The Fed Puts China in a Bind
Last week, when the U.S. Federal Reserve raised interest rates, it was a sign for many investors that things were getting back to normal. For China, facing large-scale capital outflows and a declining currency, it was a sign of a serious problem.
For the past decade, China has maintained a "soft peg" of the yuan, allowing it to rise and fall within a narrow band against the U.S. dollar. This has worked, for the most part, because the two countries have had relatively synchronous business cycles and broadly similar monetary policies. But now their economies are diverging in important ways.
The Fed has been openly worrying about rising prices, as the U.S. economy grows steadily and its labor market tightens. That's why it is boosting rates. In China, by contrast, state news outlets now regularly talk about the "new normal" of slower growth. Private investment has grown by only 2.5 percent this year through September. Near-zero consumer inflation has risen lately only due to speculation.
Worse, many years of excessively loose monetary policy have produced wildly inflated asset prices. Real estate in some Chinese cities ranks among the most expensive in the world. Virtually every commodity, from coal to garlic, has experienced a boom and bust in 2016, sometimes more than once. With few investment opportunities in a sluggish economy and bubble-level asset prices, investors are moving money overseas at an accelerating rate. Economists at Goldman Sachs Group Inc. estimate that $69.2 billion exited China in November. Other estimates suggest a total outflow of nearly $1 trillion for 2016.
This places China's policy makers in a bind. They need lower interest rates to boost growth and ease the burden on heavily indebted firms. But they need higher rates to maintain the soft peg to the dollar as the Fed tightens. Keep rates low, and they risk busting the peg, pushing more capital overseas and placing intense pressure on the financial system. Boost rates to maintain the peg, and they risk raising costs on indebted firms and pushing many of them into bankruptcy.
In other words, China is caught in what economists call the "impossible trinity." No country can simultaneously sustain a pegged exchange rate, a sovereign monetary policy and free capital flows. At some point, policy makers must make a trade-off.
Financial markets recognize the potential danger. China's bond market has suffered its biggest rout in years, with yields on 10-year sovereigns rising from 2.6 percent in October to nearly 3.5 percent after the Fed hiked rates. Investors pondering the consequences of higher funding costs in an economy with rising defaults are rightly concerned.
There is no easy way to resolve this dilemma. Ultimately, China has to fully liberalize its currency, but it can't simply let the yuan float freely without running the risk of a major outflow and a liquidity crunch. A significant drop in the yuan matters not for how it will impact Chinese trade but for how it will affect an increasingly fragile financial sector.
So reform needs to start with the banking system. First, the government must accept that its policy of letting credit grow at twice the rate of gross domestic product has only encouraged risky lending. Fitch Ratings estimates that the percentage of bad loans in China's financial system could be 10 times the official number, potentially resulting in a capital shortfall of more than $2 trillion. Reducing the flow of credit and cleaning up that toxic debt must be China's top priority.
Next, policy makers need to lay out a plausible long-term plan to unbind the yuan from the dollar. The government has said it will let the yuan float freely by 2020, but that looks increasingly unlikely. Regulators have actually been walking back currency reforms, and enacting ever-stricter capital controls. It seems logical to expect a tightening of current-account transactions next year. China is still managing its economy as if the massive foreign investment and trade surpluses that characterized its decades-long growth spree will return. Unfortunately, those days are gone for good.
Given that President-elect Donald Trump has promised a large infrastructure stimulus, the likelihood of more U.S. interest-rate increases in the next two years is growing. That will only put more pressure on the yuan -- and on China's policy makers to act, one way or another.
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