Last week was tumultuous for bitcoin, as Chinese authorities announced plans to ban bitcoin trading in the country.
I am not surprised that Chinese authorities are acting to put a lid on bitcoinBTCUSD, +0.04% trading. What is surprising is why more governments, including the U.S., are not doing the same. The CEO of the largest bank in the U.S., Jamie Dimon, labeled bitcoin as a fraud last week. Ray Dalio, the head of the world’s largest hedge fund, says the same. These financial titans have the ears of President Donald Trump and Fed Chair Janet Yellen, so if fraud on massive scale is going on, U.S. authorities should act.
Bitcoin’s price declined from about $5,000 to a low of around $3,000 last week — as of Monday the cryptocurrency traded around $4,000. In China, bitcoin sold off more sharply on yuan exchanges than it did in U.S. dollar DXY, -0.16% terms is not surprising, as traders may not be able to get their bitcoins out of China before the ban goes into full effect, so there has to be a discount in yuan-denominated bitcoins (See this chart).
I looked at bitcoin several years ago, concluding it was a scam. I even posed the question in one of my weekly commentaries: “Is bitcoin a bubble or a scam?” One colleague astutely noted that “It’s a scam within a bubble.” That was in early 2014. While bitcoin then crashed from about $1,000 to about $300 in 2014, bitcoin recovered. This year it has run up from about $1,000 six months ago to about $5,000 before its latest tumble.
The bitcoin sales pitch is to get more people into a finite amount of bitcoins, with a cap expected to be around 21 million bitcoins. There are about 17 million bitcoins now; the algorithm is designed to increase that cap slowly before it is exhausted. (The number of bitcoins increase by “mining”; for details, see this 2014 primer: “CNBC Explains: How to mine bitcoins on your own”).
The sheer absurdity that humans will bid for a line of code on an exchange in ever larger numbers and see its price skyrocket is hardly unprecedented. From tulips in the Netherlands in 1635-37, to South Sea Company stock in Britain in 1720-22, to the Wall Street Crash in 1929 driven by unlimited leverage on the exchange in combination with a financial system credit bubble; the list goes on and on (see these charts).
China’s slam of bitcoin should be viewed through how its own currency, the yuanUSDCNY, -0.1291% , correlates to bitcoin. In June the Chinese yuan hit a low of 6.86 to the dollar, while in September amid the bitcoin crackdown the yuan appreciation accelerated, changing hands at one point at 6.44. The bulk of the appreciation in the yuan (fewer yuan per dollar means a stronger yuan) has come in the past three months, just in time for the 19th National Congress of the Communist Party of China next month (see chart).
The point is that the Chinese leadership would do anything to keep the Chinese economy going in order to keep power at this important juncture in Chinese history. Messing with the yuan exchange rate, or with bitcoin for that matter, is one of the tools to meet their goals before the October summit.
The bitcoin ban is a way for China to enforce capital controls, given the $1 trillion that has left the country since the summer of 2014. Foreign exchange reserves have stabilized in 2017, and risen by less than $100 billion. The clampdown on outflows, the rebound in the yuan, and the bitcoin ban all comprise multiple steps taken by Chinese authorities to assure smooth sailing at the National Congress.
The yuan-engineered short squeeze took its first big victim on Sept. 6, when Corriente Advisors threw in the towel after a bearish bet on the yuan resulted in a $240 million loss. Using yuan options, forwards, and most other derivatives unfortunately makes any bear easily detectable by the Chinese authorities, who in some cases directly oversee the financial intermediaries that facilitate those bets in Hong Kong. So, if the Chinese authorities know where the shorts are and what the terms of the derivative contract are, it won’t be hard to squeeze them with $3 trillion in forex reserves. This is precisely what they may be doing.
Two years in a row, we experienced huge overnight spikes in the Hongkong Inter-Bank Offer Rate (HIBOR) market, where in one case overnight yuan borrowing costs rose to 66%, while the following year they topped 100%. I have no doubt that the People’s Bank of China engineered those moves in order to squeeze the yuan shorts on multiple fronts. The latest sharp appreciation of the yuan before the October summit is also designed to do damage to yuan bears and to show that the PBOC is in control of the Chinese financial system.
The PBOC-engineered short squeezes do absolutely nothing to change the dynamic in which the Chinese economy’s growth rate has slowed dramatically, while borrowing has surged and keep surging. China’s “total social financing” does not include shadow banking leverage, which adds another 100% to the total debt to GDP leverage ratio, making the total close to 400% and still rising (see chart).
When I examined this dynamic of rising leverage ratios and a slowing economy, coupled with a stock market crash in 2015, I thought that by 2017 the strain in the financial system would begin to show and the Chinese economy would experience a hard landing. The fact that it has not happened does not mean it won’t happen. There is no such thing as “controlling a credit bubble” after it begins to pop. The Chinese authorities may have slowed this process down, but I doubt they will be able to prevent the hard landing. Watch out in 2018.