Beijing is right to fear a rate-raising Federal Reserve

The last thing that the Chinese economy now needs is a tightening in the U.S. credit cycle and a rising U.S. dollar. Such a combination is bound to complicate Beijing’s efforts to deal with its capital outflow problem, to prevent an undue depreciation of the Chinese currency and to successfully deflate China’s outsized domestic credit bubble.

Yet, Beijing would be well-advised to brace itself for rising U.S. interest rates and a strong dollar. After all, Chair Janet Yellen’s Federal Reserve is now faced with the prospect of an expansionary U.S. budget policy at the very time that the U.S. economy is close to full employment and U.S. wage inflation is beginning to gather momentum.

This would seem to leave the Fed with very few options but to continue normalizing U.S. interest rates, which is all too likely to propel the dollar to ever-higher levels. Over the past two years, despite exceptionally low U.S. interest rates, China has been challenged by a major capital outflow problem. Indeed, it is estimated that, during this period, Chinese corporations and households shipped more than $1 trillion of capital abroad in search of a safer harbor for their savings.

In an effort to prevent those outflows from causing an undue weakening in the currency, the Chinese government has allowed China’s international reserves to fall from around $4 trillion at the beginning of 2015 to barely $3 trillion today.

The government has also been forced to revert to strict capital controls to keep capital inside the country. This represents a serious setback to two of the government’s primary goals — making China’s currency fully convertible and attaining international reserve currency status for the renminbi.

It also has brought China’s international reserves to a level that the International Monetary Fund (IMF) considers to be not much above the minimum reserve level that the country should be holding for prudential reasons.

Higher U.S. interest rates and a strengthening U.S. dollar are bound to exacerbate China’s capital outflow problem. They will do so by increasing the attractiveness of U.S. financial assets relative to those of China.

In addition, rising U.S. interest rates and a strong dollar must be expected to add considerable financial pressure to the Chinese corporate sector.

According to the the Bank for International Settlements, since 2008, Chinese corporations have taken full advantage of the very easy monetary policy abroad and have increased their U.S. dollar-denominated borrowing by around $1 trillion. As the value of the U.S. dollar rises, those dollar-denominated debts become more expensive to repay.

A rising U.S. dollar will also represent a major headache for China in the management of its currency, especially at a time that the Trump administration continues to regard China as a serial currency manipulator. If China does not allow its currency to depreciate against the U.S. dollar, it risks having its currency appreciate against all other currencies besides the U.S. dollar.

This is something that the Chinese government can ill-afford now that it is trying to deflate the country’s credit bubble. That bubble has seen credit to the non-government sector increase by a staggering 90 percent of GDP over the past eight years.

Yet, if China allows its currency to depreciate against the U.S. dollar, it risks having the renminbi’s exchange rate rise above the sensitive threshold of 7 renminbi per U.S. dollar.

That is bound to be a red flag to the new U.S. administration, which has repeatedly indicated that a fundamental economic policy goal must be to level the playing field with countries (like China) that have taken unfair advantage of the United States in the area of international trade.

There would never seem to be a good time for Chinese President Xi Jinping to face rising U.S. interest rates and a strengthening dollar. However, now would be a particularly inauspicious time. The all-important Communist Party Congress takes place at the end of the year, and China is now having to face up to the major imbalances in its economy caused by excessive domestic creation.

All of these issues do not seem to portend positive future U.S.-Chinese economic relations. This would especially seem to be the case given the economic promises that the leaders of these two countries have made to their respective electorates.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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