When planes crash, they listen to the cockpit voice recorder. There’s a dark joke that’s based in fact: a lot of times the last words they here are “Oh ****”. Fill that in with the expletive of your choice.
World financial markets had one of those moments last night in America/this morning in China.
The thing is, a lot of journalists don’t know enough macroeconomics, and neither do their readers. Journalists don’t write about what they don’t know, and they don’t write if their readers don’t know what they’re reading.
So, there is some stuff written about this. It’s a news item today, but it’s not a headline like it should be.
What happened? This morning in Hong Kong (last evening in Utah) a key interest rate was driven up to 67%. It’s back down now, but still a lot higher than normal.
There’s a ton going on here, so let’s review some facts, and how things work in practice.
Banks lend reserves to each other. This is a good practice, that keeps them all liquid. Those loans are mostly overnight — a bank that’s short on reserves one day might be flush with them the next, as deposits and withdrawals are made. Overnight bank to bank loans are very safe, and therefore have a very low interest rate.*
China’s currency has been depreciating. This has gotten to be pretty steady over the last few months: it’s worth less one day than it was before. So, there’s a pattern.
How do currencies depreciate (or appreciate)? Currency markets are huge: global, 24/7, digital and nearly instantaneous, billions of dollars of one currency traded for billions of dollars of another one all to lock in several hundred dollars of profit on a minor advantage. Think about that, a currency trader, fresh out of a place like SUU, working for a big financial firm and making at most $100K per year has to generate about $500 dollars in revenue every day for the firm to cover their salary and benefits — and they have to do that with gigantic trades of other peoples’ money with very thin opportunities.
Why do currencies depreciate? This is tougher. There’s a lot of cash in the world (mostly kept track of digitally rather than physically), and most investors of cash (mostly large financial firms that lend to producers and governments) need to keep several varieties on hand: dollars, renminbi, yen, euros, pounds, and so on. All day long their traders are trying to figure out if they need a little more or a little less of each one. The thing is, they trade one currency for another, because they want all of them in cash all the time. And they also support any sort of non-financial investor that needs to get money into a country to invest there, or out of a country to invest somewhere else. When there are more people trying to get cash out of a country than into it, they will give up more of the currency they’re trying to get rid of for less of the one they want. That’s a depreciation.
What’s going on in China is that, at the gross level cash is flowing in to make investments, at the gross level cash is flowing out so people can make investments elsewhere, and on net the outflows are greater than the inflows, so the value of the currency is dropping. Why would this be happening:? Because it’s fairly easy to see that China isn’t doing very well. That doesn’t mean it’s doing terrible, or will do worse, or anything catastrophic. It just means that relative to other places, it doesn’t look too good right now.
China used to have fixed exchange rates. Now it has flexible exchange rates. When you have fixed exchange rates, the government agrees to honor all exchanges of currency at a constant rate. If you’re country is in good shape, money comes in faster than it leaves. And those people who want to get money in are willing to give up extra, say, dollars, to get fewer renminbi. Because the government is doing those trades, it accumulates dollars and other foreign currencies. That big pile of foreign monies is called foreign exchange reserves (or just foreign exchange). Over the last few decades, China has accumulated a lot of foreign exchange.
But now China has flexible exchange rates, and the game is different.
Everything I had ready for class is above the line. This stuff below is all new after class (except for the footnote). I tried to mostly write this post in an order that would seem sensible as you try to figure this all out.
How are flexible exchange rates executed differently than fixed exchange rates? Well, in fixed exchange, one trader is always the government, and they are telling you how much of your currency they’ll take for each unit of theirs. Even if you are trading privately with someone else, you both know that you can always go to the government and get a set price, so you won’t deviate much from that. But, under flexible exchange, the two parties are negotiating, and there’s nothing pinning down the exchange rate … except that both parties know what others are offering, and what was done recently, so they’re not just guessing.
Now, go back to fixed exchange. The government sets the rate. If, at that rate, investors are trying to get their money into the country faster than they are getting out, the government accumulates foreign exchange. But if the investors change direction, the government spends/loses that foreign exchange as they maintain that exchange rate that’s no longer quite right. If things get bad enough, the government can set a new exchange rate (a devaluation), or they can lose their foreign exchange so fast that there’s a crisis.
What China did is play the fixed exchange rate game well over the last few decades (and accumulated foreign exchange). Then they switched to flexible exchange, and were probably hoping they’d get to keep all that foreign exchange (and maybe even spend it on something else).
Except that now China has flexible exchange, and the only way to keep an exchange rate that’s flexible at some value you find desirable is to buy and sell in the foreign exchange market just like any other trader.
So, the point that Shan made in class that China has a target for the exchange rate is true, but it’s only sensible to have a target if you have the foreign exchange to keep your exchange rate near that target. China does. For now. But no country has enough foreign exchange to do that forever. The policy discussion inside at the top in China is 1) should we keep letting our currency depreciate (which has pluses and minuses), or 2) do we spend some of this foreign exchange we were saving for a rainy day … because now the rainy day is here.
In sum, China has flexible exchange rates right now, but flexible means they can go both ways on their own, and China doesn’t like the way the exchange rates are moving … and they can slow that down or stop it by acting like they have rates that are more fixed, but it’s going to cost them.
It’s time to start tieing all this together.
Now, on to Hong Kong. Hong Kong still operates somewhat separately from the way the rest of China does. And because of it’s colonial history, location, and wealth, Hong Kong is a financial center for all of Asia and China in particular. So, banks and financial firms in Hong Kong are the ones making most of the overnight loads of reserves denominated in Chinese currency.
