China urged to ease economic policy, cut exposure to US assets ahead of impending Fed rate hike

  • Prominent Chinese economist Yu Yongding says China must ‘prepare in advance’ for a US rate hike or face consequences
  • A US rate hike could strengthen the value of the US dollar against the yuan and trigger a fund outflow from China

China should waste no time in diversifying from US dollar assets and easing its economic policy, according to analysts, as the world’s second largest economy is increasingly wary of its vulnerability to changes in US monetary policy.

Yu Yongding, a prominent Chinese economist and former central bank adviser, said it was regretful that China’s own monetary policy is facing constraints as a result of monetary shifts in the United States and Europe.

“If the US Federal Reserve raises rates, there are many measures available but it’s more difficult [to implement] in this environment and the costs will be high,” Yu said at a virtual seminar organised by Renmin University of China on Thursday.

“I regret to say that there are certain things we could have done earlier … If we continue to delay it, it will just get more difficult.

“China’s monetary policy should support an expansion of fiscal policy to steady the economic growth.

“We are competing with the US, from a geopolitical perspective, US’ [gross domestic product] growth may overtake China’s this year – this is a big problem that we should pay attention to.”

The People’s Bank of China (PBOC) said on Monday it will cut the reserve requirement ratio for major commercial banks by 0.5 percentage points, releasing 1.2 trillion yuan (US$188 billion) worth of long-term liquidity into the interbank system on December 15 to shore up the economy.

But the Chinese central bank has previously been cautious about monetary easing, with officials saying monetary policy would remain prudent and downplaying the impact of developer Evergrande’s debt crisis.

However, economic pressure has been mounting for China after its strong post-pandemic rebound in the first quarter of this year. China’s economy grew by 4.9 per cent in the third quarter of 2021 compared with a year earlier, down from the 7.9 per cent growth in the second quarter.

Yu, who has said China should cut exposure to US Treasury bonds, also said persistent inflation would result in diminishing returns on Chinese investment in US government bonds.

Tensions between the US and China have been rising since 2018, leading to calls from China’s circle of policymakers to limit exposure to the US dollar as Washington issues large amounts of US Treasury bonds to fund its deficits.

China is currently the second largest foreign owner of US Treasury bonds, holding US$1.047 trillion worth of US government debt as of September, according to the latest data from the US Treasury.

Following a buying spree that peaked in 2014, US Treasury bonds have remained a staple investment in China’s foreign exchange reserves, which totalled at US$3.222 trillion at the end of November.

“We need to prepare in advance. It’s difficult to predict when it will become a problem, but it may happen,” Yu said. “In the short term, the US exiting its quantitative easing programme is unfavourable for China’s economy. In the long term, the impact will become more serious.”

US Federal Reserve chairman Jerome Powell has said the US needs to be ready to respond to the possibility that inflation may not recede in the second half of next year, fuelling expectations a rate hike could take place as soon as next June.

Diverging monetary policy with the US could have many consequences for China, which is poised to expand support for the economy.

A US rate hike could strengthen the value of the US dollar against other currencies, including the yuan, making borrowing in US dollars more costly for Chinese companies.

More importantly, it could trigger a fund outflow from China, adding pressure on the value of the yuan, a primary concern for the Chinese government.

In August 2015, after the US Federal Reserve began signalling a rate hike, the PBOC surprised markets by devaluing the yuan, leading to a mass capital exodus and a record fall in its foreign exchange reserves.

“Right now, the crucial question is the yuan exchange rate [against the US dollar],” said Zhong Zhengsheng, chief economist at Ping An Securities, who was also a speaker at the virtual event yesterday.

“If the Fed rate hike takes place in June next year, our monetary policy obviously should not be tight, but can we ease?

“I think this decision depends on whether we should let the yuan exchange rate [against US dollar] move – allowing for significant depreciation and flexibility.”

China’s central bank announced late on Thursday it will raise the reserve requirement ratio from 7 per cent to 9 per cent from Wednesday next week to curb the yuan’s rally against the US dollar.

“With the US tightening monetary policy just when China is starting to ease, and the odds of more action in currency markets rising, the most likely trajectory for the yuan in the next several months is to depreciate both against the dollar and on a trade-weighted basis,” said Gavekal Economics in a note today.

Analysts believe that China needs to accelerate monetary and fiscal policy expansion to support growth and reduce the negative impact from a potential US rate hike.

“The inflow of funds [to Chinese securities] in 2020-21 set a historical record, causing concerns about future capital outflows. However, unlike in 2015, we face some favourable conditions,” said CICC Research in a note on Wednesday.

“If monetary easing lags behind, then the easing may be understood as a confirmation that economic fundamentals are worse than expected, raising more challenges when it comes to management cross border capital flow,” CICC said.

“From this perspective, the pace of monetary easing and stabilising credit should take place sooner rather than later.”

Authors: Frank Tang, Amanda Lee, SCMP

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