The PBC’s exchange rate policy, the link to credit multipliers, and capital asset price volatility

With the US Federal Reserve beginning to contemplate shrinking the size of its balance sheet, it is a good time to review the evolution of central banks’ balance sheet since the Global Financial Crisis (GFC) and what they imply for the credit conditions and investors’ sentiments in major economies. Since my obsession and interest is with the Chinese economy, this blog piece will be dedicated to analyzing the elasticity of credit in the China. By looking at the People’s Bank of China’s (PBC) balance sheet, we will see if we can infer anything about the current state of the economy and financial system.

I often hear or read the following point among Chinese analysts: the PBC’s balance sheet has not grown as much as those from other major economies (i.e. the US, Euro Area, Japan) and therefore China is less susceptible to financial volatility and inflationary pressures than those economies. If we use January 2008 as a pre-crisis starting point, indeed the total assets of the Chinese central bank has only doubled while the ECB’s, the BoJ’s, and the US Fed’s respectively grew three, four, and five times (see Chart 1).

Chart 1

However, just plainly looking at the absolute size of the central bank’s balance sheet misses the larger point and potentially confuse concepts of assets versus liabilities. When analyzing the growth of the central bank’s balance sheet, we need to: 1) understand why the assets grew; 2) What was the domestic economies’ response to the change in the central bank’s balance sheet. Let’s analyze these two points in turn.

1) Why did the assets of central banks grew?

Anyone who followed The Matrix movie series will know: the most important question is always why. In my mind, the reason behind the growth of a central bank’s balance sheet is crucial to understanding the consequences the expansion will have on the domestic economy. In the section below, I will detail why the US Fed increased its assets and how this differs from the reason behind the PBC’s increase in its balance sheet. I will not veer into discussion about the ECB and the BoJ because of my relative lack of knowledge with those jurisdictions. (However, given that both the Eurozone and Japan runs a floating exchange rate, the reasons behind the expansion of their central bank balance sheet shouldn’t be too different from the US.)

In the US:

In the US, after the bankruptcy of Lehman Brothers in September 2008, the financial markets -especially in the short-term funding market – froze. Firms, banks, and funds that traditionally used financial assets such as mortgage-backed securities to raise funding via repo could no longer secure the funds to maintain daily operations and repay their short-term interest. This was a classic liquidity issue where debtors are not insolvent but the inability to rollover short-term funding leads to insolvency and bankruptcy.

The US Fed, being the ultimately issuer of base money and authorized under Section 13 of the Federal Reserve’s Act[1] to lend to whoever they want, was forced into a position of dealer of last resort. Essentially, when there was panic among traditional dealers of liquidity, the Fed had no choice but to step in and provide a floor price to certain financial assets to ensure firms, banks, and funds can rollover short-term funding and wait for economic conditions to improve.

The section above described the immediate aftermath to the financial crisis. However, in 2009 with the economy in freefall and the American Congress bickering over the shape-and-form of a government-led economic stimulus, the US Fed committed to regular monthly purchases of US Treasuries and eventually mortgage-backed securities. There were several intentions behind these purchases. One aim was to depress the risk-free rate to make mortgage payments easier for household to prevent further selling in the housing market. Secondly, a lower risk-free rate would imply higher valuation for financial assets and hopefully promote households to consume through a positive wealth effect. Lastly, lower interest rates can hopefully nudge businesses to invest and add to the recovery. With these intentions in the mind, the US Fed entered into several rounds of monthly asset purchases colloquially known as QE (quantitative easing) programs between 2009 and 2014.

To describe simply, outside the period of the crisis, the US Fed expanded its balance sheet out of choice. The multiple rounds of QE were designed to stimulate a very weak and fragile American economy. As I will make clear later, the weakness of the American economy throughout the period of QE made very aggressive and expansionary monetary policy less consequential than otherwise in a more normal and vibrant economic scenario. The effects of monetary policy on the real economy during periods of economic depression was compared to “pushing on a string , a phrase coined John Maynard Keynes during the Great Depression.

In China:

However, the situation in China could not have been more different. Prior to Lehman’s bankruptcy, the Chinese economy was likely operating above capacity. Nominal GDP was growing at nearly 20 per cent and inflation was between 6 – 8 per cent. The sudden shock of the Lehman bankruptcy and the subsequent collapse in American demand pushed China’s nominal GDP growth down to 6.7 per cent but the economy quickly revived after the Chinese government pushed out its 4 trillion yuan economic stimulus.

In terms of monetary policy, the difference between the US and China was that China was not the master of its own fate. In the period after Lehman (September 2008) until May 2010, the PBC established a hard peg against the USD to remove a source of uncertainty for its investors and exporters (see Chart 2). However, given the rapid recovery in China and China’s large current and financial account surplus vis-à-vis the rest of the world, the PBC had to offer its own balance sheet to defend the exchange rate. However, unlike the current situation, the PBC had to act as a dealer where they were the net seller of RMB. In essence, the PBC was providing a floor price to USD in terms of the RMB to prevent a very strong appreciate of the RMB. Despite having its balance sheet only double, unlike the other major central banks, the PBC’s balance sheet grew out of necessity as opposed to choice: this is the cost of running a quasi-pegged exchange rate regime.

Chart 2

The difference reason behind the balance sheet expansion has difference consequences in terms of credit expansion from of the monetary base.

2) What was the domestic economy’s response to the change in the central bank’s balance sheet?

Before we dive into the implications of an expanding central bank balance sheet, we need to first review what is the function of a central bank and is ask a very basic question: what is money?

From a very monetary perspective, what is useful to society and the banking system is not the central bank’s assets, but rather, its liabilities. A central bank’s liabilities- especially the monetary base- are the notes and values that commercials banks, households, and businesses ultimately accepts as a unit of account, a store of value, and medium of exchange.

