PBOC balances credit crisis risk against currency flight danger
Central bank pulled two ways as US rate rise set to pose stark question - raise credit costs in debt-heavy economy or watch capital drain away?
The United States economy is showing unexpected strength, pushing expectations that the Federal Reserve will soon boost interest rates into high gear. But rising US rates will pose a serious dilemma for the People’s Bank of China: should the central bank raise domestic rates and risk a severe credit event in the heavily indebted economy, or hold back on credit-cost increases and face stronger capital outflows?
Friday’s US jobs report showed the unemployment rate dropped to 4.6 per cent, the lowest level since 2007. This gives the Fed a stronger case to raise rates 25 basis points at its December 15 to 16 meeting.
With the Fed increasingly likely to resume the rate normalisation cycle that started a year ago, the US dollar recently strengthened to 13-year high and yield on the benchmark 10-year Treasury note also soared to the highest in 17 months.
“While the ramifications of the stronger dollar and higher bond yields have not yet affected US economic data, it is already causing problems for emerging markets,” analysts for Jefferies said in a note on Monday.
Weak local currencies, coupled with higher commodity imports such as oil, would mean many emerging markets’ central banks would find themselves tightening “quicker and faster” than the Fed, they said.
However China, already struggling with a growing debt mountain, was caught in the middle; balancing the risk of a credit even against accelerated capital flows, analysts said.
“The [Chinese] financial system might not be able to afford higher rates,” said Stephen Andrews and Hans Fan, analysts for Deutsche Bank, in another research report.
Consensus expects China’s debt levels to continue to rise sharply, possibly reaching about 300 per cent of gross domestic product by the end of 2018 and hitting 320 to 330 per cent by the end of the current five-year plan that spans 2015 to 2020.
“These are eye-wateringly high levels of debt for a developed market, let alone an emerging
market, ” the Deutsche analysts said.
Under these circumstance, even if PBOC raised domestic rates “very mildly”, the impact on debt-servicing costs in the economy would be “material”, they said.
They estimated a mere 10 basis-point increase in the five-year government bond yield each quarter would prompt the debt servicing costs for the economy to start climbing 20 to 25 per cent year on year.
“This would be a huge drag on growth for an economy that has a credit-driven GDP growth model,” they said. “[Therefore] it seems unlikely to us that, in the medium to long-term, the solution to China’s debt problem is more debt and higher interest rates.”
However, on the other side, keeping rates steady or raising rates at a slower pace may also put China in a difficult position.
“If US rates rise and Asian rates do not follow, or rise at a slower rate, we think concerns over capital outflows will remain elevated,” the Deutsche analysts said.
The scale of capital flowing across Asia’s borders is already unprecedented. China saw approximately US$500 billion leave its financial system over the past 12 months, against inflows of US$300 billion to US$400 billion just two to three years ago.
“The shifting interest-rate spread differential between the US dollar bloc and China is only likely to exacerbate China’s capital outflow issues,” they said.
In October, mainland Chinese authorities banned UnionPay cardholders on the mainland from buying investment-related insurance products in Hong Kong, a move to try to stem cash outflows.
At the end of last month China stepped up efforts to curb capital flight by introducing measures to restrict domiciled non-financial corporates from transferring or lending yuan offshore, with an upper limit of 30 per cent of shareholder equity.
“It is the first sign that the Chinese authorities have become wary over the pace of [yuan] declines post the poor third-quarter balance of payments, after initially ‘tinkering’ with only domestic retail outflows into assets such as Hong Kong insurance products,” Jefferies analysts said.
However, the effect of these policies remained to be seen and more could be in the pipeline.
Deutsche Bank estimated the amount of new liquidity the PBOC had injected into the banking system over the past 12 months could be US$800 to US$900 billion, a huge liquidity injection that is equivalent to 15 to 20 per cent of the total growth in China’s commercial bank balance sheets this year.
“This does beg the question that will China have to erect a new ‘Great Wall of China’ to try and prevent these capital outflows crossing its borders,” the Deutsche analysts said.