What China must do to meet the challenge of a US interest rate rise
Hu Shuli says the government should focus on improving the real economy and rolling out reforms, as pledged, in the financial sector and elsewhere
Emerging economies have been bracing themselves for a rise in US interest rates. Last week, the release of the minutes of the US Federal Reserve's policy meeting in April sparked another round of speculation of when the rate hike might begin. Most now expect a start date in December, rather than September.
Either way, there is little time left for preparation, particularly for China, whose economy is decelerating. It must restructure its economy and introduce systemic reforms to brace itself for the spillover effects of an interest rate rise.
Different economies have responded differently to the global financial crisis. The US Fed ended its bond-buying programme last October, but has repeatedly put off raising interest rates. In March, the European Central Bank introduced US-style quantitative easing in the euro zone. A month later, the Japanese central bank said it would maintain its stimulus measures.
In China, talk was rife this month that Beijing, too, would soon begin monetary easing. Although the People's Bank of China said the economy has yet to reach the zero lower bound on interest rates and US-style quantitative easing was unnecessary, it has nevertheless cut interest rates three times and twice lowered the reserve requirement ratio for banks. It has also launched a debt swap programme allowing local governments to exchange their maturing high-interest debt for lower-yield bonds.
And once the US raises its interest rates, all economies will have to readjust.
Historically, a reversal of US Fed policy had the power to reshape global fund flows and even trigger a regional crisis. Such an impact will only be magnified in the globalised economy of the 21st century. So it is worrying that, apart from a small number of senior officials and market analysts, many Chinese remain unconcerned about what an interest rate rise in the US could do to the Chinese economy.
We can't afford to be so blasé. In the wake of the global financial crisis, many Chinese banks and financial institutions have taken advantage of the low interest rates abroad and the appreciating renminbi to borrow heavily. This massive inflow of funds into the local banking system, including the shadow banking sector, is now propping up the real estate sector, trust companies and local government financing platforms.
A rise in US interest rates would trigger a retreat of this hot money from the property and stock markets, and put a squeeze on bank liquidity. Any attempt to deleverage and lower asset prices could encourage further capital flight, the renminbi's depreciation and credit tightening. If the Chinese economy failed to speed up its restructuring in time, a US interest rate rise could pose a high-risk threat.
There are those who believe China has little to worry about, given the scale of its economy and the size of its foreign exchange reserves. Besides, the central bank has room to further lower the interest rates and reserve requirement ratio, while capital controls are still in place. But let's not ignore the evident weaknesses of the financial system and the signs of fatigue in the real economy.
Although there's no need for undue alarm, China must prepare itself to meet the challenge, rather than rely on luck to survive it.
Beijing's best defence is to improve its real economy and accurately implement the right structural reforms at the right pace. In a way, China is competing with the other emerging economies in a race to restructure the economy and lower its systemic risks. If it wins this race, by painstakingly following through on its programme of reforms, China will have transformed its problems into gain.
In a global competition for funds, a healthier Chinese economy will attract investors. It need not fear the competition posed by higher interest rates in the US.
The Chinese central bank should be commended for its efforts to press on with interest rate liberalisation and the limited easing of capital controls. These measures will enable Chinese companies to respond more efficiently to market signals and better manage their risks.
Meanwhile, other reforms cannot wait. Fiscal reform, for one, must focus on an administrative overhaul that includes alleviating the pressure on local governments to invest.
There is also a need to head off downward pressures on the economy. This means using monetary policy as a tool to reduce short-term risks. However, China must resist the temptation to resort to large-scale stimulus that ultimately distorts the economy.
Since China began its transformation into a market economy, it has survived both the Asian financial crisis and the global financial meltdown, thanks in part to the fact that its economy isn't totally open. But as it continues to open up, there's one test it must face. It should regard the US interest rate rise as a drill to strengthen itself against external challenges.