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Federal Reserve

Alarm bells ring for China’s leaders as US Fed fires warning shot

Interest rate increases pose longer-term challenges for nation as it tries to tame debt and stem the risk of more capital outflows

PUBLISHED : Thursday, 15 December, 2016, 11:24pm
UPDATED : Tuesday, 03 July, 2018, 9:47pm

The US Federal Reserve’s decision to raise interest rates is no doubt ringing alarms bell for Chinese leaders meeting in the capital this week for annual closed-door talks to chart economic policy for next year.

Immediately after the announcement early Thursday (Hong Kong time), Chinese onshore government bond futures plunged to the daily limit, reportedly prompting the central bank to step in. The yuan also tumbled to test the key level of seven to the US dollar, and the benchmark stock index ended the day below the 60-day average.

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But the real challenges for the country from a stronger US currency and higher dollar interest rates loom much larger, posing threats to foreign exchange reserves, currency and prospects for growth.

In the decade or so since the collapse of US financial services firm Lehman Brothers, Beijing has been convinced that the US’ financial power and its free-capitalist model is in decline. It has also been confident that its model of state capitalism is the better bet, and that it is at the forefront of an inevitable shift in global economic gravity to the East.

It has tried to marshal this perceived growing economic might by promoting the yuan as a nominal international reserve currency and creating institutions such as the Asian Infrastructure Investment Bank to help boost regional infrastructure.

But the tide has begun to turn against China. The country is grappling with surging levels of debt, the fallout from a stock market rout and exchange rate swings. Even the country’s choking air pollution has clouded its reputation as a poster child for the post-crisis recovery, raising suspicions that it could be a source of regional or even global risk.

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Analysts said the Fed’s rate move confirmed that some of China’s confidence in leading the global economic way was premature, and stronger international economic headwinds could prompt Beijing to focus ­inwards.

Louis Kuijs, head of Asia economics with Oxford Economics, said the country might focus more on domestic challenges, taking a more “realistic and pragmatic” attitude to policymaking.

“China’s policymakers are at the moment revisiting what really are the most important objectives of economic policy overall,” Kuijs said. “It’s not really so important the yuan becomes a global currency ... What’s much more important is to ensure that China can continue to grow and will maintain financial stability.”

Whether policymakers take that tack could become clearer after they wrap up their annual Central Economic Work Conference, which is expected to conclude on Friday.

There are already some signs of the general policy direction for 2017 – the Communist Party’s Politburo has decided to make steady economic growth the priority, reflecting the leadership’s desire for stability ahead of next year’s party congress.

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“Stability is the top key word for China’s 2017 economic policy,” Standard Chartered chief China economist Ding Shuang said.

And that means the opening of the capital account will be secondary, according to Ding.

Beijing has already brought in capital account controls to stem the decline in foreign exchange reserves. Development of offshore yuan markets has also slowed as appetite for the currency has weakened.

If the Fed continues to raise rates, yuan depreciation and outflows will only worsen, particularly in the case of a currency war.

Henry Chan Hing Lee, from the National University of Singapore, said that China, like most countries, would be vulnerable to competitive devaluations because of the Fed’s de facto central bank status and unlimited capacity to generate currency.

“China’s only defence is to closely guard its capital account,” he said.

Higher US interest rates also mean higher repayment costs for already heavily indebted local governments and state firms.

China’s economic boom has been fuelled largely by cheap debt and a steady flow of funds into the country. Its state firms and local authorities amassed debt so quickly that it is now a systemic problem, according to the International Monetary Fund.

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At the same time, the country, with its US$10 trillion economy expanding at more than 6.5 per cent a year, is not completely at the mercy of US rate rises.

The yuan, while weakening against the dollar, is relatively stable against a basket of currencies, and the nation’s US$3 trillion in foreign exchange reserves, although shrinking, remain the world’s ­biggest.

And while the rate rises would give the central bank less scope to relax monetary policy, Beijing’s fiscal authorities still have room to increase the deficit to propel growth.

“Deep down, China’s policymakers already knew that the US was still a force to be reckoned with in economic and monetary policy, and that decisions on monetary policy in the US still have major repercussions globally,” Kuijs said.

Additional reporting by Jane Li and Frank Tang