Chinese one-hundred yuan banknotes are arranged for a photograph in Tokyo, Japan, on Tuesday, Aug. 11, 2015. China devalued the yuan by the most in two decades, a move that rippled through global markets as policy makers stepped up efforts to support exporters and boost the role of market pricing in Asia's largest economy. Photographer: Tomohiro Ohsumi/Bloomberg
© Bloomberg

For the second year running, the US Federal Reserve has rudely interrupted the Chinese Communist party’s annual economic planning meeting, which ends on Friday. 

During last year’s Central Economic Work Conference, the Fed raised interest rates for the first time in a decade. This week the US central bank not only raised rates again but also hinted at three more increases next year, adding to pressure on Chinese officials already struggling to contain capital flight.

The rise, and the prospect of further tightening next year, mark a potential turning point for the world’s two largest economies. During the past decade, high yields compared with rock-bottom Fed interest rates have drawn foreign capital into China. This fuelled the renminbi’s decade-long, 37 per cent appreciation against the dollar, which peaked in January 2014.

But those “hot money” flows are now moving in reverse as the Sino-US rate differential narrows. Aggressive Fed tightening could even one day cause the differential to flip, with bigger yields potentially on offer in the US.

As a result an already delicate balancing act for Beijing has grown still more difficult as Chinese officials attempt to stem the renminbi’s fall against the dollar without choking off growth or raising Chinese companies’ already high debt burdens.

Some analysts think the People’s Bank of China may raise rates itself — something it has not done since 2011.

chart: US-China interest rate gap narrows

Jeremy Stevens, an economist at Standard Bank in Beijing, says there is now an “outside risk” of a rate rise next year by the PBoC. The catalyst for such a counter-intuitive decision — China’s economy is growing at its slowest annual pace in a quarter century — could be the renminbi, which has fallen more than 6 per cent against the dollar this year with further to go. 

On Thursday the PBoC set the renminbi’s daily dollar “reference rate” at 6.93. “It wouldn’t shock me at all if the renminbi is at 7.3 or 7.4 by March,” Mr Stevens says. “At some point they have to decide to do something to support the currency.” 

The Fed’s move is a reminder of the many risks Beijing now faces in the wake of Donald Trump’s surprise victory in last month’s US presidential election. 

Most assessments of “Trump risk” in Beijing have focused on the president-elect’s cavalier disregard for the One China policy that has been a central pillar of Sino-US relations for more than four decades. 

But the Fed’s suggestion that there could be three further rate rises next year shows that, for China, the greatest shocks from Mr Trump’s victory may instead stem from the inflationary consequences of his promised tax cuts and infrastructure stimulus. 

Even before the potential economic ramifications of Mr Trump’s victory began to be digested, Beijing moved last month to stem outflows by implementing a series of capital controls. 

In its attempt to keep the renminbi from falling too far, too fast against the dollar, China’s central bank has also been selling down its foreign exchange reserves, which have fallen 25 per cent to $3tn since early 2014. 

As bond and currency markets factor in expectations of higher US growth and inflation under Mr Trump, the pressure is continuing to build.

“The US yield is moving up, putting pressure on renminbi and capital outflows,” says Wang Tao, China economist at UBS in Hong Kong. “That tightens domestic liquidity, which the PBoC has not fully offset, partly out of concerns about the exchange rate.”

The PBoC has guided Chinese money-market rates higher in recent weeks, partly in anticipation of the Fed move. “Monetary conditions in China have tightened without a rate hike,” notes Chen Long, China economist at Gavekal Dragonomics.

Others are calling for more dramatic action by China’s central bank. This month Sheng Songcheng, a PBoC adviser, told a forum in Beijing that the priority of monetary policy should be to boost market confidence in the exchange rate. He argued that the central bank should consider interest-rate rises to achieve this goal.

Zhu Ning, professor of finance at Tsinghua University, says expectations of a Chinese rate increase have “become more mainstream” over recent months, principally because of “the strength of the US [economic] revival and the tempo of Fed rate rises”. 

Mr Zhu also points to the inflationary pressures building at home. Some analysts are now predicting that Chinese producer price inflation, which only turned positive in September after years of deflation, could be as high as 5 per cent by March. 

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