China’s debt spectre could haunt Fed’s policy
Back then, I said that US monetary policy is not made in Washington, it’s made in Beijing. Joachim Fels, global economic advisor
HONG KONG: In September 2015, the US Federal Reserve cited risks from China as a key reason for delaying its first interest rate hike in a decade.
A wall of Chinese debt maturing in the next few years could jolt the country back into the US central bank’s policy deliberations.
Two years ago, it was a collapse in Chinese stocks, a surprise yuan devaluation and shrinking foreign exchange reserves that roiled financial markets that delayed the Fed, but it did raise rates three months later and has tightened further since.
Now, some see risks emerging in China’s dollar-denominated bonds that could give the Fed greater pause for thought as it raises rates, even as other central banks signal a shift from ultra-easy policy.
To be sure, Fed officials have not publicly flagged China’s debt as a major risk in their policy discussions.
However, debt analysts point to the possibility of another September 2015 moment in which the Fed takes its cues from concerns about China.
“Back then, I said that US monetary policy is not made in Washington, it’s made in Beijing,” said Joachim Fels, global economic advisor at bond giant PIMCO.
“China does have a major impact on monetary policies elsewhere ... This year has been smooth sailing for global central banks because there were no shockwaves from China but I expect that to change if we think beyond the next few months.”
The outstanding amount of dollar bonds issued by Chinese entities has grown almost 20 times since the 2008-09 global financial crisis to just over half a trillion dollars, according to data from the Bank for International Settlements.
Since September 2015, it has grown almost 50 per cent.
China’s dollar bonds are now almost a third of the emerging market total dollar issuance, up from a quarter in September 2015 and less than 5 per cent before the Fed first began printing money in December 2008.
A fifth of China’s dollar bonds mature within a year, according to BIS data. More than half are due in the next five, Thomson Reuters data show.
If US borrowing costs start rising as a result of the Fed’s exit from its unconventional monetary policy, that debt would have to be rolled over at higher costs, chipping away at the real economy in China.
Alternatively, Chinese companies might decide to refinance their debt in local currency, creating weakening pressure on the yuan.
Either development would reverberate globally and create a major external challenge for Fed policy.
For its part, the Fed doesn’t see any immediate dangers with China’s dollar debt.
“You’ll find if you look at China they certainly have dollardenominated debt but ... you’ll see that they are not as reliant on external debt as people might have thought,” Dallas Fed chief Robert Kaplan said in Mexico City on Friday.
Also, a significant portion of Chinese dollar borrowing makes economic sense – such as companies funding overseas investment projects.
And if those dollars are converted into yuan, they could help ease any weakening pressure on the Chinese currency.
For now, dollar borrowing conditions remain stable with 10-year benchmark US yields still low by historical standards, despite four Fed rate hikes since September 2015. Broadly, the dollar is as strong now as it was back then.
Indeed, the bigger risk focus for many analysts currently is not China’s dollar bonds, but its local currency debt, which ratings agencies estimate to be almost three times the size of the economy.
But analysts say that the longer China’s rapid accumulation of dollar debt continues, the harsher the future adjustment for the economy will be, especially if lenders start repricing Chinese credit risk.
“Regardless of how you cut your pie, you’ll discover debt is a big problem. China has made a major contribution to global leverage since 2008,” said Aidan Yao, senior emerging Asia economist at Axa Investment Managers.
“When markets start to wobble, there’s a feedback loop that has an impact on the Fed’s trajectory. Policy normalization is not going to be in a straight line.”
A forced deliberating could renew weakening pressure on the yuan as dollars find their way out of the country, although capital controls help mitigate that risk.
“While the market generally believes that money flows have stabilized and the worst of the yuan’s slide is over, the reality may well be the opposite,” said Kevin Lai, chief economist for Asia exJapan at Daiwa Capital Markets.
“As more dollar debt has been taken up, the pressure on outflows is merely being delayed. Such pressure is also getting bigger, not smaller. This would eventually feed into even bigger downward pressure for the yuan.”
