US rate hike to pressure China’s capital reserves and currency
Capital outflows will accelerate and yuan depreciation pressure will increase, analysts say
As the US Federal Open Market Committee prepares to announce its first interest rate hike in almost a decade, analysts say markets have priced it in but warn that China’s currency will feel the pressure and capital outflows could accelerate.
The US federal funds rate has occupied the growth-friendly target range of zero to 0.25 per cent since mid-2011. Since that time, domestic unemployment has almost halved to 5 per cent, while economic growth has averaged around 2 per cent.
With full employment nearing, the FOMC is expected to increase the rate by 25 basis points on December 16 in an effort to slow economic growth to a pace consistent with the reduced potential growth rate.
Observers agree rate adjustments will continue into 2016. HSBC predicts a cautious approach with two more rate increases next year.
“Moving too fast could increase the chance of a recession,” said Kevin Logan, HSBC’s chief US economist. “The current low level of nominal interest rates means the FOMC would have little room to counter a recession if one occurred.”
Analysts at Fitch forecast three rate increases in 2016, pointing to the strong labour market and recent financial market stability, while Nomura analysts say the pace of adjustment will depend on economic momentum and inflation.
“Given the length of time that the FOMC has maintained interest rates at the current very low level, it is difficult to say with confidence how financial conditions will react once the adjustment to higher rates begins,” Nomura analysts wrote last week.
Early signs that “things are playing out benignly” would include resilient domestic sentiment and lending conditions, stable capital flows to and from emerging markets and a gently rising dollar, says Standard Life Investments economist Jeremy Lawson.
At the same time, higher US rates could magnify the differences between healthy and vulnerable emerging markets economies, according to Michael Hasenstab of Templeton Global Macro.
Emerging markets currencies have been fairly firm since the third quarter, but HSBC economist Frederic Neumann says they are well down for the year due to expectations of a rise in US rates.
And although Neumann says the impact of the rate hike is now largely priced in, analysts warn that the adjustment will inevitably impact on China’s capital account and currency.
“Capital outflow will probably escalate further, exerting downward pressure on the yuan,” said BNP Paribas economist Jacqueline Rong.
Combined with rate cuts and easing in China, increased US rates will create lucrative opportunities for aggressive traders to establish fresh yuan-short and US dollar-long positions, according to Daiwa analyst Kevin Lai.
“Yuan depreciation is now a market consensus view. In anticipation of future depreciation, many corporates and wealthy individuals are taking their money out of China,” Lai said.
While some currency flexibility will be permitted, consistent with China’s recent progress in currency regime liberalisation, authorities are likely to step in to prevent rapid and excessive yuan depreciation, analysts say.
That was evidenced by last month’s reported suspension of several channels of cross-border yuan flow, including yuan trade settlement account financing, onshore repo financing access to offshore renmimbi clearing and participating banks, and the renmimbi qualified domestic institutional investor scheme, according to HSBC strategist Ju Wang.
Rong says a “mild depreciation” of up to 3 per cent against the US dollar is possible.
But Daiwa analysts say pressure will continue to escalate, forecasting China’s foreign exchanges reserves to dwindle to US$2.8 trillion by end 2016 and US$2.3 trillion the following year.
Despite the possible ramifications, HSBC analysts say there is less to fear from adjustments to US monetary policy than from a slip-up in growth, whether in the US, China or Europe.
“A recession in any of these economies would quickly percolate around the world, with policy-makers having few bullets left in their belts. In short, it’s not higher rates we should fret about, but the fact that we may not be able to push them much lower to stave off another global slump,” Neumann said.
US interest rates were last increased in mid-2006, when China’s economy was worth around US$2.5 trillion. It is now worth over US$10 trillion, while aggregate US-China trade has almost doubled.