USA, China are rushing in opposite directions to save the global economy
USA, China are rushing in opposite directions to save the global economy

USA, China are rushing in opposite directions to save the global economy

The newfound autonomy of the People’s Bank of China may prove to be an unlikely source of support for the recovery

Chang Shu, Tom Orlik and Tom Hancock, Bloomberg

January 27, 2022 at 17.35

Last modified: January 27, 2022, at 17.41

The People’s Bank of China, unlike the US Federal Reserve, finds itself entering 2022 under pressure to stimulate growth rather than tackle inflation. Photographer: Andrea Verdelli / Bloomberg

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The People’s Bank of China, unlike the US Federal Reserve, finds itself entering 2022 under pressure to stimulate growth rather than tackle inflation. Photographer: Andrea Verdelli / Bloomberg

The firefight between growing economic threats and a continuation of the global recovery: an impressive concrete and glass structure in the heart of Beijing’s financial district, elephant statues guarding the door, the Chinese flag waving.

It is the headquarters of the People’s Bank of China, which unlike the US Federal Reserve has switched to a stimulus mode to protect the world’s largest growth engine from Evergrande property downturns, virus shutdowns and higher global borrowing costs as the Fed tightens.

With the task of averting destabilizing unemployment and a debt implosion, Governor Yi Gang’s PBOC has a newfound autonomy that was unthinkable a decade ago and that may prove crucial to keeping China’s expansion above 5% this year.

It’s summed up in a new mantra heard from China’s economic policy makers, roughly translated: “We set our own agenda.”

Decades of stop-start reform have led to freer currency movements and more refined capital controls, meaning that even when the Fed urges a first rate hike since 2018, China’s central bank has autonomy to move in the other direction.

And after avoiding the widespread stimulus from Western peers when the coronavirus first hit in early 2020, the PBOC finds itself with dormant consumer prices and room to “open up the monetary policy toolbox.”

For China, it sets the stage for a triple dose of support from increased lending, lower borrowing costs and – potentially – a weaker yuan that would increase exports. PBOC has already made a payout on interest rate cuts, and most economists expect more to come.

By China’s normal standards, the premium for successful stimulus will be small – more preventing a continued slowdown in growth than driving a new acceleration. And past political mistakes – which allow a debt bubble to expand to enormous proportions – add risk to the outlook and limit the PBOC’s room for maneuver.

However, if Yi and his team can handle it, the boost from PBOC stimulation should at least offset some of the barriers to global growth from a tightening of the Fed. Projections from the International Monetary Fund show that China is set to contribute more than a quarter of the total increase in global gross domestic product in the five years to 2026, exceeding the US share of around 19%.

Those with the most exposure to China’s economy – commodity exporters like Australia and Asian neighbors like South Korea – will breathe a sigh of relief if efforts to stabilize succeed. Countries with weaker ties to China, but more at risk as the Fed tightens – like Mexico and Turkey – have less to gain.

Many investors are betting on a recovery in Chinese assets after the MSCI China stock index limped the S&P 500 by 49 percentage points last year, the largest gap since 1998. Strategies at Goldman Sachs Group Inc., BlackRock Inc. and HSBC Holdings Plc are among those who have become bullish on the country’s equities.

Divergent PBOC and Fed policies reflect divergent rates for the Chinese and US economies.

In the US, the combination of high energy and food prices, supply shortages and rising rents has pushed the consumer price index to 7% year-on-year. Markets now see a first Fed rate hike in March as close to a security, with the hawkish tone of President Jerome Powell at the January FOMC press conference confirming the view. Bloomberg Economics forecasts four more during the year, as well as a quick start to driving assets from the inflated balance sheet.

PBOC is moving in the opposite direction. Its 10-basis-point cut in borrowing costs last week and a promise to use additional tools were a clear signal that priority has shifted away from curbing financial risks and toward supporting growth.

The biggest draw comes from the sector that was once China’s most reliable growth driver – real estate. A default by the giant developer Evergrande has shaken market confidence and tightened financing conditions. Sales and new construction are now falling by leaps and bounds. With property contributing – directly and indirectly – around one in four yuan of GDP, it is set to weigh on everything from demand for iron ore to the cost of home electronics.

Then there is the virus. With the Xi’an eruption triggering more Covid-19 cases than any other since the initial wave in early 2020, and the arrival of global athletes for the Winter Olympics adds to the petri dish, there is a risk of further lockdowns. As the experience of the outbreak in the summer of 2021 showed, even short-term and targeted measures to control the spread of the virus can take a heavy toll on consumer consumption.

Pull these pieces together and China again faces the risk of a significant blow to growth.

