Chinese Blackmail?

Is China blackmailing the Fed not to hike US interest rates by threatening to devalue its currency, the Yuan? It just might be. It would certainly be a powerful threat. The US will buy nearly $500 billion worth of goods from China this year. A Yuan devaluation would make those imports from China cheaper which would push down the US price level and frustrate the Fed’s efforts to achieve its 2% inflation target. It could cause outright deflation in the United States.

China is in a very difficult position. For decades, the country has achieved exceptionally rapid economic growth. Now, however, its growth model of export-led and investment-driven growth has reached the end of the line. The global economy is too weak to allow China’s trading partners to continue buying more and more goods from China every year.

Weak global demand is exacerbating China’s crisis of excess industrial capacity at home. After decades of very rapid investment growth, China now has excess industrial capacity across every industry on a massive scale. Producer prices have fallen 43 consecutive months as oversupply continues to flood into glutted markets. Falling product prices are pushing a growing number of Chinese corporations toward bankruptcy. Non-performing loans within the banking sector are rising rapidly, increasing the possibility of a new systemic crisis within the financial sector. Additional investment would only make all these problems worse. Therefore, China has no choice but to invest less.

Now that China has begun to invest less, it requires fewer raw materials. Consequently, it is importing fewer commodities. That explains the collapse in global commodity prices over the past year. So now, China is not only buying less from the rest of the world, but it is also paying much less for what it does buy. Therefore, Chinese imports have fallen at a double-digit annual rate all year. All of the commodity producing countries that had benefited for so long from the great China boom are now suffering. In turn, they can no longer afford to buy as much from China as they once did. Weak demand from both the emerging markets and the developed economies means that Chinese exports are now contracting on a year on year basis, too.

This difficult situation has been made much worse for China by significant Yuan appreciation. Between 1995 and 2005, China kept the Yuan pegged to the Dollar. Since then, China has gradually raised the value of the Yuan relative to the Dollar by 30%. As long as the Dollar was weak against other currencies the appreciation of the Yuan relative to the Dollar was not too painful. But that began to change in 2013 when the Bank of Japan launched Quantitative Easing to weaken the value of the Yen. The following year, the European Central Bank followed suit. As a result, the Yuan has appreciated by 54% against the Yen since August 2013 and by 22% against the Euro since March 2014.

If the Fed now begins to hike interest rates, the Dollar will appreciate further against the Yen and the Euro; and, since the Yuan is tied so closely to the Dollar, it will appreciate further against the Yen and the Euro, too. Further Yuan appreciation would cause an even greater contraction in Chinese exports. This, China cannot tolerate.

Market participants had expected the Fed to increase US interest rates at its September FOMC meeting. The Fed had been signaling that move for months in advance. On August 11th, China sent tremors throughout world markets by unexpectedly devaluing the Yuan by roughly 3%. Commodity prices, the currencies of the Emerging Markets and equity prices all tumbled. Most of the major equity markets corrected by more than 10%.

I believe this small devaluation was meant to be a warning to the Fed. The message was clear: If you hike interest rates, we will devalue. In September, the Fed did not hike.

So, now, the Fed is in a bind. If it does not increase US interest rates soon, there is a risk that the US stock market and property market will be blown into new bubbles. (Stock prices recovered almost all their earlier losses after the Fed didn’t hike in September.) On the other hand, if the Fed does increase interest rates, then China is likely to devalue the Yuan, thereby exacerbating the already intense downward pressure on global prices and profits.

The Fed next meets on December 15-16. It will be interesting to see if China sends another warning before then. My feel is that China is not bluffing. In fact, it may only be a matter of time before China devalues again regardless of whether the Fed hikes or not. China is heading for a hard landing and it’s running out of options.

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