A New Perspective On China’s FX RRR Hike 2
This scenario is the real threat to the Chinese (and global) economy, which makes it prudent to think of China hiking its FX RRR from the perspective of USD liquidity. In doing so, we can see that the hike has two main effects.
First, that the Chinese government is taking advantage of the large amounts of USDs flowing into the country through trade and financial investment (as CNY strength vs the USD attests) by putting some aside for future use. Put another way, the Chinese are ensuring that should global USD liquidity dry up in the future, they will at least be able to meet some of their needs by building a larger buffer of USDs now.
This is due to the RRR’s role as a buffer that helps to prevent bank runs. The hike mandates that banks have a larger amount of USDs on hand to meet daily net outward transfers of Dollars (if USD transfers net to an outflow). In other words, should liquidity in global Dollar markets dry up, causing Chinese banks to struggle to obtain them to fund their USD liabilities, they have a larger buffer to fall back on.
Second, the hike could also reduce the amount of USD denominated loans that domestic banks can make. This is simply due to them having to hold more Dollars in reserve, which means that they have to fund more of their USD lending via borrowing in the global FX or repo markets, instead of from their own USD balances. The result is less USD loan creation and a slower rate of growth in USD leverage within the Chinese economy.
Consequently, the FX RRR hike acts to reduce Chinese USD leverage and exposure while allowing them to save Dollars for the “rainy day” when global USD funding markets seize up.
Which begs the question, why are the Chinese building USD buffers and acting to reduce exposure in the middle of a widespread crisis in their real estate sector?
Are they taking steps in preparation for a “rainy day”, where Evergrande’s contagion negatively impacts Chinese corporations’ ability to tap global USD funding markets?
Whatever the case may be, context is important, and the context surrounding the FX RRR hike is gloomy, to say the least. Recently, we have had a broadly stronger USD, a RRR cut on CNY deposits, real estate developers defaulting every which way, and Chinese data which suggests a weakening economy.
All of this is, of course, connected. Some of these connections and resultant negative feedback loops can be traced back to Evergrande’s contagion, while others can’t. This is easily observed via the CNY continuing to remain strong against the USD, even though the Dollar is rallying against almost every other currency.
In other words, the Evergrande contagion is just one piece in the overall global economic puzzle, which by extension means that the Chinese government can only do so much to help keep the global economy afloat.
More importantly, if the Evergrande contagion does spread to the rest of the world via the Dollar funding markets, it would be doing so at a time where international financial conditions are starting to tighten, and economic conditions weaken. Which isn’t a good combination at all.
Maybe this is the scenario Chinese leaders were really preparing for when they chose to hike their RRR on FX deposits. If so, it would be wise for everyone else to start paying attention.
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