China has bigger economic worries than the Fed’s interest rates

GlobalPost
Chinese President Xi Jinxing takes part in a media conference with his German counterpart Angela Merkel in Berlin on March 28, 2014.
Chinese President Xi Jinxing takes part in a media conference with his German counterpart Angela Merkel in Berlin on March 28, 2014. 
ODD ANDERSEN

The Federal Reserve decision to hold interest rates at record lows on Thursday might please some financial market participants, but it probably won't do much to stem the massive amounts of money flowing out of the Chinese economy. 

As investors go back to speculating about when the Fed will hike the federal funds rate, which will affect everything from the interest rate on your car loan to the dollar-denominated debt owed by a Taiwanese manufacturer, China's losses are likely to continue.

And when you're talking about the world's second-largest economy, that matters. A lot. 

Capital outflows from the Middle Kingdom have reached “unprecedented” levels, according to the Financial Times. In the year to the end of July an estimated $610 billion was pulled out of China, the FT said. In August alone a staggering $150 billion left the country.

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It’s been happening in other emerging markets, too, as investors anticipating higher interest rates move their money to the United States. (Doing so promises them better investment returns and offers a safe haven from a slowdown in the global economy.)

But the challenges facing Chinese policymakers go beyond the Federal Reserve's interest rate decision.  

A major reason Chinese and foreign investors are pulling their money out of China is fear the key growth engine is weakening and that the local currency, formally known as the renminbi, will lose strength as well.

Those concerns intensified in August when Beijing, which keeps the currency loosely pegged to the dollar, suddenly devalued the renminbi, triggering mayhem in global financial markets and sparking speculation that Chinese leaders were deliberately trying to weaken the currency to boost flagging exports, which are an important driver of the Asian economy.

That Chinese policymakers were willing to risk setting off a currency war with other emerging markets (a cheaper  renminbi would make their exports relatively more expensive in overseas markets, thus tempting those markets to devalue their currencies, too) and the wrath of trade partners, particularly the United States, suggested Beijing was a lot more worried about China’s economy than it had been letting on.

The negative reaction to the devaluation has increased downward pressure on the value of the renminbi, which is probably not what Chinese policymakers wanted to happen.

While a cheaper renminbi is good for Chinese exporters, it undermines confidence in the economy and fuels expectations for further falls in the value of the currency. That makes nervous investors more inclined to move their money out of the country.

That's bad because excessive outflows drain the economy of the very thing that lubricates it: money. If there’s not enough liquidity, economic activity is likely to slow.

To combat the persistent outflows Chinese leaders have been pulling on a variety of policy levers to do two things at the same time: support the value of the renminbi and bolster economic growth.

To that end, they've been selling some their massive foreign exchange reserves, most of which are parked in US treasury bonds, to buy the renminbi and boost its value. The idea is that if Beijing can stabilize the renminbi, investors will have more faith in the Chinese government’s ability to manage the economy and be less inclined to sell the currency.

But buying the renminbi exacerbates China's domestic liquidity problem: If the central bank is absorbing renminbi there will be less of it available for banks to lend. So China has also been injecting money into state-owned financial institutions, in the hope they will use those funds to lend to individuals and companies. They've also been cutting interest rates and reducing the amount of money banks must keep in reserve to get more renminbi flowing into the economy. 

To increase inflows of funds, Beijing is also making it easier for Chinese companies to borrow overseas.

While economic growth is always the overriding concern for Chinese leaders, who are paranoid about social instability, there's another reason they are so keen to keep the currency strong.

President Xi Jinping is due to land in the United States next week, and the last thing he wants on his first state visit to the White House is a humiliating lecture from President Barack Obama on China's foreign exchange policy.