As of 2016, China is the largest economy in Asia and the world’s second-largest economy in terms of nominal gross domestic product (GDP) at approximately $11 trillion. Although China’s GDP grew at 6.9% in 2015, this was its lowest growth rate in 25 years. China has experienced approximately a decade of expansion as the United States continued to provide accommodative monetary policy between 2007 and 2015. Access to cheaper capital encouraged lending and consumption in China to propel at a more rapid rate than many of its developed world peers. China was relatively unconcerned when the U.S. Federal Reserve Bank began its tightening cycle in 2004. China was the world’s sixth-largest economy at the time, operating an effectively closed economy, and its currency, the yuan, was undervalued. Fast-forward 12 years, and China has a sluggish economy, an overvalued currency and the U.S. as one of its major trading partners. In early June 2016 annual talks, Chinese officials are set to press their American counterparts about the probability of a June rate hike and consider the likely impact that rising interest rates in the U.S. may have on the Chinese economy.
In 2016, China is now substantially more exposed to global capital flow and currency risks. These risks are examined in further detail below.
China experienced substantial cash inflows in the past decade, utilizing U.S. capital markets where it's easier to borrow due to a low rate environment, but it is now facing the harsh reality of a full-scale cash retreat. Additionally, Chinese companies that have borrowed large amounts of U.S. dollars are now facing increased repayments as the U.S. Federal Reserve Bank lifts interest rates. The Institute of International Finance estimated that there was $175 billion in total capital outflows in the first quarter in 2016. It estimates that 2016 net capital outflow is likely to retreat to $538 billion, down from $674 billion in 2015. If the U.S. Federal Reserve Bank increases interest rates more rapidly than expected, or changes its present dovish tone to a somewhat more hawkish tone, capital outflow in China may intensify as the yuan comes under further depreciation pressure.
China does not let its currency trade unrestricted in the financial markets in the way the U.S. does. It pegs the yuan’s value to the U.S. dollar and restricts trading to a 2% band above or below a daily target set by the People’s Bank of China (PBOC). In 2015 the PBOC depreciated its currency by approximately 3%. In May 2016, the yuan fell to a four-month low against the U.S. dollar after PBOC set the fixing rate at its lowest level in five years. The PBOC has devalued its currency in response to its continued rise when market forces suggest it should be declining. This action has been a key contributor to substantial capital outflow in China during 2015, causing an elevated level of investor anxiousness. An argument could be made that the PBOC began devaluing its currency in 2015 in preparation for U.S. rate hikes to avert bigger falls that would accelerate further capital outflows.
The Bottom Line
The U.S. Federal Reserve Bank signaled its intention to begin tightening monetary policy in 2015, albeit in a dovish manner. This left the PBOC in the unenviable position of having to find a balance between trying to reduce the value of its currency to help rejuvenate its exports and stimulate its economy, making it more appealing for foreign investment as its currency was overvalued due to its peg against the U.S. dollar. At the same time however, it is aware that the yuan’s depreciation may contribute to capital outflows as Chinese investors transfer money out of China to take advantage of rising interest rates in the U.S.