A repeat of the massive decline in production seen in early 2020 seems unlikely. Yet the combined impact of national property declines and local closures could be severe. In its latest report on financial stability, the PBOC envisioned a worst case, where growth falls close to 2% – well below the consensus forecast of 5.2% for 2022 and below even the most pessimistic forecast in Bloomberg’s study of economists.

For the central bank, the best chance to steer a path away from such terrible scenarios lies in reaping the fruits of past reforms.

It’s an idea from the academy that – from former governor Zhou Xiaochuan to his successor Yi – has had a persistent fascination with top PBOC officials: the impossible trilemma. It is the theory that an economy can not control its exchange rate, open to cross-border capital flows and set its own interest rates at the same time – it must choose two of the three.

China’s experience illustrates why.

In 2002, when Zhou took over as head of the central bank, China’s yuan was pegged to the dollar. The capital account was in theory closed, but in practice it was easy to evade controls and move funds in and out of the country.

As a result, the PBOC was at the corner of the trilemma with limited monetary policy independence. Set interest rates too high relative to the Fed and there would be a massive capital inflow. Too low and capital would flow out.

With the yuan undervalued, interest rates limited within a narrow range, and raw credit ratios the most important instrument for managing ups and downs, the economy ran hot and asset prices skyrocketed. The seeds for later problems – like the Evergrande property bubble – were sown.

The movement towards more market-driven exchange rates began in 2005 with a one-time strengthening of 2% against the dollar. The road ahead was far from slippery. Slow progress was a constant source of irritation for the United States – which saw an undervalued yuan as an unfair source of competitive advantage for China’s exporters. Some reform steps failed – as when a mini-yuan devaluation in 2015 triggered a global market panic.

Nevertheless, in the years that followed – with stops, starts and big mistakes along the way – PBOC moved the yuan towards fair value and virtually eliminated daily market interventions. The careful process has moved China to a new regime with a close-to-market exchange rate, targeted capital controls and monetary policy that is now more independent from outside influence.

“Because China’s exchange rate policy has become more flexible, it has become much easier to maintain monetary independence,” said Yu Yongding, a former PBOC adviser and longtime advocate for the yuan liberalization. His old colleagues agree. In their monetary policy report at the end of 2021, the yuan flexibility of PBOC cities is one of the major reasons for resilience when the Fed tightens.

A refined set of capital controls also plays a role. Although China allows more two-way movements in its currency and more global investors to pick up its assets, strict control remains over the ability of individuals and companies to move money abroad. A shift in economic wisdom in the West over the past decade has led the IMF to support capital controls, which it had once called for the abolition of countries.

For China, the benefits of reforms cannot come quickly enough. Lower borrowing costs and ample liquidity will help prevent contagion from the Evergrande standard, which is spreading too far. They should also stimulate investment – at least offset some of the resistance as real estate construction falls.

Previously, if lower rates drove the yuan weakness, it would be a panic signal that required the PBOC to wade in to stabilize the market. Now, accepting that the yuan is a two-way bet, currency weakness would be an additional benefit of helping drive export earnings.

For the rest of the world, the looming threat of accelerated Fed austerity is a stumbling block on the road to recovery. To never miss an opportunity to present China as a force for stability, President Xi Jinping used his speech at the Davos Forum this month to warn about “ severe adverse effects“when the Fed hits the brakes.

The problem is particularly serious for China’s other emerging markets, which face the prospect of capital outflows as US interest rates rise. The prospect of PBOC stimulation, which stimulates Chinese demand, promises at least a partial equalization, especially for countries like Chile and Brazil, which count China among their largest export customers.

For Asia’s central banks and financial markets, the divergence between the Fed and the PBOC will – over time – introduce a new dynamic to navigate. As China’s financial system opens wider, PBOC policy will begin to exert an influence on Asian markets that collide with the Fed’s. From Seoul to Jakarta, central bankers and currency traders must decide whether US or China’s policies are the strongest anchor. Even now, some regional currencies are tracking the yuan more than they used to.

Success in stabilizing the economy is far from guaranteed. The PBOC’s progress on reforms came too late to prevent a debt explosion, which is now close to 285% of GDP. The consequences of this are clear in the Evergrande debacle, and the need to empty the bubble limits the capacity for stimulation.

In a worst-case scenario for the virus – with widespread contagion triggering a new national shutdown – no amount of interest rate cuts or yuan depreciation would prevent a plunge in production.

Yet, at a critical time, the PBOC’s patiently pursued reforms have bought them at least a little more room for stimulus. Will that be enough? China’s leaders, emerging markets, cautiously looking at Fed austerity measures, and investors focused on the risk of debt crisis, hope the answer is yes.

Disclaimer: This article first appeared on Bloombergand published by special syndication agreement.


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