Central Banks Recalibrate: From Open-Ended Money Floods To Targeted Liquidity Pumps

A lot has been written about the PBOC appeal to its SLF recently, and rightfully so. To my view, there is undoubtedly a connection in timing between the SLF announcement and conduct and the very troubling economic figures (away from whatever sentiment survey is adjusted into mush). The end result of the means of the SLF is still one of “loose” liquidity, but I don’t believe there is enough appreciation for the wider context of where the PBOC is trying to go.

In fact, the SLF was first mentioned in PBOC material as far back as Q1 2013. The purpose was to allow the main banks a liquidity plug for seasonally specific times where conditions were too tight (particularly in June 2013). The effectiveness of the program is not especially clear on its own, especially since usage was almost 420 billion yuan during the same month that SHIBOR rates found record highs. But that was never the full intent under the PBOC’s “reform” agenda.

The SLF cannot be evaluated on its own, particularly since the trend in monetary policy in China is following the orthodox economics course. The Chinese central bank is moving away from liquidity, or what may fairly be called “money supply” targets, just as the US did three decades ago. The ultimate destination for Chinese monetary policy is a unified interest rate targeting scheme very much like that used in the rest of the world (why the Chinese want to follow that course only highlights how much orthodox monetary economics is an overriding ideology more than anything else).

To get to that point, the SLF was paired with a new “tool”, the Loan Prime Rate (LPR) that was introduced on October 25, 2013. The combined imprint was to allow banks a liquidity outlet under a regime whereby the interest rate is paramount – again, like that of the federal funds market. The flexibility of the SLF allows the PBOC to target specific financial institutions while keeping undisturbed its interest rate target.

In an unusual predicament, I actually think the following comment quoted in Bloomberg has it mostly correct:

“With growth slowing and regulators cracking down on shadow banking, it seems like the PBOC is trying to cut costs for preferred borrowers and sectors without reflating the property sector,” David Loevinger, former U.S. Treasury Department senior coordinator for China affairs and now a Los Angeles-based analyst at TCW Group Inc., said in an e-mail. “But it risks stepping back from a more market-based allocation of credit, which China sorely needs.”

The US exit from QE is not data-based, as it represents this definite trend in central banking after the persistent failures to successfully navigate the post-recession period. The lack of recovery is fostering a different look to central bank policy, whereby a “flood” of liquidity, as the prior textbook approach indicated, is being steadily replaced by more targeted approaches. The reason for this change is obvious, as the “flood” design is entirely too populated with heavy costs, chief among them asset bubbles; that if these programs had actually been successful the downside of them would have been more easily, but not perfectly, absorbed into robust growth.

Thus, the lack of robust growth to “pay” off the large costs of monetary programs are left to be dealt with under far less than ideal circumstances – in some cases, like Europe, starting from relatively dire foundations. While the ECB appears to be in “flood” mode, that is actually not the case as there are targets throughout these “new” programs. About the only place left absorbing the unfiltered tide of liquidity is Japan (proving once more all of this).

That means not only is China eschewing broad liquidity expansion contrary to what is so often proclaimed, but rather the PBOC is actually recognizing, as are most other central banks, just how ineffective monetarism has been and can be. Furthermore, they are also under less illusion about the high cost of past monetarism, now looking to try to “thread the needle” of some monetary expansion that will not disturb the housing sector (bubble) in either direction. Call it managed decline or targeted growth without bubbles; whatever it is, it is a preposterous-sounding position to take.

I think it also fits very well into the warning provided by PBOC governor Zhou Xiaochuan made earlier this year:

“If the central bank is not a part of the government, it is not efficient in coordinating policies to push forward reforms,” [Zhou] said.

“Our choice has its own rational reasons behind it. But this choice also has its costs. For example, whether we can efficiently cope with asset bubbles and inflation is questionable.”

For asset markets that think central banks are going to be as generous as they have in the past, they are sorely mistaken. The paradigm is much different now, though the change is not being digested easily. Broad, naked liquidity solves no economic problems and central banks, always late arrivals, have finally caught on to that. Targeted liquidity will likely, in my opinion, be ultimately as impudent, but since the emphasis is on fewer costs (read: less bubbles) you would think “markets” might want to be more aware.

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