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The Fed has China in a Tough Spot

Key Points
  • Rate hikes by the Federal Reserve put pressure on the People's Bank of China to respond to manage the currency and capital flows.

  • The slowdown in government infrastructure spending is being offset by a revival of housing construction, which is vulnerable to rate hikes.

  • Additional Fed rate hikes in 2017 may put increasing strain on China and revive worries about growth, currency and capital flows as tough trade negotiations near, threatening a return of global stock market volatility.

Last week, the U.S. Federal Reserve raised rates by 0.25%, its third hike since December 2015. The following day, China’s central bank hiked rates by 0.10% for the second time this year (making for a combined 0.20%). The central banks of the U.S. and China are the only major central banks hiking interest rates, as you can see in the table below.

Only two major central banks have been hiking rates

*MLF is not a traditional policy rate

Source: Charles Schwab, Bloomberg data as of 3/19/2017.

China is in a tough spot

Rate hikes by the Federal Reserve put pressure on the People’s Bank of China (PBOC) to do the same. Differences in one-year interest rates between the U.S. and China play an important role in driving the relative value of the dollar and the yuan, China's currency, as you can see in the chart below.

Changes in relative interest rates play key role in currency moves

Source: Charles Schwab, Bloomberg data as of 3/19/2017.

Changes in relative interest rates play key role in currency moves

The yuan had been falling against the dollar, risking tougher trade negotiations by China with the U.S. later this year. If China were to take no action on rates, it would mean a further narrowing of the U.S.–China interest rate differential that risks putting the yuan back on a downward path and could trigger the resurgence of capital outflows. By hiking rates, China is supporting the yuan versus the dollar and discouraging capital outflow but risks the return of falling prices for factories, pushing up costs for over-indebted businesses, and slowing the economy again after policymakers worked hard last year to reaccelerate growth.

Government cutting back

What makes the decision to raise interest rates for the PBOC harder is that it comes at the same time China's government is cutting back on infrastructure spending support for the economy.

Earlier this month, China's lawmakers and government officials met for the annual session of the National People's Congress, China's parliament. They approved the budget which plans for smaller growth in infrastructure spending this year. This spending slowdown already began in late 2016, as you can see in the chart below.

China’s pace of infrastructure spending is slowing

Source: Charles Schwab, Bloomberg data as of 3/19/2017.

China's pace of infrastructure spending is slowing

This is important since the boost to infrastructure spending in early 2016 was crucial to reversing the economic slowdown at the time.

Private sector picking up

A potential offset to the slowdown in government-financed construction is a pickup in private sector building. There has been a sharp increase in the sales of construction equipment over the past six months, while government infrastructure spending has slowed. Historically, changes in the growth rate of construction equipment has led changes in home building by about six months, as you can see in the chart below.

Construction equipment sales pointing to a surge in home construction in China

Source: Charles Schwab, Bloomberg data as of 3/19/2017.

Construction equipment sales pointing to a surge in home construction in China

Any improvement in real estate investment would offer an important support for growth as government infrastructure spending slows. However, a revival in residential construction is sensitive to interest rates. If the PBOC broadly hiked interest rates it could undermine a key support for the economy.

Not all rate hikes are equal

This year, in response to the Fed’s clearer path of rising rates, the People's Bank of China (PBOC) raised the rates it charges on its Medium-Term Lending Facility, (loans which span between 3 to 12 months), its reverse repo rates (on the money it borrows from banks) and its Standing Lending Facility (short-term loans offered to banks). The PBOC moved a lot of different rates, but they weren’t the traditional ones China uses to manage monetary policy.

Central bank target rates vary among countries; for China the traditional rate is the one-year lending rate (often combined with changes to the reserve requirement ratio, which determines how much banks much keep in reserves for the loans they make). Even though the PBOC has raised a number of different rates, it hasn’t touched the traditional policy rate since 2015 when it made a cut.

So what the PBOC did was to find a way to keep the most economically-influential interest rate steady while using specifically-targeted rates to support the currency. Since the economy isn't strong enough to withstand a hike to the one-year lending rate, these moves allow the PBOC to more finely manage credit and currency without having a big impact on broad economic growth or the housing rebound.

What's next?

China responded to the first rate hike of the year by the Fed; potential additional Fed rate hikes in 2017 mean China is likely to be along for the ride. That may force the PBOC to hike the more traditional and broader policy rate if hikes to other targeted rates aren't enough. Doing so could upset China's balance after struggling back against a stock market crash, a $1 trillion slide in foreign exchange reserves, weaker growth, deflation and falling profits.

While worries over China's economy, currency, and capital flows have eased, unless China carefully and effectively uses multiple targeted rates and private sector construction picks up as government spending slows, these concerns may return later this year, sparking some of the same global stock market volatility they did when they last surfaced in early 2016.

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Important Disclosures

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