not seasonal.
One of my clients asked me two weeks ago about continued tightness in the interbank market and this was my response:
My interpretation of the liquidity tightness is also maybe a little different. If you check the latest NBS numbers you will see that deposits were actually down, and it was not household deposits that dropped, which could be explained by the holiday, but rather corporate deposits. One month does not make a trend, but this is pretty consistent with the argument that highly negative real deposit rates will cause depositors to take their money out of the banking system.
In that case there may just be a mismatch between the lending and deposit side. Loan officers are always encouraged to lend like crazy, and the funding side assumes the deposits are there, but perhaps they were caught off guard by the decline in deposits. I am just guessing, as are we all, but we are trying to keep an eye on the topic to figure it out.
So why did corporate deposits drop? My guess is that large businesses may be finding it much more profitable to lend money to other businesses, especially those who don’t have easy access to bank credit, than to deposit cash in the bank at such negative real rates. Both the Credit Suisse report and an email I got last month from a friend of mine at Bank of China suggests that there may be an increase in intercompany lending, and to me this would be a very plausible consequence of negative real deposit rates. And of course for those worried about systemic risks this would be very worrying news.
First of all, Pettis lives in China, is well connected, is tolerated by the government and has access to data. He is also permitted to go outside and walk around, take taxis and stuff. He can see with his own eyes what is happening. He’s also measured and careful.
My ‘rule of thumb’ for China hyperinflation is to take the official Chinese ‘growth’ number which is a measure of the increase in China’s money supply. To this I add the official Chinese rate of inflation. The current rate of hyperinflation would be about 15% or a little over a percent per month. This may be too conservative. GDP growth does not allow for velocity which would accelerate the rate a lot more.
Velocity matters since it creates its own demand for more money (very- short- term credit) which is what is indicated by the rise in interbank borrowing rates.
I can’t see China from Northern Virginia but hyperinflation follows certain patterns of development that repeat themselves. That there is a market within China for more than one currency is very dangerous for China. The trade in English pounds- sterling was the axle around which the Wiemar hyperinflation revolved as was the US dollar trade in Hungary- post- WWII. A second currency gives the ‘smart set’ the means to escape the ravages of a currency rapidly pricing itself into worthlessness even as that second currency is the instrument of repricing. Without the smart set selling the local currency within a country there is small chance of hyperinflation.
The US hyperinflation underway in the late 1960’s and early 1970’s was a gold- then petrodollar driven phenomenon. The smart set in the US sold dollars for gold until the Fed under Paul Volcker drove up the interest cost of dollars, smashing both the gold- for dollar and the oil- for dollar arbitrages.
It was certainly true in Zimbabwe where the privileged were able trade in US dollars or South African rand for their rapidly devaluing Zimbabwe dollars. Similar trades in US dollars for local currencies propelled hyperinflation in many Latin American countries. Dollars were obtained easily from cambios, drug gangsters, exchange banks and importers then resold on the streets at rates that swiftly devalued local currencies. The dollar trade on the streets of China is more of the same.
Economists fail to measure the effects of black markets and ‘unofficial’ activities. US GDP does not include the massive, multi- hundred billion dollar drug selling- and related money laundering activities. These are hard or impossible to observe directly but these and related underground or black market activities have to be taken to account.
In China, the underground economy might be larger than the official economy.
Pettis leaves out of his observation the intermediation of China’s shadow banking non- system of loan sharks and ‘lending pools’. This set of middlemen adds a cost that is part of the hyperinflation calculus. Customers of loan sharks need to repay quickly and minimize inflation- driven service costs. The intermediation/repayment/roll-over cycle adds velocity. A customer will borrow from a second loan shark to pay off the first while the first loan shark is borrowing from the second or third. A lot of cash — both dollars and yuan — is changing hands very rapidly within China.
Note how China aims to increase reserves on bank balance sheets. This indicates a lack of reserves which by itself is an indicator of credit cycling. In credit expansion all available moneys are leveraged to the greatest degree possible so as to earn as much as can be had. Good new loans are constantly sought so as to retire or re- balance the increasing numbers of unserviceable loans. There is a voracious demand for more and more credit. Absent rules to the contrary there would be zero reserves. China’s central bank insistence on increasing reserves requires the creation of phantom reserves which are on the banks balance sheets only when the regulators are looking. Chinese bankers are no less corrupt than their American or EU counterparts. They know how to make two (or more) sets of books!
My guess is that there are no real reserves within the Chinese banks, certainly not within the shadow banking ‘system’. Banks and non- banks are relying on loan turnover to allow servicing costs to be met and keep up appearances. This would be China’s version of ‘Extend and Pretend’ and will work as long as velocity continues.
China Hyperinflation has several amplifiers:
- Foreign currency exchange within China that is disadvantageous to the yuan itself but advantageous to those who trade it.
- The need for the Chinese to support the so- called ‘value’ of their F/X reserves.
- The need for China to purchase raw materials including oil and coal — and soon, food — with foreign currencies.
- The need for China’s manufacturing enterprises to have cheap capital and a favorable real exchange rate.
- The dollar/yen carry trades and hot money capital flows.
- The need for the Chinese money establishment to support itself in the face of its insolvency at the expense of prudent savers and anyone or anything other than itself.
These are a lot of good reasons for hyperinflation along with the need for the establishment to keep its bubbles inflating and to socialize all losses.
Chinese banks are likely insolvent. Printing money and making as many loans of whatever quality as possible gives the banks the appearance of health. The shadow banks, the local lending groups and phantom banks that lend @ whatever rates the market will bear are likely in better shape but dependent upon the availability of both yuan and foreign currencies. As Pettis points out, much of the borrowed money is used for the wildest speculations in (vacant) real estate and (inflated) commodities. The entire banking/business structure is yet another Ponzi scheme. It supports itself by recycling old debts into new while seeking to inflate their value away. Since debts in China are not indexed nor is there a Chinese equivalent to the USA Treasury bond market with attending vigilantes, the inflation strategy will work … until it stops.
Central to the dilemma is the inability of China to float its currency overseas. Unlike the dollar, which is accepted by every oil- and drug pusher in every land, the yuan is scarce and accompanied by containers of worthless plastic crap that the currency must be spent on. Anyone can buy goods world- wide for dollars, nothing but lead- painted childrens’ toys can be had for the yuans. This is provided that the yuans can be obtained in the first place.
Chinese businesses sell the toys for dollars which go to China where they are traded on the street for yuan @ whatever the market will bear. This ‘bear market’ for yuan is … the market! The small external trade in yuan is not enough to give the currency independent value.
Pettis does not call for a crash in China. He doesn’t think a deleveraging event will take place. I am ambivalent. I think China’s hyperinflation will accelerate as the Establishment seeks to support its various bubbles while liquidating its exposure to yuan loans- gone- bad. It needs hard currency to obtain fuel. It desires above all things to have valuable foreign exchange reserves. Hyperinflation leaves China with its precious dollar cash hoard … value paid for by the destruction of China’s currency and banking system. Right now, I get the idea that China’s leadership is little different from Libya’s. The minuscule tweaks of interest rate and reserve policies are indicative: they don’t give a damn!
The prognosis is a long hyperinflationary slide leading to a depression- then, the class war within China.
But the Chinese must know this already. It’s the end of all waste- based economies: Bankruptcy and ruin.