Worried China braces for the brave new world of Fed tightening

Liquidity is already becoming scarcer and interbank rates are ratcheting higher. Caixin reports growing calls for a cut in the Reserve Requirement Ratio to prevent an incipient crunch, yet the central bank (PBOC) would be courting fate if it loosened policy at this delicate juncture.

The Industrial Bank of China said the PBOC will have to shadow the Fed “passively” to prevent an exchange rate rupture.

Geoffrey Yu, a top strategist at UBS, said the Chinese central bank is willing to tolerate a slightly weaker yuan but will step in to prevent a currency slide. “If they start losing capital they will rein things in. They could make it more expensive to short the currency in the Hong Kong market, and could clamp down further on capital controls,” he said.

The key signal to watch is whether they reverse the recent relaxation of margin rules for “currency forwards”. If they do that, it means that Beijing is seriously rattled. “China is an OK-place on an eighteen month horizon. The big risk is that the US growth cycle accelerates and the dollar rises, then it could be more dramatic,” he said.

Iris Pang from ING said the policy shift in Washington will force Beijing to respond. “The Chinese central bank needs to give the market a clear signal of what it will do next, otherwise investors’ confidence over yuan assets will be eroded,” she told the South China Morning Post.

In a strangely-timed move, Standard & Poor’s chose this moment to strip China of its ‘very strong’ credit rating. The downgrade is likely to irritate President Xi Jinping just weeks before a crucial summit of the Communist Party, intended to exalt his leadership. A challenger – Sun Zhengcai from Chongqing – has been deftly purged.

S&P cut China’s sovereign debt from AA- to A+, back where it was a decade ago. “The downgrade reflects our assessment that a prolonged period of strong credit growth has increased China's economic and financial risks. Since 2009, claims by depository institutions on the resident non-government sector have increased rapidly. The increases have often been above the rate of income growth,” it said.

HSBC China, DBS China, Hang Seng China were degraded in parallel. “We believe these banks, which primarily operate in China, are unlikely to avoid default if China defaulted on its sovereign debt,” it said. The agency said bank loans to China’s private sector have surged by 25 percentage points of GDP over the last two years to 183pc.

The timing of S&P’s downgrade raised eyebrows since China’s credit addiction has been the subject of vocal reports by major watchdogs for at least two years. Moody’s and Fitch already had lower ratings. “This won’t be news to anyone who has kept half an eye on China over recent years. S&P is playing catch-up,” said Mark Williams from Capital Economics.

The bigger problem is that Xi Jinping has failed to grasp the nettle of reform. He has not slimmed down the state-owned behemoths that crowd out the economy and perpetuate a host of destructive pathologies. “Xi’s idea of state-sector reform is to keep them afloat as a way for the party to retain control of the country,” he said.

“They are not shutting down over-capacity. We are hearing that plants are coming back on stream after the inspectors have left. We had hoped they would be more serious about this by now,” he said.

It is a far cry from what is deemed reform in the West. Capital Economics says the risk is that China’s growth rate – the genuine figure based on proxy measures – will drift down towards 2pc by the early 2020s. There lies the middle income trap.

S&P is oddly-late in rebuking Beijing for blowing bubbles. This is the one area where there has been a shift in policy this year. The new super-regulator, Guo Shuqing, is cracking down hard on shadow-banking, targeting the trust companies and fund houses used to evade lending curbs. The concern right now is whether the assault on shadow credit is going too far.

China will have to handle Fed tightening with great care. Hot money funds and skittish Chinese investors are well aware that China suffered capital flight reaching $100bn a month after the Fed tapered bond purchases and then began raising rates in late 2015, an episode that traumatised officials. It also triggered a worldwide stock market rout in early 2016 and a slump in commodity prices.

There has been an uneasy calm since then. The country has engineered another short-cycle mini-boom, driven by a rise in the effective budget deficit to 12pc of GDP (IMF data).

This has revived animal spirits and – oddly in some respects – lifted the yuan to a 15-month high. Capital outflows have slowed. There is a robust flow of foreign capital into the country as new rules let global investors bid for a chunk of the internal $9.5 trillion bond market through ‘panda bonds’.

But this seeming return to business-as-usual has been bought at the cost of greater headaches down the road. The Institute for International Finance calculates that China’s total debt ratio has hit 302pc of GDP, uncharted waters for a developing country without deep and mature markets.

The Chinese economy has been slowing since June as the sugar-rush from fiscal stimulus fades. Fixed investment turned negative in July in real terms. Growth is slipping in steel, cement, cars, and mobile phones. Electricity use is ebbing. House prices in the big ‘Tier-1’ cities such as Beijing, Shanghai, and Guangzhou are falling again.

Rob Subbaraman from Nomura says the whole East Asian region is vulnerable as the financial cycle rolls over and productivity slides. “Asia’s economic sweet spot could soon turn sour,” he said.

Mr Xi will start to tolerate more short-term pain after the party congress next month and that will be a cold douche for the Pacific Rim. “Prepare for China tremors on global financial markets in 2018-19 as China bites the bullet,” he said.

Mr Subbaraman warned that “real bankruptcies” are on the way. This would be sobering experience for a world that takes moral hazard for granted.