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Economy

The PBOC as Circuit Breaker

Mar 04 , 2014

We currently have in China economic conditions that are even better than most textbooks for the teaching of international finance. As it happens, I actually have been teaching international finance for the past several years at the University of Maryland and find last week’s currency matters in China perfect for the illustration of some critical course content. 

The fact is clear although the motive seems not to be, so let’s clarify. The fact is that last week the Chinese Yuan fell sharply against the U.S. Dollar, by the most in two decades. Many voices came to the table to opine on the reasons and ramifications of that. 

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. 

And if my current students are reading this, yes, this material will indeed be on the second exam. 

Michael Justin Lee, lecturer in the University of Maryland’s Department of Finance and Center for East Asian Studies, is the author of McGraw-Hill’s “The Chinese Way to Wealth and Prosperity” and Chief Snark at www.CapitalistSnark.com. His email is leem@umd.edu.

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