By JC Collins
On December 29, 2015, in the post The Myth of China Dumping US Dollars, I wrote the following in regards to the past accumulation of USD by the People’s Bank of China:
“The PBoC continues to keep the renminbi weak against the dollar for the purpose of purchasing US dollars which are accumulated by Chinese business and exporters. The People’s Bank of China borrows renminbi in order to purchase these dollars.”
“Once purchased, the PBoC cannot sell renminbi as it would be inflationary. Same as the US with dollars. In order to prevent excess inflation, the PBoC issues new debt and raises the required reserve ratio of capital held by Chinese banks. This has led to the increase of domestic debt within China.”
This increase of domestic debt amounts to the large printing of renminbi which was used to purchase US dollars. This is in essence the forming of a bubble within China. This bubble debt was used to further modernize the country and build infrastructure and “ghost cities” which will be used to house a growing middle class as China migrates 100 million of its rural population into these cities between now and 2020.
The POM article continues:
“The effect of all this is that the PBoC owes renminbi which it sold at low valuations, based on the exchange rate, and owns dollars at high valuations, based on the same exchange rate.”
The article further explains why China could not simply “dump” US dollars as a method of financial warfare on the United States. That is the most misunderstood part of the China/America dynamic. The People’s Bank of China prints/borrows RMB to purchase the dollars which have accumulated in its foreign exchange reserves.
In order to reduce these USD denominated reserves, the PBoC has to sell USD from its foreign exchange reserves to buyback RMB from circulation. As the Federal Reserve increases interest rates, the demand for dollars increases, at least initially, and it is expected that RMB will depreciate as investors fear a capital flight from China, or other emerging markets.
In the post Renminbi Internationalization, Interest Rate Increases, Market Volatility, and the POM Analysis we review in more detail how this dynamic will play out. From the post:
“China, and the rest of the world for the most part, will have to weather the initial financial storm from the Fed’s first rate increase. It appears now that things are beginning to settle down somewhat after a week of market turmoil.”
“In fact, the PBoC is now announcing that they are going to implement further interest rate liberalization, increase renminbi internationalization, and make further changes to the exchange rate management structure of the renminbi. This is exactly what has been discussed here on POM.”
This fits with the POM thesis that there will be a push and pull of Fed rate increases and renminbi internationalization, both of which will work towards balancing the international monetary system. What so many fail to recognize is that this push and pull, or waxing and waning of volatility, is purposeful and by design.
One of the tools used by the PBoC is the circuit breaker mechanism which is meant to halt trading if the Chinese equities market begins to drop too fast. This breaker was utilized a few times last week to prevent capital flight and manage the deleveraging of RMB debt. Keep in mind that this debt is based on the accumulation of dollars, as defined above.
It is assumed that investors are losing faith in China. That is a simple way of explaining the process. Investor reactions are well strategized and measures to address the emotion based herd mentality of investors are designed and implemented at timed intervals.
The “breaker” mechanism described above is one strategy. Another is the slow and gradual internationalization and liberalization of the renminbi to pace the frequency of interest rate increases by the Federal Reserve.
It is always possible that American strategists could attempt to play with this pacing and sequencing in attempts to further weaken China’s domestic financial market. It is also probable that China is aware of this and has placed its own not-so-obvious mechanisms to prevent a larger volume of capital flight than would be expected.
It is estimated that China’s foreign exchange reserves dropped by just over $500 billion in 2015. The current level of foreign reserves now stand at $3.3 trillion. It would be my conclusion that Chinese authorities are “deleveraging” these reserves down to the $300 billion range over the next two to three years. This will take place, as described above, through RMB internationalization, and the selling of USD reserves for RMB.
It is also important to understand that the RMB internationalization, being the increase of renminbi denominated financial products offered to foreign banks and institutions, will help offset the domestic influx of renminbi. This will reduce the chances of unwanted inflation and facilitate the coming appreciation of the Chinese currency.
Readers can also reference the POM post titled Renminbi Demand is about to Explode, which covers the AIIB and BRICS Development Bank. Both institutions will be giving development loans denominated in RMB beginning around the mid-point of 2016.
The complexity of this monetary and financial waltz can be frustrating and confusing when so many analysts and commentators produce articles which do not take into account the multilateral monetary transition, and the need to balance the international system.
The dollars which China is selling for RMB will eventually make their way back into America’s domestic financial markets. The slow and prudent pace of this deleveraging will not cause the collapse of the USD which many have predicted. But it will facilitate a gradual depreciation of the USD.
As stated, no massive “dumping” of USD by China can happen as it would have negative effects on both countries. Probably more so on China, as its newborn offshore renminbi market would be unable to absorb that amount of USD deleveraging, and the domestic onshore market would be flooded with RMB and cause series inflation issues.
As most POM readers know, a depreciation of the USD is desired by the United States, as it will decrease the cost of American made goods and help increase exports. This increase in exports will see an expansion of jobs in America and help adjust the debt-to-GDP ratio. This is the origins of Trumps “Make America Great Again” meme.
The bigger pieces begin to come into focus.
Let’s recap and add a few other dynamics.
China’s accumulation of USD will slow and eventually reverse. In essence, it already has. This reversal of reserve accumulation by the PBoC will be supported by the broader internationalization of the renminbi. The internationalization of the renminbi has been supported by its inclusion into the Special Drawing Right basket of currencies held by the International Monetary Fund.
This means more central banks around the world will begin accumulating RMB in their foreign exchange reserves. This diversification away from USD denominated reserves will help balance the international monetary framework.
The international demand for RMB will be supported by some commodities trading being denominated in renminbi (see POM post China’s New Crude Benchmark) and derivatives priced in renminbi. A wide array of additional RMB denominated financial products will also be developed, such as the loans through the Asian Infrastructure Development Bank and BRICS New Development Bank.
The RMB currently has three distinct markets. The onshore renminbi market (CNY) operates separately from the offshore renminbi market (CNH). Both have different valuations but will eventually converge into one as the offshore liquidity grows with the RMB internationalization.
The offshore RMB had its largest one day appreciation ever just a few days ago. The fact that this came in the midst of serve market turmoil and volatility is a testament to this thesis.
The third market is the NDF, or Non-Deliverable Forward Market. This market has been used to allow foreign investors to take a position on the RMB. This market will wane as the offshore (CNH) market grows and converges with the onshore (CNY).
The consolidation, or convergence, of these RMB markets will also be gradual and will pace the sequencing of Fed rate increases and renminbi internationalization.
The RMB may still feel downward pressure in the months to come as the early phases of this process complete. Eventually the internationalization of the renminbi and the reversal of USD accumulation will force a depreciation of the USD. Further deleveraging and price-clearing of the USD based renminbi debt will eventually find a floor and the Chinese currency will begin an upward trajectory.
How long this takes will be influenced by many factors. Some which include the ability of American and Chinese authorities to manage the transition pieces and maintain a slow deflating of the USD denominated bubble without undermining each other’s positions. Something which is detrimental to both.
The trend which can be determined from the above scenario is a gradual depreciation of the US dollar against the currencies of its largest trading partners. This also means an appreciation of the renminbi.
The recent collapse in crude and other commodities will be reversed as renminbi denominated development loans spur massive infrastructure development in emerging markets such as India, Malaysia, Thailand, etc.. It is estimated that Asia alone will require $8 trillion worth of infrastructure development over the next ten years. This trend bodes well for both the renminbi and commodities. – JC
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