When the Chinese yuan suddenly plummeted in mid-August 2015, the world looked on in stunned confusion. It didn’t make sense. The global economy was about to take off, they thought, and it wouldn’t be doing that without China’s vast anticipated contributions. Such a large move in such a short time frame for a major currency was another big “unexpected.”
To try and make sense of it, every explanation for it was offered from the textbook perspective. Why devalue at any given time? Exports, of course.
But the move also comes as China’s important export sector has weakened – and overall economic growth looks sluggish. Over the weekend, Chinese customs officials said July exports fell 8.3% compared with a year ago. A weaker currency helps China’s exporters sell their goods abroad.
That was the Wall Street Journal’s main point in their 5 Things To Know About China’s Currency Devaluation published on August 10, 2015. But like “rate hikes”, “devaluation” deserves the quotation marks. That’s not even close to what it was.
Imagine you are a Chinese bank that works with the Chinese corporate sector. For various economic and some non-economic reasons, companies in China require dollars on a continuous basis. In the simplest terms, in order to do nothing more than import goods means having dollars in order to pay for them (first chart below). In truth, there is far more going on (second chart below, which takes account of the first).
As a Chinese bank, where do you get these dollars? Even if you are doing nothing more than relending them to China’s corporate sector, they must be obtained from global (offshore) dollar markets. Like all banks you borrow them as cheaply as possible meaning in the shortest terms. Thus, you are now “short” the dollar; really eurodollar:
The “short” is not really dollars so much as funding liabilities. It’s the same way as other global banks are “short” the same things; the “short” relates to the funding mismatch (maturity) between short-term interbank borrowing (globally) on the liability side supporting and maintaining longer duration loan or security assets. Once you create those “dollar” assets, you are on the hook for funding them, in “dollars”, until they are disposed of – voluntarily or not.
It leaves the internal Chinese system with a further process mismatch, whereby the central bank is synthetically long “dollars” while the private banks are synthetically short them. The PBOC still accumulates the vast majority of “reserves” given its role in regulating internal versus external liquidity.
China’s currency, yuan, or CNY, is allowed to float but only on a narrow daily basis. The central bank, the PBOC, sets the range for that daily float.
But between March 2015 and August 10, there was practically no movement in CNY at all. In my mind, there was absolutely no way you could even venture a guess about “devaluation” without first explaining those five months. I wrote in late July 2015:
Trading has been confined, except for very brief, intraday outbursts, to an increasingly narrow range. Given its behavior particularly as a full part of the reform agenda to that point, this amounts to what can only be hidden and inorganic factors. Whether that means PBOC intervention is unclear, though suggested by even TIC, but this is the most important and unexplained dynamic in the “dollar” world at present.
Perhaps the June TIC updates will help shed some light on what has been going on with China’s “dollar short”, but I doubt it. The nature and especially the scale of what might be happening in the money markets has global implications, and may (conjecture on my part) start to explain the reversal in the Chinese stock bubble and ultimately even relate to the “dollar’s” renewed disruption in July so far.
