Commentary on Political Economy

Monday 31 January 2022

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

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

Adrian Blundell-Wignall


Jan 31, 2022 – 11.55am



China spends millions of dollars to influence opinions in Western countries by establishing Confucius Institutes and research centres, or by sponsoring sporting tournaments.

To influence outcomes more directly, political donations are common.

Where it has not been sufficiently clear to countries as to what these investments mean, they are encouraged to get it right via the threat of withdrawal of funding or even trade sanctions.

Countries cringe, and often try to get it right, before financial penalties apply. Witness police initially informing spectators at the Australian Open that they could not wear “Where is Peng Shuai” T-shirts.

But it’s not often that Chinese President Xi Jinping lectures the West on its monetary policy.

His arguments seem benevolent enough. Global co-operation.


US tightening could hurt developing countries at this delicate time. That, of course, is perfectly correct and has always been thus. But it would be worse to let inflation in the US form into 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’s it all about really?



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

China can, of course, influence the offshore market forward rate with swap transactions via its own state banks. But the truth is that the offshore forward rate can’t deviate from the yuan spot rate too far or for too long without capital flow pressures becoming stronger, requiring yuan movement, capital control adjustment, and/or Chinese interest rate changes.

If these pressures are in a direction favourable to China’s policy objectives, the yuan will be allowed to move. But if not, China would be forced to adjust its policy levers.


While many observers assert China tries 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 ill-advised credit boom that followed the GFC, the exchange rate was allowed to appreciate vis the dollar for prolonged periods.

Indeed, it was only during the 2015-17 period when China was close to recession – when rates were cut just as the US began its first attempt to normalise monetary policy – that the yuan was permitted to depreciate somewhat.

China’s corporate borrowing strategy is exactly 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 taper QE, and quickly reverted to its pro-financial-markets stance.

The most likely explanation for this was the stress placed on the huge edifice of leverage via derivatives between banks and shadow banks that had been allowed to build up since the GFC.


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 favourable interest rate differential allowed yuan strength to re-emerge.

The prospect now, however, is for US tightening. This will likely remove that interest rate differential, particularly with China trying to cut rates at the same time.

So, what is going on here? Why does China seem to prefer avoiding depreciation which would favour its external trade?

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


This is a great strategy while the yuan is appreciating, but not if it falls.

China has $US9 trillion ($12.8 trillion) in foreign currency liabilities, some two-thirds of which is denominated in US dollars. While it also has assets in foreign currency, these are not in the right places to offset the corporate pressures.

China’s corporate borrowing strategy is exactly the story of the Asian financial crisis of the late 1990s.

Research shows that for China’s foreign borrowing companies, a depreciation of the yuan would cost more in servicing costs than the companies would gain via trade, and particularly if they are real estate companies that aren’t exporting anything.

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

With the Fed about to resume what it tried to do in 2017, the yuan will likely face depreciation pressure. Chinese corporate debt servicing problems will mount further. Some significant companies are already struggling, as recent defaults have shown.


The misguided rush to catch up with the US via overinvestment and debt in China now runs into the US’s equally misguided attempt to avoid providing a suitable policy framework for the financial system.

The Evergrande property slump was a defining moment for Chinese economy. 


US and China rush in opposite directions to save the global economy



Two lessons for markets and central banks

The two largest economises in the world have displayed a failure to understand two of the most rudimentary lessons of economic history: (i) that forcing investment at a pace that drives the potential for returns below the funding cost will result in a crisis in the end, as with Asia’s 1997 banking crisis; and (ii), that the only time when real interest rates were significantly negative in the post-war period (before the GFC) was in the presence of the interest rate ceiling distortion, fiscal spending and easy money,

The ultimate result of the latter was the last great bout of inflation and global pain for the world economy. The same is proving true with the QE/zero rates distortion combined with fiscal expansion.

I suspect Xi’s wishes will fall on deaf ears in the US. I also suspect that the US will run faster to catch up to where it should have been years ago than will China, with its need to wear the pain required to deal with its over-investment problem.

Adrian Blundell-Wignall writes on the world economy and is a former director of the OECD.

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