In a modern capitalistic economy, most people associate the role of the central bank to provide price stability and promote full employment- obviously this is true. However, an often less appreciated function of the central bank is that it is a clearinghouse for payments between commercial banks and can help surplus and deficit banks meet their respective needs. For banks to settle among each other, what they require are the central bank’s liabilities (the monetary base).

How does this relate to our discussion on the US Fed’s and the PBC growing balance sheet? When the asset of the central bank grows, then the amount of central bank reserves (i.e. monetary base) increase; this is what is normally known as a loose monetary policy.

In the years after the crisis and arguably until today, the PBC has ran a quasi-fixed exchange rate policy. To defend the PBC’s desire exchange rate, the PBC must be willing to provide either a floor or ceiling by buying or selling its inventory of USD. In essence, in the years after the GFC, the PBC adopted the US’s ultra-loose monetary policy when Chinese economy was in a different stage of its economic cycle. In an inflationary environment where business sentiments and investments were already hot, running a very loose monetary policy is adding oil to a raging fire. The result has been an explosion in capital asset prices and this is most evident when we see look at Chinese real-estate prices.

To further reinforce this point, we can see a rise in China’s credit multiplier right after the GFC and a rapid increase in the last 18 months (see Chart 3). In my chart below, I defined the credit multiplier as a ratio of broad credit (here I used M2) compared to the monetary base (i.e. currency plus central bank reserves). The ratio is a metric to track credit transformation: for 1 unit of central bank credit, many units of private bank credit is being generated by the commercial banking system.

The result is clear: in the US and Japan, the very aggressive expansion of the central bank’s balance sheet has not translate into the creation of long-term debt by the banking system (see Chart 3). In plain terms, this mean in the US and Japan, banks are sitting on a lot of excess reserves and are unwilling or unable to make long-term loans (i.e. loans to build factories, roads etc) that would impact the real economy. This once again shows, in a very weak economic environment, the excessive use of monetary policy is akin to “pushing on a string”.

The Chinese case is very different. Prior to the crisis, China was growing at a very fast rate. With the introduction 4-trillion yuan stimulus and subsequent rounds of easing, the economy exploded. In addition, the adherence to a quasi-fixed exchange rate regime kept interest rates lower than otherwise and pushed up asset prices. Had excess capacity issues in China not been so severe, inflation would have been much higher.

Chart 3

The PBC tried to sterilize the large inflow of foreign reserves by increasing the require reserve ratio for the banking system. The require reserve ratio (RRR) is the percentage of central bank reserves commercial banks must hold at the PBC for 1 yuan of deposits. A high RRR acts as a liquidity constraint on how much banks can lend out and indirectly controls the growth of commercial banking assets. However, a high RRR punishes banks with a small deposit base and encourages these banks to seek non-deposit financing and create off-balance sheet assets; both solutions which lead to a risky and more unstable banking system.

3) What are the recent consequences of the PBC’s large balance sheet?

Up until now, the discussion has revolved around historical developments since the GFC. However, I would argue, the PBC’s large balance sheet until continues to have repercussions today in terms of Chinese capital asset prices and volatility. Since 2014, China has seen capital outflows as expectations of the exchange rate turned. This unwinding reverses the previous increase in the PBC’s assets. However, there is one problem: a lot of this base money was used to finance long-term assets such as real-estate and infrastructure. We can conceptualize how the PBC’s liquidity is being filtered to the economy with the following stylized manner.

Chart 3.1

As per standard accounting framework; left-side implies asset, right side implies liabilities. The problem with China’s financial system is that much of assets among non-financial corporations are financed on a relatively short-term basis. If I recall correctly, the average duration of bank loans in China is around 1  year, while assets like infrastructure and real-estate are long-term in nature and are vulnerable to rollover risks. This would be less of an issue if the PBC ran a floating exchange rate policy and can provide unlimited liquidity to the domestic banking system; however, with a quasi-fixed exchange rate providing large amounts of liquidity can be problematic.

We saw this problem unfold in 2015 when the PBC aggressively cut the RRR to signal support for the weak economy and provide liquidity to the banking system. However, this result in stronger capital outflows as banks were flooded with a new source of cash; money that was once locked at the PBC can now be lent out and be used to generate profit. Some of this new lending likely went to firms and households that took the money offshore and further adds pressures on the exchange rate. Throughout 2015-2016 the PBC tried this several more times as the PBC cut the RRR by 150 bps before finally deciding the pressures from the outflows were too large to justify and no further cuts in the RRR were been made (Chart 4).

However, one of the unforeseen consequences of cutting the RRR may be the rapid increase in the China’s credit multiplier. As Chart 4 demonstrates, the credit multiplier close tracks the movement of the RRR. In a banking system with a high degree of moral hazard, a large release in base money (i.e. as a cut in RRR) would most likely be deployed to assets with the highest speculative returns. In the first half of 2015, it was margin financing and in 2016 it was real-estate likely with the bond market as the transmission channel.

Chart 4


China’s volatile capital markets are a function of the PBC’s past and current exchange rate policy. The quasi-fixed exchange rate regime in an environment of strong growth attracted strong capital inflows which went on to finance long-term capital assets. However, with expectations having turned, the outflows are pulling the rug on the Chinese financial system giving Chinese banks liquidity pressures as they attempt to finance long-term assets using short-term funding. In an attempt to address the liquidity shortfalls, the PBC cut RRR to unleash liquidity that was previously locked up. The aggressive cuts with this powerful – but blunt- tool further contributed to further asset price volatility as banks further invest into assets with the high speculative return.


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2 Responses to The PBC’s exchange rate policy, the link to credit multipliers, and capital asset price volatility

  1. Yaron says:

    great article


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