I recently argued that the Fed did not make a mistake in December 2015 by raising interest rates. Rather, it made a mistake by talking up interest rate hikes the year and a half leading up to December 2015. This signalling that future monetary policy would be tightened got priced into the market and affected decisions well before the December rate hike. In so doing, the Fed got ahead of the recovery and helped precipitate a slowdown in U.S. economic activity in the second half of 2015.
That is the domestic side of this story. There is also an international side that I want to revisit here. Specifically, the Fed's tightening leading up to December 2015 catalyzed two important developments in the global economy: the reversal of capital flows to emerging markets and the turning of the Chinese economy into an explosive tinder box.
Consider first the reversal of capital flows from emerging markets. According to the International Institute of Finance, emerging markets in 2015 experienced net capital outflows for the first time in almost three decades. They saw approximately $735 billion in net capital outflows in 2015, of which about $637 billion came from China. So to explain the sudden reversal of capital flows from emerging markets, one really has to explain what happened in China.
One striking manifestation of China's capital outflow is the decline in China's foreign reserves. They peaked in June 2014 near $4 trillion and since then has declined almost $663 billion. Currently, Chinese monetary authorities are burning through about $100 billion of reserves a month. This dramatic turn can be seen below:
So what is driving this capital outflow from China? My contention is that the tightening of monetary policy caused by the Fed talking up of interest rates hikes was behind this outflow. This next figure supports this understanding. It shows how the growth of Chinese foreign reserves appears to be tied to changes in the stance of U.S. monetary policy.
If we zoom in on the period since 2012 and look at China's foreign reserve growth and the expected path of the federal funds rate, we see a similar relationship. Using the 12-month ahead federal funds rate futures contract, the figure below shows that the Fed's talking up of interest rates closely tracks the decline in China's foreign reserves during this time:
So the timing of the Fed's tightening does suggest it was tied to sudden reversal of capital out of China. So what is the mechanism linking the two developments?
The answer is twofold. First, China's currency has been tied to the dollar and through this link Fed policy gets transmitted to China. Fed policy via the dollar, therefore, is an important determinant of Chinese nominal demand and economic activity. To be clear, the Yuan-Dollar link has not always been constant, but it has been steady enough to make Fed policy felt in China. This link can be seen below:
Given this connection, when the Fed started talking up interest rates in the second half of 2014 and continued doing so through 2015, not only did the dollar rise but so did the yuan. Here is the rise of the dollar:
This appreciation of the dollar pulled up the trade-weighted value of the yuan by approximately 15% between mid-2014 and mid-2015, implying a sharp tightening of monetary conditions in China during this time.
This imported monetary tightening could not have come at a worse time for China. Its economic growth was already slowing down as it naturally transitions from a high-growth economy based on heavy industry and a large tradeable sector to low-growth one based more on consumption and a large service sector. In addition, there has been a debt boom in China that started with the large fiscal stimulus of 2008 and continues to this day. This debt boom, in conjunction with a lack of reforms to state-owned enterprises and other parts of the economy, has made the Chinese economy more vulnerable to economic shocks. So, between a natural slowdown and an increased susceptibility to shocks, the Chinese economy was not ready for the Fed's tightening of monetary policy as it talked up interest rate hikes.
Chinese officials, however, were not going to go down without a fight. They tried to offset the effect of the Fed's tightening on the economy by easing domestic monetary conditions. This can be seen in the two charts below. They lowered the benchmark lending rate and the required reserve ratios for banks about the time the Fed started talking up interest rates.
This response by Chinese officials is the second part of the answer for it created a tension. The easing of domestic monetary conditions puts downward pressure on the value of the yuan, while the link to the dollar keeps it propped up. The fundamentals, in other words, are saying the yuan needs to devalue while the exchange rate peg keeps it overvalued. Investors, anticipating this tension cannot last forever, have been rapidly pulling their money out of China in anticipation of a devaluation. The only way to defend the elevated value on the yuan, then, is to burn through foreign reserves. So while there are many moving parts here, the catalyst to the sudden reversal of capital flows seems to be the Fed's tightening of late 2014 - 2015.
Consider now the turning of the Chinese economy into an explosive tinder box. To be clear, China's economy was already going to be a tinder box given the natural slowdown in economic growth and the rapid accumulation of debt. But the Fed's tightening turned it into an explosive one. The tightening of U.S. monetary policy has pushed China into corner where there are no good policy options.
The tightening has significantly overvalued the yuan, some say by 15% or more. And it does not appear likely the Fed will be easing (relative to other central banks) anytime soon. So China appears stuck with an overvalued currency at a time of economic stress in China. What can Chinese officials do?
One option is that they could do a major devaluation of the yuan. China, however, has a lot of external debt, including some $1 trillion in foreign debt owed by Chinese firms. So a devaluation would significantly raise its real debt burden. It could also create a huge deflationary drag on the global economy. We got a glimpse of the uncertainty a devaluation might create last August when China devalued a mere 2%. Imagine what happens when it falls 10% or more.
A second option is simply to defend the peg by burning through the foreign reserves. If this path is chosen, however, it is likely to cause China to start burning through reserves at an accelerating rate. Investors, worried that at some point reserves will run out and force a devaluation, would intensify their run out of China. We are already seeing signs of this acceleration. China still has a large stash of foreign reserves, but it could wind down relatively fast.
A final option is to tighten capital controls to prevent funds from fleeing China. There has been a growing chorus of supporters for this option. This option cannot end well either. As Eswar Prasad notes, tightening capital controls would only undermine confidence in China and hasten the capital flight. It is also hard to believe Chinese officials could put up capital controls that could meaningfully stem the outflow of capital for one of the largest economies in the world. China is too big and its institutions too weak to make this work. Finally, even if they could impose capital controls do we really think China would use this reprieve to do deep structural reforms to get it pass the crisis? I suspect it would only be kicking the can down the road and allowing more economic imbalances to grow.
Put differently, the Fed's tightening has forced Chinese officials into trying the impossible trinity as there are no good alternative options. As the name implies, however, the impossible trinity is an unsustainable policy mix. Eventually, something will give. Since capital controls are unlikely to work and since the stash of foreign reserves is finite, I believe China will be forced to do a major devaluation. It will not be pretty. And when it happens we can thank the Fed, in part, for bringing this about.
P.S. This post was motivated in part by a conversation Cardiff Garcia and Matthew Klein of FT Alphaville had with Michael Pettis.