The big risks in China’s ‘tightrope’ monetary policy

Although the Federal Reserve refrained from raising interest rates last week, it emphasized that policy makers still believe a gradual adjustment is warranted. On the surface, that’s a market-friendly policy because it means a slower pace of dollar appreciation, which would benefit emerging markets and commodities.
Then there’s China, where a gradual adjustment higher in US rates could mean trouble ahead for that nation’s economy and markets. The US federal funds rate and Chinese interest rates are linked via a “trinity” of foreign-exchange rates, capital flows and monetary policy. When the fed funds rate rises, the yuan tends to depreciate versus the dollar, and that can trigger capital outflows from China. The People’s Bank of China must then respond by conducting policy in a type of ‘corridor’ system.
As the word trinity suggests, the PBOC’s ability to achieve balance can be challenging. Indeed, as the bank has gradually adjusted reverse repo rates, government bond yields have been on the rise, climbing above the upper end of the corridor. The rise in yields has been caused by uncertainty about the appropriate level of the repo rate to balance financial risks without engineering a credit crunch. Already, there has been a material decline since February in China’s “credit impulse,” which is essentially the sum of corporate issuance, interbank liquidity and currency reserves.
The PBOC now faces the inherent complexity of running a ‘tightrope policy,’ steering the repo rate while also cracking down on excessive leverage in the financial system. It doesn’t take much for tightrope policy to go awry, as evidenced by the European debt crisis of 2011 to 2012 when the ECB tightened financial conditions by managing liquidity. Bond yields for those nations on the periphery of the euro zone shot above the ceiling of the ECB’s corridor, resulting in a situation where liquidity and solvency became interchangeable, and governments lost market access.
China faces a nearly identical problem, as rising government bond yields create issues for municipal bonds that local Chinese governments rely on heavily to finance projects. In a recent PBOC working paper, staffers concluded the central bank can manage the trinity of a free-floating currency, capital flows and (independent) monetary policy as long as financial stability is ensured and policy coordination is communicated. The critical variable is real, or inflation-adjusted, interest rates, which have been rising consistently since 2011. While the deleveraging that is underway in China’s economy has reduced the growth of money supply dramatically, a growing divergence between higher long-term real rates and a deceleration in broad money growth suggest the central bank could lose control over financial stability.
Without a clear sense of what the neutral repo rate should be, tightening measures designed to crackdown on financial excesses are insufficient to stave off a potential debt crisis in the world’s second-largest economy. If such crisis were to occur, the potential for negative consequences for the global economy and trade are significant.

— Bloomberg

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion