U.S.-China Economic Poker Game Looms With Market Calm at Stake

  • Policy actions by one side could rebound with volatility
  • Top economic officials set to meet in Beijing June 6-7

As top American and Chinese officials prepare for their annual powwow against the backdrop of a looming Federal Reserve interest-rate increase, the policy actions of the world’s two-biggest economies have never been so closely bound.

In what could be likened to a poker game, officials from the world’s two biggest economies will attempt to assess each others’ policy plans -- and their potential domestic implications -- when they sit down in Beijing June 6-7.

China wants to loosen the yuan’s link with the dollar while averting an exodus of capital. The Fed wants to gradually move away from near-zero interest rates, with almost all officials penciling in at least two quarter-point hikes this year. The past nine months have made clear how the two sides’ goals can conflict, with the withdrawal of U.S. stimulus encouraging Chinese outflows and a surprise August yuan devaluation generating market ructions that put a pause on a Fed rate move.

A Fed-induced surge in the U.S. currency would put pressure on the yuan, lighting a match under money outflows that have eased significantly after a record $1 trillion left in 2015.

Avoiding another financial conflagration is one task for Fed Vice Chairman Stanley Fischer, U.S. Treasury Secretary Jacob J. Lew and other officials when they meet their Chinese counterparts. The gathering will be the eighth and final Strategic and Economic Dialogue since the Obama administration agreed on the annual sessions, which were an extension of a Bush administration initiative.

“Both China and the U.S. have a shared interest in avoiding mutual monetary policy surprises that could constrain their own room for domestic policy actions,” said Eswar Prasad, a former chief of the International Monetary Fund’s China division and now a professor at Cornell University in Ithaca, New York.

For China, the biggest risk emanating from the U.S. could be the forward path of rates that the Fed will communicate at its June 14-15 meeting.

For a quick overview of how China is easing its grip on the yuan, click here.

In March, Fed officials said they expected two rate increases in 2016, according to their median estimate. Seven of 17 officials wanted three or more hikes in March. It would take only two additional officials to prefer three hikes this time to establish the median at three, upending market expectations and continuing the dollar’s 3 percent appreciation off a low for this year reached May 2.

Yuan Pressure

“If the Fed does end up raising rates more than expected that will clearly increase the pressure on China’s FX market,” said Louis Kuijs, head of Asia economics at Oxford Economics in Hong Kong.

For now, the risk that officials migrate to a median three-hike majority looks low, as U.S. data is coming in about where the central bank expects. Fed members in March estimated the economy would expand at 2.2 percent for the year, and most have written off a first-quarter slowdown as a fluke. The Atlanta Fed’s GDPNow model indicated as of Thursday that the economy is expanding at a 2.9 percent annual rate in the second quarter.

“There is a broad consensus among Federal Open Market Committee officials for a hike in the summer, and one later in the year,” said Sassan Ghahramani, chief executive officer of SGH Macro Advisors, a policy research firm in New York. Chinese officials “are sensitive to the potential spillover” of U.S. rate hikes on the currency, he added.

Chinese officials plan to ask their American counterparts in annual talks next month on the chance of a U.S. rate increase in June, people familiar with the matter said this week. In China’s view, if the Fed does lift borrowing costs, a July move would be preferable, they said, asking not to be named as the talks were private. The central bank denied the Bloomberg News report.

Even so, China stability concerns are unlikely to forestall a mid-year rate hike. Several Fed officials have said they are focusing more on the domestic economy while weighing international considerations.

Any worries by Chinese officials are unlikely to “make a big difference for the Fed,” said Michael Hanson, senior global economist at Bank of America in New York. “They’ve come to the conclusion that global markets can handle it.”

For People’s Bank of China Governor Zhou Xiaochuan -- who’s trying to assure the Communist leadership’s 6.5 percent minimum growth rate while managing a transition to a more market-led economy that relies less on leverage -- the prospect of volatile capital flows makes an already tough task all the harder.

Clamping Down

To help contain risks, China has been clamping down on a myriad of illicit channels used to get money out of the country, from curbing purchases of overseas insurance products to stopping friends and family members from pooling their $50,000-a-year quotas to export large sums of money.

Still, companies and savers continue to move cash over the border, such as through Hong Kong with suspected fake trade invoices.

“The depreciation of the yuan against the dollar is very likely for the rest of the year,” said Iris Pang, a Greater China economist at Natixis SA in Hong Kong. “Capital outflow would become the new-normal of China, and China has to accept this fact.”

Building Defenses

China has been building its defenses for a Fed hike. Companies have been rushing to pay down U.S. dollar debt and authorities have taken steps to allow more foreign investment. Foreign-exchange reserves increased for the second month in a row in April after falling by more than half a trillion dollars in 2015, their first-ever annual decline.

With global stock markets demonstrating some stability since March, China also has been letting the yuan follow its emerging-market peers lower against the dollar, potentially reducing the amount of depreciation when the Fed does next raise its benchmark.

“These might buy Chinese officials a degree of flexibility in the face of a Fed rate hike,” said Frederic Neumann, co-head of Asian economic research at HSBC Holdings Plc in Hong Kong. “But China still faces a tough task stabilizing its economy, and Fed rate hikes aren’t making things any easier.”

Before it's here, it's on the Bloomberg Terminal.