Fed Leaves China Only Tough Choices
No one will blink if the Fed raises U.S. interest rates 50 basis points today, signaling an end to the cheap-money era. The U.S. central bank has telegraphed its move for months and while pockets of lingering weakness will spur some Fed watchers to challenge the decision, there's little reason to believe such a small move will nudge the world's biggest economy back into recession.
A relatively easy decision for the Fed, however, is making life much harder for policymakers on the other side of the world. The People's Bank of China has recently been burning through its $3.4 trillion stash of foreign-exchange reserves, spending nearly $100 billion a month to prop up the value of the yuan. Higher U.S. interest rates and a stronger dollar are sure to spur further capital outflows, especially given continued worries about the Chinese economy.
Chinese leaders seem willing to accept some mild depreciation while preparing for full liberalization of the yuan; in the future, the currency's value may be determined against a basket of 13 currencies including the euro and yen, which would increase downward pressures. If the PBOC were to pull back now, however, the currency's gentle glide could quickly turn into a nosedive. Given the dollar's strength against emerging market currencies, a true free float could spark a devaluation of more than 30 percent.
In that event, China would have few weapons at its disposal. In November, the yuan joined the IMF's elite club of reserve currencies -- a victory of great symbolic importance to Chinese leaders. If they imposed capital controls to halt the yuan's downward slide, they'd suffer massive embarrassment, not to mention hard questions about their economic management skills.
China has little option but to continue muddling through, then, allowing the yuan to decline in value while working to moderate its pace. This certainly counts as currency "manipulation" in the eyes of Donald Trump and other presidential candidates. In this case, though, China isn't defying the market so much as attempting to cushion market-driven dislocations.
The dilemma highlights an uncomfortable truth: Unlike the Fed, whose rate hike is a classic low-risk decision, Chinese leaders today face only high-risk policy choices. And the best they can hope for in return is a degree of stability, not the go-go growth of earlier decades.
Previously, when China's debt levels were low and the government was running large surpluses, investment opportunities were plentiful. Now credit is stretched. Fixed-asset overinvestment has left a capacity glut. Migration to cities is slowing, even as the working-age population has begun to decline. There are no more easy reforms. The changes China needs to implement -- to stimulate competition, increase productivity, allocate capital more efficiently and spur innovation -- all require wrenching sacrifices.
Despite much talk about championing market discipline, the regime doesn't appear ready to make those calls. Communist planners still struggle to recognize two important foundations of modern economic policymaking. First, dynamic, thriving economies demand death and obsolescence. In this process of creative destruction, new skills are developed. New firms evolve. Innovation leads to new products. And the companies, products and skills of yesterday are replaced. Authorities would speed China's economic transformation with a compassionate economic euthanasia. Protecting doomed companies and industries instead is not just futile, but foolhardy.
Second, China needs more dynamic leadership. The fact is, the Chinese economic miracle benefited enormously from a robust global economy and undervalued currency, which prompted large capital inflows and investment. While Chinese leaders can be credited with hard work and solid management during the boom years, they also enjoyed strong tailwinds.
Now, they seem stuck on the same methods that created China's existing problems -- rapidly expanding credit, rolling over bad loans, propping up effectively bankrupt firms, making minimal output cuts and continuing to pour money into fixed-asset investment. Groupthink and a lack of intellectual creativity helped get China into this mess. It'll take leaders capable of embracing new ideas to solve it.
That said, other countries should recognize the difficulty of transforming the world’s second-largest economy. While China must face up to its bad-loan problem, leaders understandably want to avoid widespread unemployment and bankruptcies that might fuel worker protests. While the country needs to liberalize its currency, it must be granted the leeway to do so in a manner that minimizes the chances for large disruptions, which could have global ramifications. The world should be rooting for China to succeed. Otherwise the Fed's next decision isn't going to be so easy.
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