Wednesday, March 05, 2014

The PBOC as a circuit breaker - Michael Justin Lee

Michael Justin Lee
Michael Justin Lee
China´s Yuan has been falling sharply against the US Dollar in the past week, and much debate emerged on what might be the politics behind this. It only means China´s central bank PBOC is doing its job as a circuit breaker by letter hot money out of the economy, writes financial analyst Michael Justin Lee in the ChinaUSFocus.

Michael Justin Lee:
Actually, the interpretation is not at all difficult if we imagine ourselves in the position of the Peoples Bank of China. What is the motivation of any central bank? Surely it is the maintenance of a stable and growing economy. 
With that in mind, let’s consider in what economic situation China finds itself currently. Without question, China’s economy is slowing from recent high rates. This means that China requires a great deal less money sloshing around in its economy than it did just a year ago. Too much capital raises the risk of further inflation, which is already starting to spook many in China. 
Therefore, some reduction in capital is necessary. The PBOC chose to target one particular kind of capital. They chose what is commonly called hot money. 
Not all capital are equal. Some are better than others. The hot money form of capital has always been a bugaboo for emerging markets because what hot money giveth, hot money taketh away later. 
This not a big problem when the economy is roaring ahead. But when the economy is slowing, a central banker’s legitimate fear is that all the hot money might be yanked away precisely when it might be needed most. 
Therefore, from the central banker’s psychology, if the money is hot, it’s better to have it gone sooner rather than later. And that is what the PBOC engineered last week. The economic mechanism is less important than the psychological one. 
One headline in the Wall Street Journal can be used for an example. It was: “Yuan’s Recent Decline Triggers Fears on Leveraged Bets.” This fear is exactly what the PBOC was trying to engineer. Consider if the PBOC didn’t break the market consensus’ thinking that the Yuan could only strengthen. Necessarily, this would incite more capital into China, some big portion of which is hot money, which is exactly what China doesn’t want in a now slowing economy. 
There’s a financial phenomenon known as the self-fulfilling prophecy which states that if a large enough mass of people think a particular way about something and act upon that thinking, then their very acting upon it would cause that thing to happen for a time. For example, if we all expect the currency to rise, our buying of it will itself cause the currency to rise, even if our original expectation were wrong. And that is what the PBOC feared about the consensus thinking of a Yuan’s rise. 
Their action last week was intended to be a circuit breaker. Just like in engineering, a circuit breaker exists to interrupt the flow of a current lest there be an overload eventually. The PBOC understands this applies in economics too.
More in the China USFocus.

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