The Fed bought US Treasuries and mortgage-backed securities (MBS) for about six years in a program known as “quantitative easing” which kept interest rates at record lows to spur borrowing and economic recovery.
But at its June meeting this year, as well as raising interest rates for the third time in six months, the Fed also announced a plan to begin by letting US$6 billion a month in Treasuries mature without reinvestment and to increase that amount at three month intervals up to US$30 billion.
Similarly, the Fed said it would run down its agency debt and mortgage backed securities by US$4 billion a month until it reaches US$20 billion.
Now, the European Central Bank (ECB) also appears likely to decide later this year on when to scale back its monthly bond purchases. When ECB President Mario Draghi first hinted at the prospect last month, world bond yields rose sharply for a while.
Moreover, Canada’s central bank raised interest rates for the first time in seven years this month, and the Bank of England is expected to raise rates next year to combat rising inflation.
The Fed led the way in tightening monetary policy as the global economy recovered from the 2008 recession but must now determine how plans by other central banks’ plans may affect their own policy.
While a stronger European economy has been welcomed by the Fed, lessening risks to the global economy, a move by major central banks to all tighten monetary policy simultaneously has not been seen for a decade.
“The effects of ECB tapering are not limited” to euro zone countries, Cornerstone analyst Roberto Perli wrote recently.
Draghi’s comments in June drove up 10-year Treasury yields by the most since the US election last November, and a move by the ECB to stop printing money could prompt the Fed to slow its plans for fear that financial conditions would tighten too fast.
When Fed policymakers meet on July 25-26 they will need to decide a start date for reducing their bond holdings or leave more time to evaluate what Fed Governor Lael Brainard recently cited as a possible “turning point” in global monetary policy that may affect economic growth.
The Fed’s plan to reduce its portfolio may well push up longer term bond yields, driving up long term borrowing rates for business, and lead to higher mortgage rates for the housing industry.
Analysts have made comparisons to the so-called ‘taper tantrum’ in 2013 when world bond yields jumped after the first signal from the Fed that it might tighten policy.
“Just how sturdy is this recovery in the face of rising long rates? I would be a little more nervous about that,” said former Fed research director David Stockton, now a senior fellow at the Peterson Institute for International Economics. “I would not feel any urgency” to reduce the balance sheet for now.
Fed officials have said they think the balance sheet reductions should begin soon, and analysts have pinpointed September as the likely month the Fed will stop reinvesting the proceeds it receives as securities mature.
But the minutes of the Fed’s June meeting indicated a split between officials ready to start balance sheet reductions in ‘a couple of months’ and those wanting to wait for more economic data.
Since then the number of hurdles for the Fed to jump before tightening policy further has multiplied.
Global long-term bond yields jumped after the ECB indicated it may begin tightening policy last month and may rise again.
Annual US consumer price inflation increased by 1.6 per cent in June, the smallest rise since October last year, and year-on-year inflation has been declining since February when it hit 2.7 per cent, reducing the need for the Fed to tighten.
And the prospect of the US Congress failing to raise the federal debt ceiling before the Treasury runs out of cash in October has already driven up yields on three-month Treasury bills due to mature on Oct 19 to 1.17 per cent on Friday, near the highest levels since October 2008.
As a result the chances of a third rise in the Fed funds rate this year recently fell below 50 per cent, according to CME Group’s FedWatch.
Complicating matters more, each central bank has two policy tools in play – a target interest rate, and a massive balance sheet accumulated. Between them, the Fed and ECB own roughly US$9 trillion of assets.
Fed Governor Brainard has already pointed out how hard it may be to sort out what it will mean if the ECB starts to scale back its bond purchases at the same time the Fed is both raising short-term interest rates and shrinking its balance sheet.
“I will want to monitor inflation developments carefully, and to move cautiously on further increases in the federal funds rate, so as to help guide inflation back up around our symmetric target,” Brainard said. — Reuters