And there’s more investors trying to get money out of China than in, and they’re doing most of this through Hong Kong.
And maybe we’re starting to see some herd behavior that might lead to an asset bubble. This would happen if investors are not trying to get out of China because their business fundamentals have gotten worse, but because they’re following the herd of others trying to get their money out of China. We usually think of asset bubbles as situations where the prices are going in one directoin irrationally. You never know for sure, but maybe there’s some of this going with China’s exchange rate right now. The thing is, even if the price movements are irrational, a rational trader can still make money off of them. And, if a rational trader is doing the same thing as the herd of irrational traders, then the irrational traders are encouraged to keep doing what they’re doing.
This brings us to short trading. A short trade is where you pay someone a little money now to borrow their asset, with the promise to return it at some set date in the future. It helps if the asset is fungible (this means that you don’t have to return the exact same unit of the asset, but can repay with some other unit of the asset — so dollar bills are an example of a fungible asset). How do you make money off of a short trade? Basically, it’s a bet that the price of the asset is going to go down. Because what you do is borrow the asset, and immediately sell it, then buy it back later on when its price is lower, and pocket the difference.
So if the value of the renminbi is falling day after day, you can make money short trading. To do this, you’d borrow others renminbi today, trade those for some other currency, then tomorrow you’d buy cheaper renminbi, and pay off your loan.
And, who’s loaning renminbi? Banks in Hong Kong with excess reserves. Normally they loan those to other banks, but if they can loan them to a currency trader and get more money for them, then why not?
Journalists and bureaucrats like to call this speculation. I think that’s nasty. They’re trying to tack a moral cost on to a smart business transaction.
And what is that smart transaction? It’s using the Hong Kong banks as a source of funds to short the renminbi because — irrational or not — a lot of investors are trying to get out of China. These traders are just trying to get into China today so they can get out tomorrow too. It’s not immoral, but it’s certainly not typical (which can make it easier to convince people with your sketchy claim that it is immoral).
Now another player has come into this market. Here’s the players:
- Banks with excess reserves, who trade with banks with insufficient reserves, to be paid pack with reserves tomorrow (plus a little extra). That little extra they pay back is expresses as an interest rate.
- Banks with excess reserves, who trade with currency traders who give them a little extra of something desirable today (like dollars), to pay them back the same amount of reserves tommorow.
- Banks with excess reserves, who trade with the government of China who gives them a little extra of something desirable today (like foreign exchange), to pay them back the same amount of reserves tommorow.
What China has done is change the word “little” in the third bullet point to “a whole lot more” to outbid the currency traders in the second bullet point. This means the banks who are short on reserves in the first bullet point have to pay a lot more back tomorrow (which is expressed as a higher interest rate). China can keep doing this as long as they either want to spend their foreign exchange reserves, or as long as they have foreign exchange reserves to spend.
This is kind of like a pack of dogs fighting a bear. The dogs have annoyed the bear, and it just swatted them really hard. The bear won this round. Does that mean it will win the fight? Simon Rabinovitch, from Boston University had a good tweet summing this up:
Better for a central bank to be feared or respected? China opts for the former …
This next bit will sound a little vacuous, but it’s true: governments always win foreign exchange fights until they lose. The thing is, government officials tend to think they’ll never lose. Which is why depreciations often lead to crises. I’ll be quoting from here down from this piece at Seeking Alpha (they may want a free registration, and I would not worry about doing that).
Central banks trade short-term outbreaks of calm for long-run continued problems of inefficiency and imbalance. Market forces, including speculation, is trying to trade short run disorder and turmoil, sometimes very nasty, in order to find a more suitable long-run balance.
Is this an “oh sh*t” moment? Who knows. Here’s what we do know.
- There are problems in the non-financial part of China’s economy.
- This is leading to problems in the financial part of China’s economy.
- The financial sector is nimbler than just about any non-financial industry, so the problems snowball more quickly.
- There probably is some short trading being funded through otherwise normal banking in Hong Kong.
- Traders making rational moves are being labeled as speculators.
- China’s government made a big play targeted at those traders, and didn’t care if it hurt banks that were short on reserves in the process.
A big picture insight that you won’t get until you kinda’ sorta’ understand this whole post, is that the government of China is unlikely to have taken that last step unless it had taken a lot of other steps targeted at the top of the list … and given up on them.
If the PBOC [i.e., China’s central bank] was desperate last week, the catalog of words describing their likely stance this week is unbelievably short (pun intended). In the handbook of central bank operations, when conditions truly spiral out of control, the first entry in that chapter says to blame speculators. Primary among them, subchapter one in the handbook, are the short sellers.
… amount to are acts of proclaimed exhaustion; the central bank or central financial authority has no other options left …
This relates to the post from earlier this week that Xi Jinpeng and his administration may be micromanagers that are being overtaken by events they can’t handle.
In attacking the speculative aspects of these currency repressions, central banks never answer the question that should be addressed from the very start: why are speculators "attacking" in the first place? … Speculation is but one mechanism by which imbalance is brought back to a steady state. It is a violent, messy and disorderly method, but cuttingly effective which is why short speculation makes for such a good, public target.
For now, this move seems to have worked. Sometimes that happens. Sometimes not.
Do you see now why this is not a big news item? It’s not easy to figure out. If you want to keep up on it, you can go to Google, put in “hibor” as your search term, then click on the “News” link at the top, and see what’s new.
* Do note that the rate did not go up to 67%/day, so that you borrow 100 today and repay 167 tomorrow. Instead, that 67% is per year, and is calculated as what you’d get if you could get that overnight rate for 365 days in a row, and compounded it each day. It’s good practice to work out what the rate per day actually was.