Risk of “Double Tightening” Grows in China

As the Federal Reserve begins its interest rate hike cycle and tightens monetary policy, many developed and emerging market economies have also started to tighten their respective monetary policies in response to soaring inflation, and to the return of international capital to the U.S. dollar market caused by the Fed’s rate hike. As it stands now, developed countries such as South Korea, Canada, New Zealand, and the United Kingdom, as well as more than 30 emerging market economies such as Argentina, have started to raise interest rates. The European Central Bank is also reducing quantitative easing and is expected to start raising interest rates in the second half of the year. In the future, the dollar-dominated international currency will shift from negative and zero interest rates, and the global economy is likely to show “stagflation” as well as recessionary prospects. For China, which is in different economic and monetary cycles, the external monetary policy risks it faces have increased as the Fed accelerates the pace of interest rate hikes. In particular, the potential “double tightening” of international economic growth and monetary policy will not only have an impact on its domestic economy, but also putting pressure on the country’s “self-oriented” monetary policy. In addition, changes in the RMB exchange rate and capital flows will have an increasingly significant impact on China’s economy.

Recently, Guan Tao, global chief economist at Bank of China International Securities, put forward four stages of the impact of the Fed’s interest rate hike on the RMB exchange rate and cross-border capital flows. In the first stage, the Fed’s mild and orderly tightening led to a deceleration in foreign capital inflows to China and a slowdown in the appreciation of the RMB. The second stage is a more aggressive rate hike by the Fed, which will even start tapering at the same time. Guan Tao believes that this may cause the market risk appetite to decline, driving a phase of capital outflow from China, in which case the RMB exchange rate may rise and fall, with two-way fluctuations. In the third stage, if the Fed tightens more aggressively than expected, it could prick asset bubbles and trigger a recession. At this stage, China may not be able to stay out of the way, and the RMB exchange rate may come under renewed pressure. The fourth stage is the resumption of monetary easing by the Fed. Under this change, the RMB exchange rate may enter another cycle of appreciation and bring in capital inflows. Guan Tao believes that the initial phase of the second stage has just begun, and the pressure on the RMB exchange rate is further increasing. Meanwhile, the financial data in the first three months of this year also show that financial capital is flowing outward from the country, which significantly increases the risk of the domestic exchange rate and the financial market. Guan Tao expects this pressure to be even greater in the third stage.

Researchers at ANBOUND had expected a reversal in interest rate differentials between China and the U.S. and capital outflows as the Fed raised interest rates. At present, the impact of these issues on China is limited, as the RMB remains stable and there is still room for monetary policy to promote “stable growth” of the Chinese economy. However, as time changes, the trend of further deterioration in the external situation will inevitably bring new pressure to the domestic economy and financial markets. Although the U.S. may not necessarily be in recession, a growing number of emerging markets are already in trouble, making China face greater risks. Therefore, in the case of “double tightening” is increasingly likely, the lack of U.S. dollar liquidity will make China face unprecedented pressure and challenges, and even repeat the situation of the financial crisis in 1997 and 2008, forcing the domestic monetary policy to adjust accordingly.

The latest data from the United States show that its inflation has reached 8.5% in March, a new high in four decades. Data from the Bank for International Settlements show that nearly 60% of advanced economies now have inflation above 5%, and more than half of emerging economies have inflation above 7%. Amid high inflation and rising geopolitical risks, global economic growth may slow or even slip back into recession. Former U.S. Treasury Secretary Larry Summers said a combination of high inflation and low unemployment historically has spawned a recession. He is skeptical that the Fed can chart a path that will see the country out of its inflationary funk without causing an economic downturn. He added that the odds of a “hard landing” over the next two years are certainly better than half, and quite possibly two-thirds or more. A “hard landing” of the U.S. economy would drag the global economy down, even as it did during the 2008 financial crisis. After all, capital market prices in the U.S. and the developed economies are now well above where they were then. If that happens, U.S. dollar liquidity will shrink further and the impact on other currencies will increase. For China, this would mean not only a contraction in foreign trade, but also turbulence in domestic capital markets as U.S. dollar capital flows out, putting more pressure on the RMB exchange rate. To cope with these worse scenarios, Guan Tao suggested that exchange rate reform, RMB internationalization, opening up of the capital account, foreign reserve management, and foreign exchange management should be addressed to prevent changes in external risks.

Researchers at ANBOUND believe that in order to deal with the above risk scenarios, China needs to strengthen the stability of the RMB and promote a “soft landing” of the economy as soon as possible, which is the basis for a series of financial policies such as exchange rate policy, interest rate policy and capital control. Only when the economy is stable can the capital market and exchange rate be stabilized, and various targeted management policies can play a role. Only by maintaining a stable domestic economy can the country form conditions for stable exchange rates and capital flows in the face of intensified changes in the external environment. Otherwise, China will have to raise interest rates and passively follow the Fed’s policy adjustments. In the context of intensified changes in the external environment and the potential “double tightening”, the country needs to be prepared for “risk prevention” from its policy formulation and judgment of the situation, and be able to anticipate more difficult possible situations in the future. On the one hand, China should strengthen factors for stable domestic economic growth, in particular, strike a balance between its fight against the COVID-19 pandemic and boosting production, so as to prevent the economy from being affected by inappropriate policies. On the other hand, it should strengthen its judgment of the market situation, maintain the foresight of policy adjustment, and formulate policies and policy combinations in advance to deal with various extreme situations.

Wei Hongxu
Wei Hongxu
A researcher at ANBOUND, graduated from the School of Mathematics at Peking University and has a PhD in economics from the University of Birmingham, UK