Don’t be misled by posts which focus on “Chinese monetary policy.” This is first and foremost about credit markets.

Read this FT Alphaville post about the Chinese carry trade (and bow down and revere them, while you are at it). The previous Chinese credit overextension, the inability to keep this process going forever, and Bernanke’s talk of “tapering” all point in the direction of more expensive credit for the Chinese economy. This economy was addicted to cheap credit in the first place, so that’s a big deal. (By the way, promising to print more currency won’t solve the core problem here, with apologies to Scott Sumner.)

Note that a lot of the cheap credit has been funneled through a dollars mechanism, as explained in the first link. To the extent dollars become more expensive to borrow, the Chinese central bank cannot easily do a complete offset. The relevant lever here seems to have been U.S. interest rates, I am sorry to say.

What can the consolidated Chinese central bank/government do? They can be easy with the yuan but that makes illegal and semi-legal capital flight all the more dangerous as a threat. Keep in mind that China has to enforce capital controls — in both directions — at the same time as it conducts monetary policy, so it does not have access to the full range of effective instruments in a “carry trade world.” There is already too much borrowing which cannot be made good, not even by more lending. And they don’t want to push their current bubbles any further but rather seek to defuse them. (Keep in mind also that capital controls do not work forever, so one possibility is that we are witnessing Chinese capital controls coming apart at the seams over a slightly longer time horizon, even though that is not what we saw on the screen today).

They also could lend out dollars at lower rates than the U.S. market will do to China. That would indeed help in the short run, but it’s easy enough to see why they do not wish to go down that route. It would require rationing, it would lose money, and it also would most likely postpone the day of reckoning and of course unlike the Fed they can’t simply print more dollars at will. For all of the $$ trillions in Chinese reserves, it’s still probably not enough to make good on current bad investments, given that the use of those reserves could be controlled only very imperfectly, at least once they are lent out at discount rates.

And so there we have the dilemma. I don’t endorse their current policy of letting interbank markets freeze (update: they are now injecting cash), but it’s not clear they have many desirable options. The importance of dollars as a “dual currency,” the presence of excess capacity and multiple bubbles, and the perceived need to maintain two-way capital controls are significant constraints.

Here are my previous posts on “Austro-Chinese business cycle theory.”

By the way, this entire mess also helps explain why Bernanke was so nervous about the previous course of U.S. monetary policy. You will notice that once the talk of “tapering” hit the news, emerging markets absolutely tanked, a bad sign for the future and a very bad sign for what (possibly) has been going on. See my previous remarks here.