Trump tariff threats send China’s policy makers into the Upside Down

(Originally published Jan. 13 in “What in the World“) The threat of Trump tariffs is already turning China’s monetary policy on its head.

Even as Beijing struggles to revive growth, drag its economy out of a deflationary spiral and keep heavily indebted property developers and local governments from going bust and triggering a financial crisis, the country’s central bank is scrambling to raise interest rates.

What? Anyone who took Economics 101 in college remembers that, when economic growth slows, central banks usually try to lower interest rates to revive spending and investment. But the People’s Bank of China last Thursday announced that it would this month sell a record 60 billion yuan ($8.2 billion) in 6-month bills in Hong Kong. The next day, it said it had halted five months of buying the central government’s treasury bonds.

Selling short-term notes soaks up cash and boosts the supply of debt, thereby pushing up their yield. Central banks usually do that when they’re worried about inflation, not deflation. The same goes for withdrawing purchases of Treasury bonds: buying government debt for cash injects cash into the economy and pushes down government borrowing costs—which is just what the U.S. Federal Reserve did with quantitative easing.

But now, the Fed is worried about strong economic growth fueling inflation. So markets are worried that, after a series of rate increases, the Fed won’t resume cutting them as quickly as investors had hoped. China’s economic outlook, meanwhile, remains gloomy despite government stimulus efforts.

As a result, China faces both a decline in investment from abroad and increasing efforts by its own companies and savers to move their cash out of China to somewhere they can earn more for their money. That has helped send China’s yuan to its lowest against the U.S. dollar in 16 months.

Here’s the PBoC’s problem in charts. First, here’s what’s happened to Chinese government bond yields over the past year. They’ve gone down as the government and the PBoC try to revive growth and reduce the repayment burden on borrowers. Investors betting that Beijing will have to keep cutting rates have sent Chinese government bonds on such a rally that yields on 10-year bonds recently reached a record low of 1.6%:

Source: People’s Bank of China

In the U.S., meanwhile, bond yields have climbed after the Fed raised rates to quell inflation:

Source: ustreasuryyieldcurve.com

The result is that the relative return on U.S. government bonds relative to Chinese government bonds—the spread—has climbed across the board to more than 3 percentage points.

Source: People’s Bank of China, ustreasuryyield.com

That has made the prospect selling yuan to buy dollar-denominated assets much more alluring, overcoming the risk of fluctuations in the exchange rate. Incoming U.S. President Donald Trump’s threat to boost tariff on Chinese imports to 60% from 20% make that an even more tempting bet. Higher tariffs will likely hurt China’s exports, putting further downward pressure on the yuan. Higher tariffs will also push up the cost of Chinese imports to the U.S., keeping inflation higher and discouraging the Fed even further from cutting interest rates. Thus, the spread is likely to persist or even grow.

The result? China is experiencing a policy paradox more common to smaller, open economies such as Thailand or Turkey. Sometimes, a country can lower its benchmark domestic interest rates to support growth, only to suffer capital outflows so large that real borrowing costs go up as the supply of money dwindles. Both Thailand and Turkey have in the past found themselves having to nudge interest rates up to lure capital back into their economies.

Now, it’s the PBoC’s turn. While it tries to flood the market with short-term bills to push up rates at the short end of the curve, it’s halting its own purchases from the market for longer-term government debt to push up rates at the long end.

Raising rates is not only paradoxical; in China’s case it seems almost suicidal. Pushing up yields on bonds risks nudging up other borrowing costs and putting further pressure on China’s cash-strapped property developers and local governments, perhaps even pushing some into default.

But there’s a perverse logic to withdrawing central bank support for government bonds, one the PBoC cited in its announcement. The bank said it was halting purchases because of a shortage of supply. That isn’t just PR. Beijing isn’t exactly fond of borrowing and most of its bonds are usually bought and held to maturity by China’s big banks, which need them as a stable, low-risk asset to offset the risky property loans on their balance sheets. As a result, Chinese government bonds are always in somewhat short supply. So, by removing competition with banks for bonds, the PBoC could give the country’s banks more room to lend.

And apparently there is plenty of need for new financing. China’s local governments are reportedly so broke they’re offering to pay bills with unfinished apartments.