Pater Tenebrarum

About the Author Pater Tenebrarum

I'm an independent analyst and have been involved with financial markets for 31 years. I write economic and market analyses for independent research organizations and a European hedge fund consultancy. I'm the main author of the blog 'Acting Man', which presents articles on the markets and the economy, a mixture of commentary on current events as well as economic theory and history from an Austrian school of economics viewpoint.

Friday Never Happened – ”Because of China”?




Nonsensical Reasoning is Concocted to “Explain” Day-to-Day Market Moves

We were wondering what could have triggered today’s move in the stock market that so promptly negated Friday’s sell-off. On Friday traders were allegedly worried about a) Greece (what, only now?) and b) China – where it was decided to limit margin trading somewhat and expand stock lending for short sellers in a vain attempt to slow the expansion of the world’s latest and currently strongest stock market bubble.

Neither explanation made any sense. If investors were really worried about Greece, they would have been worrying non-stop since late December at a minimum. Instead European stocks ex-Greece have experienced a near parabolic blow-off move to the upside, pushing them to the highest trailing P/E in history.


What happens in China’s stock market meanwhile is usually completely irrelevant. It always has been – China’s market marches to its own drummer due to the country’s closed capital account and is therefore in no way correlated with other stock markets. Moreover, China’s stock market has never, as far as we can remember, reflected events in China’s economy. The market seems almost exclusively driven by whether or not the authorities want it to rise.

Today Western stock markets have been taking back the losses suffered on Friday, and once again China is allegedly the reason. This time, the explanation makes even less sense, but it gives us an opportunity to elaborate on a point that many people are quite possibly not aware of.


1-SPX, intra-daySPX, 10 minute chart: Friday vs. Monday – click to enlarge.


We realize market commentators and the press have to say something in an attempt to “explain” short term market moves. It would be boring if they were to repeat the truth every day. In that case they would have to say over and over again: “it’s all just noise”. While sometimes a legitimate “trigger event” may precede short term market moves, the moves as such are still nothing but noise. This should be obvious by simply looking at the combined action of Friday and today (as of the time of writing): has anything changed? No – but there was a lot of motion, a.k.a. “noise”.


China’s Reserve Requirements

Yahoo Finance informs us about the ostensible “reason” behind today’s rally. As noted above, after being blamed for Friday’s sell-off, China is credited for today’s rally as well:


U.S. stocks extended gains on Monday after opening sharply higher amid an unexpected stimulus from China’s central bank as investors kept eying corporate earnings.


On Sunday, China’s central bank lowered the reserve requirement ratio for all banks by 100 basis points. The wider-than-expected cut was the People’s Bank of China’s second reduction in two months, and marks a continuing effort by the world’s second-largest economy to combat slowing growth.


(emphasis added)

Readers are probably well aware by now that reserve requirements no longer play any role whatsoever in most Western banking systems. In the US reserve requirements exist on paper, but have in practice been circumvented by banks since at least the mid 1990s, when “sweeps” were first introduced. These allow banks to sweep demand deposit balances into so-called MMDAs (money market deposit accounts) overnight, where they masquerade as savings deposits – and hence require no reserves.

The proof is in the pudding: even though bank reserves actually declined throughout the latter part of the 90s and in the 2000ds prior to the crisis and the Fed’s QE operations, both credit and money supply exhibited explosive growth rates. In Europe the authorities seem not to believe bank reserves to be much of a necessity either. Prior to the crisis, a mere 5.4% of the euro area’s true money supply was actually covered by vault cash or reserves held at the central bank. In late 2011 the ECB lowered the already laughably small reserve requirement of 2% to just 1%, in order to give a bunch of essentially insolvent banks additional leeway to stay afloat.

Things are quite different in China though. The PBoC actively employs reserve requirements, usually in order to avert run-away domestic money supply growth. This is a result of China’s mercantilist policies. China’s leadership erroneously believes that the trade balance is a measure of a country’s prosperity. It has been known for at least the past 165 years that this is complete humbug, but many political leaders evidently still believe it. Here is a link to an early explanation as to why this view is misguided, by Frederic Bastiat. It opens with the sentence “the balance of trade is an article of faith”. It is indeed.

China’s exchange rate policy has resulted in large dollar inflows in the past. Given the closed capital account, the PBoC buys these dollars from exporters and gives them freshly printed yuan in exchange. If it were to do nothing else, the domestic money supply would rise very fast in line with these inflows, as every additional dollar received would lead to the creation of additional yuan at the given exchange rate. In order to exercise a modicum of control over money supply growth, the PBoC tries to counter this by slowing down the issuance of fiduciary media by commercial banks – and for this purpose it employs reserve requirements.

It is therefore correct that a lowering of reserve requirements is tantamount to an easing of monetary policy relative to the policy that pertained prior to the lowering. However, this activity has to be put into context. In reality, there is actually no additional easing. Rather, the PBoC is trying to counter what has recently become an outflow of dollars, as reflected in its declining foreign exchange reserves. Ceteris paribus, outflows will lead to lower domestic money supply growth. Thus, all the PBoC is doing is not to leave the ceteris in a state of paribus, so to speak. This isn’t a reason to become more bullish on asset prices – on the contrary, it is actually a reason for alarm.

It is alarming with respect to asset prices, because it means that new liquidity driven by dollar inflows is drying up in China. Meanwhile, just because the PBoC is removing an obstacle to the creation of additional fiduciary media by commercial banks, there can be no assurance that the banks will actually spring into action and increase their inflationary lending. China’s real estate bubble is tottering on the brink and it seems quite conceivable that Chinese banks are wary of this development and won’t increase their lending much.

Note that money supply growth in China has actually slowed down rather dramatically over the past two years. In March the growth rate of the broad aggregate M2 fell to 12.1%, the lowest growth in 15 years. Narrow money M1 grew at a mere 2.7% – down from almost 40% in late 2009. This has so far had a disproportionate impact on what is without a doubt China’s biggest bubble – the boom in real estate prices. The recent large move in Chinese stocks is mainly driven by individual investors opening new trading accounts in droves and buying stocks on margin, apparently in an attempt to “make up” for the losses suffered in the expiring real estate bubble. As such, the echo bubble in stocks appears quite dangerous to us, as a great many newly-minted shareholders seem weak and over-leveraged.


2-China-money-supply-1China’s money supply growth, M1 and M2. The original chart ended in 2014, we have penciled in what has happened since then – click to enlarge.


3-SSECThe echo bubble in China’s stock market – click to enlarge.



Contrary what appears to be assumed in the press report above, cuts in China’s reserve requirements are actually not really a good sign. These days investors and speculators are so uniquely focused on central bank intervention and its effect on asset prices, that everything that sounds like monetary easing is taken as a reason to buy, even if it is actually a sign of growing economic weakness and concern by the authorities such as is the case in China today.

Not only have moves in China’s stock market usually no effect on markets elsewhere (with Hong Kong a notable exception due to new regulations allowing more cross-border trading of dual-listed stocks), but the PBoC is not really easing anyway – it is merely trying to counter the monetary tightening effect caused by recent capital outflows. The effects of the sharp slowdown in money supply growth should continue to percolate through China’s economy and a major bust in seems ever more likely.

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