How the end of easy money in the US will impact China

June 27, 2015 08:00
The Federal Reserve could raise interest rates in September or next year, ending years of cheap credit. Photo: CNN

The US Federal Reserve kept the federal funds rate in the zero to 0.25 percent range at its recent policy meeting.

Immediately, Fed officials tangled on the timing of a highly anticipated liftoff.

Fifteen of them wanted to raise interest rates this year, two preferred to wait until next year.

That sent a signal to the market that a liftoff could happen by September, ending nearly seven years of cheap money.

With the prospect of a rate hike no longer in question, attention has shifted to the pace of credit tightening.

However, it’s widely believed the Fed will take a cautious approach. I believe the next rate hike cycle will be around 1.5 percent.

At that pace, the increase is affordable for the US government.

The federal government would have to pay an extra US$170 billion in interest payments with a 1 percent increase in US treasury yields.

A 1.5 percent rate hike means an extra US$250 billion in interest payments.

That amount won't pose a grave threat to economic growth and could in fact help cool the property market.

At present, the 30-year mortgage rate is 4.04 percent from 3.65 percent in late April. It could hit 5.5 percent after the rate hike, which could weigh on the property market.

Some mainland investors have borrowed money against their US real estate assets in order to invest in China's red-hot stock market.

The size of that investment could be as much as US$30 billion. Those investors are facing increased risk from the imminent US rate hike.

Meanwhile, the mainland equity and housing markets are out of sync with a slowing economy.

It remains unclear whether A shares will continue their run-up after a deep correction in the past few days.

The market is no longer cheap.

In fact, it's very expensive, with some small and medium companies hitting P/E ratios over 70 times.

Heavyweight stocks are make more sense at 25 to 30 times P/E.

The bull market has sparked all sorts of speculation.

One theory is that the Chinese government is trying  to drive up shares and allowing individuals and private equity funds to take over.

Another is that the authorities are eager to push companies through the IPO pipeline to deal with a long queue of listing candidates.

Meanwhile, new loans surged by more than 200 billion yuan (US$32.22 billion) to 940 billion yuan in May from the previous month.

But it remains to be seen whether the increased liquidity will flow into the real economy.

If the money instead ends up in the stock market, it could exacerbate a bubble and undermine economic growth.

Monetary easing measures have yet to stabilize flagging growth.

And smaller companies continue to struggle for capital.

They're already paying 15 percent to 18 percent interest rate in the shadow banking system.

The challenge for the government is to get credit flowing into productive sectors and reduce financing costs for smaller firms.

At present, the Chinese central bank is trying to suppress long-term rates and hike short-term capital costs.

That is quite similar to the Fed's Operation Twist in 2011.

The end of cheap money in the US could spark a capital outflow from emerging markets.

Meanwhile, China presses on with structural reform even as it fosters loose monetary and fiscal measures.

This divergence between the world’s two largest economies could create a new set of challenges.

This article appeared in the Hong Kong Economic Journal on June 23.

Translation by Julie Zhu

[Chinese version 中文版]

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adjunct professor in the Department of Finance at HKUST Business School