Why is Xi Jinping so worried about US Fed tightening?

His arguments seem quite benevolent. Global cooperation.

US tightening could hurt developing countries at this delicate time. This, of course, is perfectly correct and has always been so. But it would be worse to let inflation in the United States turn into a wage-price spiral. This would result in even higher interest rates in the end. And the Fed is already so behind.

Chinese economists probably know all of this. So what is it really about?

China does not have open capital markets, and because of this most yuan currency trading takes place overseas in a parallel market.

China can, of course, influence the offshore market forward rate with swap transactions through its own state banks. But the truth is that the offshore forward rate cannot deviate from the yuan spot rate too far or for too long without pressures on capital flows becoming stronger, requiring a movement of the yuan, an adjustment capital controls and/or changes in Chinese interest rates.

If these pressures go in a direction favorable to China’s political objectives, the yuan may move. But otherwise, China would be forced to adjust its policy levers.

While many observers argue that China is trying to lower the exchange rate for trade reasons, the matter is more complex in practice.

With US interest rates at zero and Chinese policy tightening after the misguided credit boom that followed the GFC, the exchange rate was able to appreciate against the dollar for long periods of time.

Indeed, it was only during the 2015-2017 period, when China was close to recession – when rates were cut just as the United States began its first attempt at monetary policy normalization – that the yuan was allowed to depreciate somewhat.

Chinese corporate borrowing strategy is exactly the story of the Asian financial crisis of the late 1990s.

The US failed to sustain that 2017-19 attempt to raise interest rates and lower QE, and quickly reverted to its pro-financial markets stance.

The most likely explanation for this was the focus on the huge edifice of leverage via derivatives between banks and shadow banks that had been allowed to build since the GFC.

Zero interest rates and QE will do it, and the return to free money has caused a collective sigh of relief in the US financial system.

The sigh of relief was also heard in China, where the favorable interest rate differential allowed yuan strength to reappear.

The current outlook, however, is one of US tightening. This will likely remove that interest rate differential, especially with China trying to cut rates at the same time.

What is going on? Why does China seem to prefer to avoid a depreciation that would favor its foreign trade?

The answer is that many Chinese companies (and in particular some real estate companies such as Evergrande) have been encouraged to borrow in US dollars while depositing the proceeds in yuan cash deposits in China.

This is an excellent strategy while the yuan is appreciating, but not if it is falling.

China has $9 trillion ($12.8 trillion) in foreign currency debt, about two-thirds of which is denominated in US dollars. Although it also has foreign currency assets, these are not in the right places to offset corporate pressures.

Chinese corporate borrowing strategy is exactly the story of the Asian financial crisis of the late 1990s.

Research shows that for foreign borrowing Chinese companies, a depreciation of the yuan would cost more in service fees than the companies would earn through trade, and especially if they are real estate companies that do not export anything.

This is a very tender period for China, where economic activity is weak and the government wants to ease monetary policy.

With the Fed poised to resume what it attempted to do in 2017, the yuan will likely face depreciation pressure. Chinese corporate debt servicing problems will get even worse. Some major companies are already struggling, as recent defaults have shown.

The misguided rush to catch up with the US via overinvestment and debt in China is now colliding with the equally misguided US attempt to avoid providing a proper policy framework for the financial system.

The world’s two largest economies have shown a failure to understand two of the most rudimentary lessons in economic history: (i) forcing investment at a rate that results in a potential return below the cost of financing will cause a crisis to the end, as with the Asian banking crisis of 1997; and (ii), that the only time when real interest rates were significantly negative in the post-war period (pre-GFC) was in the presence of the distortion of the interest rate ceiling, fiscal spending and easy money,

The ultimate result of the latter was the last major episode of inflation and global pain for the global economy. The same is true with the QE/zero rate distortion combined with fiscal expansion.

I suspect Xi’s wishes will fall on deaf ears in the United States. I also suspect the US will be running faster to catch up to where it should have been years ago than China will be, with its need to endure the pain of dealing with its overinvestment problem.

About Jimmie T.

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