In the immortal words of the nuns in The Sound of Music, how do you hold a wave upon the sand? Central bankers in China would like to know, as they struggle to stop the tide of speculative capital now flowing out of the country.
Earlier today (Aug. 25), the People’s Bank of China cut the bank reserve requirement for the fourth time this year, and slashed benchmark lending and deposit rates for the fifth time since November. Coinciding with the stock market rout in Shanghai, there is a whiff of panic in the air.
Along with the PBoC’s surprise devaluation on Aug. 11, these moves are designed to boost liquidity and, thereby, to juice lending. In particular, the cut to the reserve ratio requirement (RRR), as it’s known, was widely anticipated due to huge sums of money that are fleeing the yuan right now, upping the risk of mass defaults or a June 2013-style cash crunch.
Today’s worries date back to the global financial crisis. As Chinese GDP growth hit double-digit rates—even as most other countries foundered—speculative inflows washed into China to profit from high onshore interest rates and the rapid appreciation of the yuan against the dollar. Much of it masqueraded as trade finance, as we have explained previously.
Data on foreign bank loans to China capture some of this activity. As you can see, starting in 2014, those flows began reversing:
In July, foreign currency held by Chinese financial institutions shrank by 249 billion yuan ($39 billion), the biggest monthly drop since on record:
This brings us to the devaluation. Before Aug. 11, the PBoC pegged the yuan’s value to the greenback, with a little room to maneuver on either side. In order to maintain a stable currency—which the PBoC has promised the IMF in order to get the yuan into its basket of reserve currencies—it had to buy dollars to offset surging demand for the yuan. That kept the yuan from rising rapidly in value, which would hurt exporters.
But when those speculative flows started reversing in 2014, it had to do the opposite: sell dollars from its (then) $4 trillion in foreign exchange reserves, offsetting the trades of all the people dumping their yuan, and keeping the redback’s value steady.
Capital flight is a self-reinforcing impulse—once some investors start selling the yuan, the herd soon follows. Even worse is what happens when officials try to counteract that trend. When the PBoC sells its dollars, it siphons the yuan it receives out of the financial system forever—sucking up liquidity in the process, leaving banks less cash to lend. It also drives down prices, creating deflationary pressure that causes real interest rates to rise—bad news for a country that’s already racked up at least $28 trillion in debt.
The PBoC’s Aug. 11 change to its yuan policy, in theory, freed it from having to keep destroying yuan as capital exited China. Today’s policy moves—and the fact that the PBoC seems to still be defending the yuan anyway—show that officials aren’t confident that their earlier actions will do the trick. Cutting the RRR should free up new money for banks to lend. But will these loans be large enough to revive growth and convince investors hold onto their yuan? Or as the nuns might say, how do you hold a moonbeam in your hand?