Money Flows out of China Spark Change in How China Creates Money

Money flowed out of China in August for the third time in 2012. Their standard MO of buying foreign monies from their exporters in exchange for yuan is going to have to change.

Average monthly gains in Yuan holdings is 35 billion this year compared to 232 billion monthly last year. Market liquidity supply sees big change

"For a long time, Chinese banks' yuan holdings for purchasing foreign exchange have been a channel for the central bank to create money. Now the old pattern is about to change, which means the central bank needs to find new ways to issue currency if it wants to maintain stable money supply growth," said Cao Yuanzheng, chief economist at the Bank of China Ltd.

Yuan holdings among banks for purchasing foreign exchange, an important measure of capital flows, declined by 17.4 billion yuan ($2.75 billion) in August to 25.64 trillion yuan, marking the second straight monthly fall.

The depreciation tendency once again indicates that the yuan's exchange rate is close to equilibrium, he said. "We believe that capital flows related to yuan exchange rate expectations is the most uncertain factor affecting overall capital flows," said Wang Tao, head of China economic research at UBS Securities Co Ltd.

If you'll recall, a lot of money poured into Yuan purely due to the expectation that it would appreciate. Now that the signs are toward depreciation, this speculative bet is being taken off the table, triggering outflows.

"The financial account deficit plus a lower current account surplus means that China may have entered a new era, that is, the stagnant growth of foreign exchange reserves."

The central bank has been increasing its use of short-term money market tools such as reverse repurchase transactions to ease liquidity tension, after it last cut the RRR in May by 50 basis points to 20 percent for major banks. It injected massive liquidity through another round of reverse repurchase operation in the last week of September. From Sept 24 to 27, it injected 365 billion yuan, a record high weekly injection through open market operations.

Buying treasury bonds in the secondary market would become a major channel for the central bank to create money in the future, China Business News reported, citing an anonymous analyst close to central bank decision-makers.

But controlling liquidity through purchases and sales of treasury bonds requires a bigger and more mature secondary market. Otherwise, large-scale purchases made by the central bank would raise interest rates and spur the issuance cost of such bonds, said the analyst.

"Currently, central bank bills and treasury bonds are in separate markets. Only if China completely frees interest rates could the two markets be linked and the central bank could operate like the US Federal Reserve," Zhao said.

Before the sterilization of foreign exchange fluctuations became a mainstream channel to issue currency, re-lending to commercial lenders was the main tool of China's central bank to create money, accounting for 80 percent of newly injected money in the 1990s.