China's dangerous dollar addiction should worry Asia

Ben Ashby & Andrew Hunt

16 Feb 2022

For all the talk of the inevitability of China's rise or this being Asia's century, President Xi Jinping's January address to the World Economic Forum warning Western economies not to "slam on the brakes or take a U-turn in their monetary policies," highlighted a key weakness.

Original article published in Nikkei Asia: https://asia.nikkei.com/Opinion/China-s-dangerous-dollar-addiction-should-worry-Asia


 

Andrew Hunt is CEO of Hunt Economics and former adviser to Dresdner Asset Management in Asia. Ben Ashby is a former managing director in JPMorgan's Chief Investment Office and current Managing Partner at Good Governance Capital.


 

For all the talk of the inevitability of China's rise or this being Asia's century, President Xi Jinping's January address to the World Economic Forum warning Western economies not to "slam on the brakes or take a U-turn in their monetary policies," highlighted a key weakness.


Many emerging economies, like China's, remain exposed to the fortunes of the dollar. As the needs of China's economy diverge from U.S. monetary policy, its dollar dependence is looking increasingly dangerous, increasing the risk of a wild ride in the Year of the Tiger.


In 1994, when the U.S. Federal Reserve last embarked on a surprise tightening, deteriorating dollar monetary conditions and declines in U.S. Treasury prices triggered bigger problems across emerging markets. This started with the Mexican peso crisis, also known as the Tequila crisis, in 1994 and culminated in the Asian financial crisis of 1997-98.


With the Federal Reserve beginning to tighten monetary conditions for the world's reserve currency, the effects will once again be felt in Asia, and China is a particular concern. The country now faces some difficult choices because it does not have true monetary independence.

To understand China's dollar problem, it is worth examining the way the greenback affects capital flows and currencies in emerging markets.


Many countries, including China, continue to set their monetary policy with reference to their exchange rates against the dollar. This is usually aimed at trying to limit currency volatility and maintaining competitive exchange rates against the world's largest consumer, the United States.


Xi Jinping is displayed in a screen during a keynote address for the World Economic Forum on Jan. 17: the address highlighted China's key weakness. © Keystone/AP


Though this boosts exports, it often leaves these countries exposed to U.S. monetary conditions. The most obvious example of this is Hong Kong, which runs an explicit currency peg, but we believe that many Asian economies remain too exposed to the U.S. monetary cycle.


When U.S. domestic monetary conditions are easy with low-interest rates, dollars are drawn into overseas markets, such as those in Asia, in search of higher returns. This tends to lift local asset prices but also causes the countries to run what often become outsized balance of payments surpluses because more money is coming into these countries than is going out.


These surpluses often oblige central banks to intervene to stop their currencies from appreciating, a process that results in a second wave of domestic liquidity creation. This new liquidity is then used by the local banks to create yet more credit and hence even more liquidity, explaining why Asian asset prices often react so favorably to looser monetary policy in the U.S. and a weaker dollar.


Asian banks and companies will often also borrow in dollars as these debt markets are far deeper and offer longer maturities than most domestic markets. If done properly, this can be a highly advantageous strategy. But this strategy can run into difficulty when dollar conditions are unexpectedly tightening, as many Asian borrowers discovered back in 1997.


This is because a virtuous cycle like this can quickly become deflationary. As the Federal Reserve withdraws liquidity and yields rise, capital is drawn back to the U.S. as it becomes more relatively attractive.


Once cheap dollars suddenly become more expensive and harder to find, there is often selling pressure in emerging markets assets. If the local central banks are obliged to intervene to support their own currencies, they will often place upward pressure on their domestic interest rates and they may even withdraw liquidity or impose capital controls to make it less attractive or more difficult for the capital to leave.


At this point, the Asian credit cycle will also begin to decline and deflationary forces are created, and this is usually reflected in lower asset prices. Finally, as liquidity conditions tighten, economic growth slows and with it corporate earnings. Of course, emerging market central banks, like the People's Bank of China, could choose to break this cycle by allowing greater currency flexibility, but many countries are loath to do this in the good times as it erodes competitiveness.


Breaking this link in bad times can accelerate outflows as foreign investors lose confidence and outflows increase. China discovered this in 2015 when over $1 trillion of capital flowed out of its markets after it devalued the yuan in response to the Fed signaling higher rates.


Now, as the concerns behind President Xi's speech become clear, so too does the fact that China faces a difficult situation. Many parts of the economy have amassed huge borrowings over the past 15 years. To support this vast debt pile, the country needs looser monetary conditions, which would also help it deal with slowing economic growth.


At the same time, though, it needs to continue attracting foreign investment to support growth. To attract these foreign funds, China has to offer higher yields than U.S. securities in order to compensate investors for taking what is perceived as a greater risk.


So China will find itself in a dilemma as the U.S. raises rates: if it follows U.S. rates higher in an effort to attract capital, it will hurt its domestic sector; but if it fails to follow U.S. rates, it will lose foreign funding and in all likelihood cause downward pressure on its currency and foreign reserves. The rest of Asia would also be squeezed stuck between tightening financing conditions and a slowing China, but Beijing's problems may be the biggest of all, given the sheer size of China's economy.