China under threat as the world starts to stir on interest rates

Globally monetary policies are diverging, creating the potential for unintentional but quite disruptive consequences for not just the global economy but the financial stability of individual economies within.

The shift in policies is occurring largely within the developed world, led by the US and its Federal Reserve Board.

Higher US interest rates would reduce Chinese companies’ access to global debt markets and trigger capital outflows from China.Credit:AP

If the Fed meets market expectations, it will lift US interest rates by at least five 25 basis point moves this year, while also starting to shrink a balance sheet swollen by its $US5 trillion ($7 trillion) or so of liquidity it injected into the US and global financial systems in response to the pandemic.

In Europe the European Central Bank has played down suggestions of any rate hike this year but market rates are rising in expectation that a spike in inflation, falling unemployment, labour shortages and the impact of the Fed’s policies on the euro will force it to raise its policy rate from minus 0.5 per cent by two 0.10 per cent increments.

On Tuesday the Reserve Bank announced the end of its quantitative easing – its purchases of government bonds to provide liquidity and keep market rates low — and is pushing back at suggestions that it should start raising the cash rate from its current 0.10 per cent level.

The market isn’t convinced it will be able to maintain that position in the face of rising inflation, low unemployment and Fed-induced increases in interest rates elsewhere that will have implications for global capital flows and currency relativities, including the relationship between the Australian and US dollars.

Most impacted by a significant surge in US interest rates and, if markets behave rationally, a significant strengthening of the US dollar against other currencies will be less-developed economies including (and, in terms of the implications for the global economy and geopolitics, most notably) China.

If US rates rise faster and further than those in other jurisdictions and the US dollar strengthens, capital will be attracted out of other economies and towards the US in pursuit of the more attractive income streams and the capital gains from the currency appreciation.

That would mean potentially significant currency depreciation for those economies on the other end of those capital flows, higher inflation rates as the cost of imported goods rose and lower standards of living.

Defending their currencies would entail higher interest rates, regardless of their economic conditions, and reduced holdings of foreign reserves.

Chinese President Xi Jinping urged the West to think carefully about shifting their monetary policies at the virtual World Economic Forum last month.Credit:AP

For Australia, a slightly lower dollar probably wouldn’t disturb the RBA, although it wouldn’t want too abrupt or volatile a descent or too much of an inflationary threat given our inflation rate is already rising and is slightly beyond its target range.

For emerging economies, particularly those within Asia, higher US rates, a stronger US dollar, tighter global monetary conditions and lower global growth could present a threat to their stability.

During the pandemic already high levels of government debt in emerging market economies have grown substantially. The International Monetary Fund says average gross government debt in those economies has risen 10 percentage points to 64 per cent of GDP between 2019 and the end of last year.

Those economies aren’t rebounding from the pandemic as quickly and as hard as the US or Europe – or Australia –and are more reliant on exports. Much of their borrowings, at both government and corporate levels, are in US dollars.

If US rates rise sharply and the dollar follows suit, global growth will slow and the cost of servicing and repaying US dollar-denominated debt with depreciating local currencies will also rise significantly and the ability to borrow or refinance would be reduced by the likelihood of large capital outflows.

The US and other developed economies have no option, if inflation rates remain elevated, but to tighten monetary conditions. That will have flow-on effects to the rest of the world, where increased volatility and risks appear likely to rise threateningly as global conditions change.

It was that prospect that ostensibly led to China’s Xi Jinping’s unusual plea to the West (and the US in particular) at the virtual World Economic Forum last month.

“If major economies slam on the brakes or take a U-turn in monetary policies there will be serious spillovers that will present challenges to global economic and financial stability and developing countries will bear the brunt of it,” he said, urging the major economies to co-ordinate their fiscal and monetary policies.

He didn’t say China itself is worried about the prospect of a significant divergence in monetary policies between itself and the US…but it is.

China doesn’t have an inflation problem but its economic growth rate has slowed quite dramatically under the weight of its “COVID-zero” approach to the pandemic, the debt crisis in a property sector that accounts for as much as 30 per cent of its economy and the chilling effects of its abrupt shift in its attitude towards the more entrepreneurial private sector within its economy as its policy goals have reoriented from wealth creation and growth to wealth distribution.

China’s central bank has responded to the slowdown in its economy that gathered pace late last year – a slowdown that threatens to see GDP growth fall below five per cent this year – by cutting interest rates, urging its banks to lend more and injecting liquidity into its financial system.

Its central and local governments have resorted to their traditional response to any slowdown – more infrastructure investment.

In other words, China’s monetary and fiscal policies are heading in the opposite direction to America’s and the rest of the developed world’s, where the policy paths are towards monetary and fiscal tightening, not stimulus.

China loosely pegs its currency to the US dollar, albeit with some discretion. Higher US interest rates would reduce Chinese companies’ access to global debt markets and trigger capital outflows from China unless it raised its rates to maintain the current positive differential and supported the yuan to avoid material depreciation.

Given that the threat posed by divergent policies is occurring even as China tries to deflate and deleverage, not just its teetering property sector but its over-leveraged economy, the authorities would be understandably fearful that they are going to be forced into invidious policy choices.

The RBA and governor Philip Lowe are keeping a close eye on the Australian dollar.Credit:James Brickwood

With the critical National People’s Congress at which Xi is seeking an unprecedented third term as Communist Party and China’s leader looming, China’s domestic economy and stability are the priorities.

The external settings, however, threaten volatility, instability and potential crisis if there is an exodus of capital and/or the existential problems confronting its property developers spill over into a wider debt crisis.

Last year, attracted by the higher yields and returns available in a Chinese economy that bounced back from the worst of the pandemic faster and harder than other major economies, foreign capital flooded in at record levels. Its banks are awash with more than $US1 trillion of foreign cash.

That cash and capital could just as quickly flood back out unless China was prepared to raise interest rates and throw its foreign reserves at defending the yuan to avoid a foreign exchange crisis that would exacerbate the plight of property developers, and other sectors, that have large US dollar exposures.

The US and other developed economies have no option, if inflation rates remain elevated, but to tighten monetary conditions. That will have flow-on effects to the rest of the world, where increased volatility and risks appear likely to rise threateningly as global conditions change.

The Business Briefing newsletter delivers major stories, exclusive coverage and expert opinion. Sign up to get it every weekday morning.

Most Viewed in Business

From our partners

Source: Read Full Article