The co-dependent relationship between the US and Chinese economies is about to take a new twist. As the US Federal Reserve finally gets serious about monetary tightening, an export-led Chinese economy could come under pressure. China can ill afford to ignore this risk.
America’s central bank has only begun to turn the screws. Despite nine months of measured hikes in interest rates, the federal funds rate currently stands at just 2.75 per cent. That is less than the annualized increase in headline Consumer Price Index (3.1 per cent) and only slightly above the core CPI inflation rate (2.3 per cent). There can be no mistaking the persistence of extraordinary monetary accommodation.
The Fed can ill afford to play it cute and seek a “neutral” policy stance. The combination of accelerating inflation — highlighted by figures this week showing the march CPI at a 31-month high — a runaway current-account deficit, and an emerging property bubble implies that the federal funds rate may need to be pushed into the restrictive zone, possibly as high as 5.5 per cent.
This next phase of Fed tightening will impose internal costs on the domestic US economy and external costs on the rest of the world. For the US, the burden will be felt most by the asset-dependent American consumer. To the extent that the interest-rate underpinnings of asset markets deteriorate — especially for property — a shift from asset- to income-based saving can be expected from US households. The reversal of nearly a decade of excess consumption growth should then follow.
That is where the Chinese economy enters the equation. An externally dependent Chinese economy is very much in the cross hairs of a Fed tightening aimed at the American consumer. Unlike the US, a consumer-driven spending machine, in China, the name of the game remains exports and export-led investment. Chinese exports have grown from 20 per cent of gross domestic product in 1999 to 35 per cent in 2004, while the investment share has hit an astonishing 50 per cent. China’s biggest export market is the US, absorbing fully one-third of its overseas shipments in 2004.
With the coming Fed tightening likely to squeeze US consumption, Chinese policymakers would be wise to resist imposing a new round of tightening measures even though the economy was still growing at a 9.5 per cent rate in the first quarter of 2005. Recent signs suggest Beijing has gotten the word. Apart from focusing on property, no new major tightening efforts appear to be in the cards.
But new flaws are starting to show up in China’s policy strategy. The currency peg constrains Chinese authorities from using traditional monetary policies for macro stabilization. Rather than adjust interest rates to control the price of credit, administrative measures are used to control the quantity of credit, as occurred last spring and seems to be occurring again.
However, because of the renminbi peg and its linkage to a still-accommodative Fed, China continues to receive large speculative capital inflows, which may well overwhelm the impacts of administrative tightening measures.
That is what appears to be happening: China’s latest efforts to slow property markets are not having much effect. Indeed, recent reports indicate that Chinese lenders have yet to alter mortgage loan guidelines in the aftermath of recent central bank actions aimed at boosting down payments from 20 per cent to 30 per cent. At the same time, there seems to be no drop in the appetite for home buying, according to a recent survey conducted by the People’s Bank of China. The more China pursues a pattern of unbalanced growth, the tougher it seems to break the habit.
There is an important silver lining — China’s steadfast commitment to reforms. The Chinese leadership is unflinching in its efforts to dismantle the state-owned economy and is eliminating some 8m to 10m jobs each year. It has to perform the delicate balancing act between export- and investment-led growth, on the one hand, and stability, on the other, to temper the extraordinary employment pressures created by these reforms. That’s a Herculean task the west often loses sight of.
Coping with China is one of the great challenges of globalization, especially for US politicians, for whom China bashing has now become all-too-convenient. But China also needs to adapt better to changing global circumstances. The strategy that worked so well in the early stages of development may be in need of an overhaul as China comes of age and faces its own imbalances. In that important respect, by going after the asset-dependent American consumer, the Fed may be doing China a real favor.
Note: This article appeared as an editorial comment in the Financial Times on April 21, 2005. It is based on an earlier essay, “The Fed and China,” published in Morgan Stanley’s Investment Perspectives, March 28, 2005
