China’s stability dilemma: currency and equity woes

China is facing a sharpening dilemma between a perceived need to keep interest rates low to help the economy manage its debt burden, and downward pressure on the Chinese yuan and foreign reserves, Fitch Ratings said.

The authorities have reduced interest rates steadily since November 2014 in a bid to help the economy manage its debt burden – which is high and still rising – at a time of slowing growth. However, lower rates are helping to drive capital outflows, weakening the yuan, it said in a statement, adding that the yuan had depreciated by just under 6% versus the US dollar since the authorities began to allow the unit to weaken in mid-August 2015.

“The 11 December decision by the People’s Bank of China (PBOC) to measure the yuan against a broader basket of currencies and not just the US dollar could also contribute to further yuan/US dollar weakness. China’s official foreign reserves have fallen by 8.8% ($321bn) since August as the authorities have sought to blunt the depreciation,” it said.

Fitch estimates capital outflows, excluding foreign direct investment, to have totaled $909bn between 2Q14 and 3Q15, and are likely to have exceeded $1trn as of end-2015.

The onset of sustained capital outflow from China may be linked with the intensification of the authorities’ anti-corruption campaign. However, the pattern of flows may also be connected with the narrowing pick-up in yield on yuan assets versus the dollar, as Chinese rates have fallen while those in the US have begun to rise, the statement said.

Fitch said the spread on two-year government paper between China and the US has narrowed from 340 basis points in July-August 2014 to just 150 basia points in December 2015. This is due mostly due to the cuts in Chinese interest rates, but US two-year rates have also risen by about 50 basis points over the same period as the U.S. Fed embarked on its first interest-rate hike in nine years in December.

Lower domestic rates are targeted partly at helping to deal with the high and rising debt. The officially reported stock of aggregate financing, excluding equity raising, rose to 196% of GDP by end-September 2015, up from 187% at end-2014. The aggregate financing growth rate has slowed over that period to about 12.5% from 18%, though Fitch expects it to pick up again as monetary easing begins to work through the system.

The weighted-average whole economy interest rate calculated by the PBOC has come down from 7 percent to 5.7 percent since June 2014, which has helped to stabilise growth.

A country cannot simultaneously allow free capital flows and control its exchange rate and domestic interest rates. This is at the core of the policy dilemma China faces between the imperative of keeping rates low for domestic stability against pressures on external stability as exemplified by the exchange rate and reserves data. China still operates capital controls, but the scale of flows suggests that these have become porous, Fitch said.

Fitch does not expect the authorities to resolve the dilemma with a large trade-weighted yuan depreciation, as this would risk creating additional uncertainty and further undermining policy credibility. It would also work against the broader priority of rebalancing the economy by strengthening the position of exporting corporates.


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