Pater Tenebrarum of Acting Man blog wrote some interesting remarks about the workings of China’s banking system.
China’s Reserve Requirements
Yahoo Finance informs us about the ostensible “reason” behind today’s rally. As noted above, after being blamed for Friday’s sell-off, China is credited for today’s rally as well:
“U.S. stocks extended gains on Monday after opening sharply higher amid an unexpected stimulus from China’s central bank as investors kept eying corporate earnings.
On Sunday, China’s central bank lowered the reserve requirement ratio for all banks by 100 basis points. The wider-than-expected cut was the People’s Bank of China’s second reduction in two months, and marks a continuing effort by the world’s second-largest economy to combat slowing growth.
Readers are probably well aware by now that reserve requirements no longer play any role whatsoever in most Western banking systems. In the US reserve requirements exist on paper, but have in practice been circumvented by banks since at least the mid 1990s, when “sweeps” were first introduced. These allow banks to sweep demand deposit balances into so-called MMDAs (money market deposit accounts) overnight, where they masquerade as savings deposits – and hence require no reserves.
The proof is in the pudding: even though bank reserves actually declined throughout the latter part of the 90s and in the 2000ds prior to the crisis and the Fed’s QE operations, both credit and money supply exhibited explosive growth rates. In Europe the authorities seem not to believe bank reserves to be much of a necessity either. Prior to the crisis, a mere 5.4% of the euro area’s true money supply was actually covered by vault cash or reserves held at the central bank. In late 2011 the ECB lowered the already laughably small reserve requirement of 2% to just 1%, in order to give a bunch of essentially insolvent banks additional leeway to stay afloat.
Things are quite different in China though. The PBoC actively employs reserve requirements, usually in order to avert run-away domestic money supply growth. This is a result of China’s mercantilist policies. China’s leadership erroneously believes that the trade balance is a measure of a country’s prosperity. It has been known for at least the past 165 years that this is complete humbug, but many political leaders evidently still believe it. Here is a link to an early explanation as to why this view is misguided, by Frederic Bastiat. It opens with the sentence “the balance of trade is an article of faith”. It is indeed.
China’s exchange rate policy has resulted in large dollar inflows in the past. Given the closed capital account, the PBoC buys these dollars from exporters and gives them freshly printed yuan in exchange. If it were to do nothing else, the domestic money supply would rise very fast in line with these inflows, as every additional dollar received would lead to the creation of additional yuan at the given exchange rate. In order to exercise a modicum of control over money supply growth, the PBoC tries to counter this by slowing down the issuance of fiduciary media by commercial banks – and for this purpose it employs reserve requirements.
It is therefore correct that a lowering of reserve requirements is tantamount to an easing of monetary policy relative to the policy that pertained prior to the lowering. However, this activity has to be put into context. In reality, there is actually no additional easing. Rather, the PBoC is trying to counter what has recently become an outflow of dollars, as reflected in its declining foreign exchange reserves. Ceteris paribus, outflows will lead to lower domestic money supply growth. Thus, all the PBoC is doing is not to leave the ceteris in a state of paribus, so to speak. This isn’t a reason to become more bullish on asset prices – on the contrary, it is actually a reason for alarm.
It is alarming with respect to asset prices, because it means that new liquidity driven by dollar inflows is drying up in China. Meanwhile, just because the PBoC is removing an obstacle to the creation of additional fiduciary media by commercial banks, there can be no assurance that the banks will actually spring into action and increase their inflationary lending. China’s real estate bubble is tottering on the brink and it seems quite conceivable that Chinese banks are wary of this development and won’t increase their lending much.
Note that money supply growth in China has actually slowed down rather dramatically over the past two years. In March the growth rate of the broad aggregate M2 fell to 12.1%, the lowest growth in 15 years. Narrow money M1 grew at a mere 2.7% – down from almost 40% in late 2009. This has so far had a disproportionate impact on what is without a doubt China’s biggest bubble – the boom in real estate prices. The recent large move in Chinese stocks is mainly driven by individual investors opening new trading accounts in droves and buying stocks on margin, apparently in an attempt to “make up” for the losses suffered in the expiring real estate bubble. As such, the echo bubble in stocks appears quite dangerous to us, as a great many newly-minted shareholders seem weak and over-leveraged.