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China has less time to defuse its debt bomb and address domestic financial risks after the US Federal Reserve, pictured here, set out a timetable to steadily increase interest rates and sell off bonds to shrink its balance sheet. Photo: AFP

Does Fed’s latest move add urgency to Beijing’s financial rescue mission?

Higher interest rates and returns in US could lead to a flow of cash out of China as investors seek alternative haven for their money, according to observers

China has less time to defuse its debt bomb and address domestic financial risks after the US Federal Reserve set out a timetable to steadily increase interest rates and sell off bonds to shrink its balance sheet, analysts warned.

Higher interest rates and returns would make the US dollar more attractive to investors and spark fears of a flight of cash out of China, putting a strain on the world’s second largest economy, according to observers.

The Fed on Wednesday outlined a road map of further monetary tightening by raising interest rates six more times over next three years and starting to reduce its bond holdings from October, nine years after the US central bank began to embrace quantitative easing.

Beijing has always put on a brave face to any change in Fed policy, but they remain one of the most important external factors influencing the direction of Chinese domestic monetary policy.

The tapering of US monetary easing started in 2014 almost coinciding with a peak in China’s foreign exchange reserves.

A narrower interest rate gap between China and the US, a stronger US dollar and reduced liquidity in international markets from the Fed’s move will all turn into headwinds for Beijing to contain financial risks at home, according to Iris Pang, chief Greater China economist at the banking and financial services firm ING in Hong Kong.

“The Chinese central bank needs to give the market a clear signal of what it will do next, otherwise, investor confidence over yuan assets will be eroded” said Pang.

As early as the summer of 2015, the Fed was forced to postpone its first rate rise in nearly a decade partly because of capital outflow concerns in China. When the Fed did raise rates in December 2015, it did spark capital flight from China, with the country’s foreign exchange reserves dropping US$100 billion that month alone.

The yuan has appreciated six per cent against the dollar this year and China’s capital outflows have eased after the government adopted draconian measures to curb the movement of cash overseas. The Fed’s decision to scale down its US$4.5 trillion balance sheet next month could test whether this hard-earned stability is secure, according to analysts.

“Our nervousness about the Fed ... indicates [the] absence of a shock absorption mechanism,” said Lu Zhengwei, chief economist at Industrial Bank in Shanghai. “China may have to passively follow the steps of the Fed” if it wants to defend the value of the yuan, said Lu.

Higher interest rates in China along with reduced liquidity may put stress on the economy as the country’s debt level approaches 300 per cent of its gross domestic output.

The central bank has injected about 1.2 trillion yuan into the banking system so far this month so banks can roll over debts and lend money to clients, a move that will help ensure stable economic growth ahead of the five-yearly Communist Party Congress due to open next month.

“A process of balance sheet shrinking, just like Fed’s unconventional easing a few years ago, is something that China has never experienced before,” said Xie Yaxuan, chief macro analyst at China Merchants Securities. “China’s monetary policy is likely to follow the Fed if their economic fundamentals are consistent, but if economic divergence appears, the yuan needs to be more flexible,” he said.

The Chinese central bank has kept benchmark lending and borrowing interest rates unchanged since 2015. While the central bank is seeking to cut “leverage”, the process is slow and the interbank market rate edged up in an equally slow manner.

The central bank did not give any formal response to the Federal Open Market Committee’s latest statement and the updated economic and interest rate projections.

The People’s Bank of China said four months ago, however, that it would not follow the Fed immediately to tighten monetary policy.

In a quarterly monetary policy report published in May, China’s central bank said a shrinkage in its balance sheet in March was a result of capital outflows and reduced deposits from fiscal authorities and it should not be read as a sign that China was tightening monetary policy to echo the Fed’s plans.

Larry Hu, chief China economist at Macquarie Securities, said China still has a buffer zone since the European Central Bank and the Bank of Japan have not fully exited quantitative easing and the interest rate gap between higher rates in China and the US still remains large.

Meanwhile, the Fed’s balance sheet downsize may do Beijing a temporary favour to weaken the yuan a little and to create a “two-way fluctuation in the yuan exchange rate” because China has been busy in the past couple weeks engineering a modest yuan depreciation.

“The strengthening of the US dollar, with the backing of interest rate hikes, may will help alleviate the yuan’s appreciation pressure,” said Hu.

This article appeared in the South China Morning Post print edition as: Fed rates timetable may affect China’s financial rescue
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