Why is Xi Jinping so concerned about the US Fed tightening?

US austerity can hurt developing countries in this difficult time. That, of course, is entirely correct and has always been so. But it would be worse to let inflation in the US form a wage-price spiral. This would result in even higher interest rates in the end. And the Fed is already so very late.

China’s economists probably know all this. So what is it really about?

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

Of course, China can influence the offshore market’s forward rate with swap transactions through its own state-owned banks. But the truth is that the offshore forward rate can not deviate from the yuan spot rate for too long or too long without the pressure on capital flows becoming stronger, requiring yuan movement, capital control adjustment and / or Chinese interest rate changes.

If this pressure is in a direction favorable to China’s political goals, the yuan will be allowed to move. But if not, China would be forced to adjust its political levers.

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

With US interest rates at zero and China tightening after the bad credit boom that followed the JRC, the exchange rate was allowed to strengthen against the dollar for extended periods.

In fact, it was not until the period 2015-17, when China was close to recession – when interest rates were cut, just as the US began its first attempt to normalize monetary policy – that the yuan was allowed to depreciate somewhat.

China’s corporate lending strategy is precisely the story of the Asian financial crisis of the late 1990s.

The US failed to sustain this 2017-19 attempt to raise interest rates and downsize QE, and quickly returned to its pro-financial market position.

The most likely explanation for this was the stress on the huge building of leverage via derivatives between banks and shadow banks, which had been allowed to build up since the JRC.

Zero interest rates and QE will do that, and getting back to free money caused a collective sigh of relief in the US financial system.

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

Now, however, there is the prospect of a tightening in the United States. This is likely to eliminate the interest rate differential, especially with China trying to lower interest rates at the same time.

So what’s going on here? Why does China seem to prefer to avoid depreciation, which would favor its foreign trade?

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

This is a great strategy while the yuan is rising, but not if it is falling.

China has $ 9 trillion ($ 12.8 trillion) in foreign currency, about two-thirds of which is denominated in U.S. dollars. Although it also has assets in foreign currency, these are not the right places to offset the company’s pressure.

China’s corporate lending strategy is precisely the story of the Asian financial crisis of the late 1990s.

Research shows that for China’s foreign borrowers, a depreciation of the yuan will cost more in service costs than companies would get by trading, and especially if they are real estate companies that do not export anything.

These are very painful times for China, when economic activity is weak and the government wants to ease monetary policy.

With the Fed resuming what it was trying to do in 2017, the yuan is likely to face a depreciation pressure. The debt service problems of Chinese companies will increase further. Some significant companies are already struggling, as recent defaults have shown.

The misunderstood rush to catch up with the United States through overinvestment and debt in China is now running into the United States’ equally misunderstood attempt to avoid creating an appropriate political framework for the financial system.

The two largest economies in the world have shown a lack of understanding of two of the most rudimentary experiences in economic history: (i) forcing investment at a pace that drives the potential for returns below financing costs will ultimately result in a crisis that with the Asian banking crisis in 1997; and (ii) the only time when real interest rates were significantly negative in the post-war period (before the JRC) was the presence of interest rate distortions, fiscal expenditures and easy money,

The end result of the latter was the latest major outbreak of inflation and global pain for the world economy. The same is true with the QE / zero interest rate distortion combined with fiscal expansion.

I suppose Xi’s desires will fall on deaf ears in the United States. I also suspect that the US will run faster to catch up where it should have been years ago than China will, with its need to bear the pain required to deal with its overinvestment problem.

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