China has dominated recent newsflow due to its stock market crash and the devaluation of the yuan (CNY).  The latter, I believe, is an attempt to free up the PBoC to conduct domestic monetary policy to deal with the aftermath of China’s massive credit expansion.

If you have a fixed exchange rate or a quasi-fixed exchange rate as China does, domestic monetary policy is largely outside of your control if capital can flow in and out freely. China does have exchange controls, but the rapid influx of reserves and concomitant credit expansion following the global financial crisis and the recent rapid outflow of reserves make you question their effectiveness. The PBoC has found it hard to control the effect of its balance sheet on the domestic economy.  The authorities let that slide during China’s rapid expansion, but they cannot ignore it now.

In the wake of the global financial crisis, China had its banks ramp up lending to an extent beyond anything I, or perhaps the world, has ever seen. Steve Keen’s chart below shows how mind bogglingly fast the build up in Chinese debt has been.

If you do have a debt bubble, you want to let the air out slowly in order to avoid setting off a deflationary spiral. A fixed or quasi-fixed exchange rate can exacerbate this problem, because maintaining the exchange rate affects the size of the central bank’s balance sheet and that balance sheet has material effects on domestic monetary conditions.

The assets on the Peoples Bank of China (PBoC) balance sheet consist mainly of foreign exchange reserves.  That is the nature of a fixed exchange rate regime; the central bank that fixes its rate must buy and sell what its rate is fixed against in order to maintain the rate.

The chart above shows that the PBoC’s balance sheet has been shrinking. The shrinkage has been driven by the loss of FX reserves (red line). The blue line, representing total assets, has declined a bit slower, because the PBoC has been buying domestic securities to inject liquidity, much as the Fed does.

The PBoC can offset the reserve loss by cutting the Required Reserve Ratio (RRR) as they have been doing.  RRR cuts free up bank reserves, offsetting the effect of the PBoC balance sheet shrinkage.  The move may have a multiplier effect, if it frees up more bank reserves than the FX reserve outflow takes away. Unfortunately, this is probably a case of the Red Queen effect*, the need to run as hard as you can just to maintain your position.

A floating exchange rate would go a long way towards solving this problem.  It would decouple the PBoC’s balance sheet from the CNY exchange rate if the Chinese authorities were to allow the CNY market to clear naturally.  That is probably a bridge too far.

* In Lewis Carroll’s Through the Looking-Glass, the Red Queen tells Alice, “It takes all the running you can do, to keep in the same place.