The U.S. Federal Reserve Board last week decided to raise short-term interest rates. The move was widely expected in the wake of Donald Trump’s election as the next U.S. president given his plans for tax cuts and infrastructure spending to boost the economy and their tendency to spur inflation. But a strong American economy will exacerbate structural imbalances in the global economy as the value of the dollar climbs and other economies battle capital flight. In particular, there are real concerns about China’s prospects and growing tension in the U.S.-China relationship.
The Fed has kept short-term interest rates steady and low since the 2007-08 global financial crisis, raising them only twice during that time. The Fed, like other central banks, kept interest rates low — nearly zero — to provide liquidity to markets, to stimulate demand, and to ensure that prices did not collapse. As the U.S. economy recovered and began to expand and unemployment dropped below 5 percent, there has been a renewed focus on inflationary pressures.
Forecasting expected U.S. growth of around 2 percent for the next three years — compared with 2.4 percent in 2015 — the Fed wants to both be ready for inflation (if growth exceeds 2 percent) and if growth slows (expansion slows to below 1.5 percent). The Fed anticipates raising interest rates three more times next year — in September, it forecast two increases — suggesting that it expects the Trump administration to stimulate the economy.
Doubters note that inflation remains low and the Fed is acting in anticipation of policy changes, which may make sense but is aggressive, nonetheless. It sets up a potential conflict between the Fed and the incoming administration: Candidate Trump talked about accelerating growth, which is more difficult when interest rates go up. He also insisted that Fed Chairwoman Janet Yellin was irresponsible by keeping interest rates low and was creating bubbles in the economy. A strong dollar will also dampen the exports that Trump believes are central to economic health, making U.S. products less competitive.
The Fed’s rate hike poses more substantial and immediate challenges for foreign governments and corporations. Borrowers that have dollar-denominated loans are going to see their value skyrocket and will find repayment increasingly difficult as the dollar soars against other currencies. The Bank of International Settlements reckoned that the total amount of dollar-denominated debt to nonbank borrowers in 2015 reached $9.8 trillion, and about one-third of that total was in emerging markets, where currencies tend to be more volatile.
Rising costs for existing debt is one problem, but those same borrowers also risk being squeezed out of the market more generally as lenders seek higher returns once an entity in the global economy offers a positive interest rate.
China faces the toughest challenges. The Fed hike pushed the value of the yuan to its lowest value since June 2008, losing 6.7 percent of its value against the dollar this year alone. Chinese policymakers have been fighting capital flight — the Institute of International Finance estimates that November’s net outflows may have reached $115 billion, nearly three times the October figure — and a stronger dollar makes that job harder. Among other moves, China has been selling dollars on foreign exchange markets to support the yuan; the People’s Bank of China is thought to have sold $279 billion in reserves to fight the yuan’s decline this year, and as much as $1.2 trillion, or a quarter of its total, over the last two years.
One of the chief sources of dollar earnings has been U.S. Treasury bonds, which China has been feverishly selling. As a result, China’s Treasury bond holdings have declined for five consecutive months, reaching their lowest levels since July 2010. Japan is now the largest holder of U.S. Treasury’s for the first time since 2008 (apart from one moment a few years ago).
Sales of dollar holdings cut into the Chinese government’s liquidity, which limits its ability to respond to a domestic economic downturn. With the Chinese economy slowing and debt and real estate bubbles developing throughout the country, many experts believe that the need for that safety net will grow more intense. A weaker yuan against the dollar is yet more grist for Trump’s protectionist mill, making more likely the prospect of retaliation — if he keeps his word.
China’s other options are no better. One of the best ways to stem capital flows is capital controls, but they reverse Beijing’s desire to turn the yuan into a global currency as well as undercut government-supported efforts by Chinese firms to make overseas acquisitions to gain technology, know-how and access to markets. Or, China could raise its own interest rates, but as the domestic economy slows, that is a risky proposition.
Finally, China could sell more Treasuries. That makes economic sense but it is political risky given the signal it sends about Chinese intentions and the state of interdependence between the world’s two largest economies. President Trump could have the face-off with China he demanded throughout his campaign, but not in the manner of his choosing.
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