Buttonwood
China and the Fed: twin piques
May 4th 2004
From The Economist Global Agenda
SourceChina and America are both about to start tightening monetary policy to ward off inflation. Financial-market traders have reasons to worryFEW people can hold a candle to Alan Greenspan, the chairman of the Federal Reserve, when it comes to opaque utterances on monetary policy. The language following this week’s Fed meeting will be parsed in agonising detail for the merest scintilla of a whisper of a hint of a change in the Fed’s ultra-accommodative interest-rate policy. But if Mr Greenspan plays his cards close to his chest, the good folk at the People’s Bank of China, that country’s central bank, make the Fed chairman look the very model of openness. Possibly, the uncharitable thought occurs to Buttonwood, because they don’t know what is going on. In a recent visit, The Economist’s economics editor asked a couple of senior officials at the People’s Bank what the current interest rate was. After some embarrassed shuffling of papers, she was advised to look in the bank’s annual report of, erm, 2002. Yet no matter how little Mr Greenspan or his counterparts in Beijing say, or how opaquely they say it, one thing is clear: monetary policy in both America and China is tightening. Since many an investor is fleeing low interest rates by placing bets on global reflation, these trades will be sorely tested in coming months.
It is increasingly clear that short-term interest rates in America are about to rise, and given the wealth of robust data in recent weeks, that point will come sooner rather than later. The Fed has done little to dampen the market’s expectations that rates will rise to ward off inflationary pressures. In China, on the other hand, the price of money plays little or no role in allocating capital: you either get the money or you don’t. In recent years, most companies have, which is partly why the Chinese economy has been growing so fast. Understandably worried that rampant economic growth is stoking inflation—the economy grew by an annualised 9.7% in the first quarter, growth in fixed investment has been soaring by 170% in some sectors, and new lending at a few banks is rising at 40%—officials have been calling for restraint. Last week, the central bank upped banks’ reserve requirements for the second time in eight months, and apparently took the novel step of telling a clutch of big banks to stop lending for a bit.
Which will have the greater effect—tightening by the Fed or the People’s Bank—is a moot point (another way of saying that your columnist hasn’t the foggiest). Undeniable is the fact that the combined impact has already been big. Most obvious has been the effect on government bonds, and especially those issued by the United States government. In a few weeks, the yield on ten-year Treasuries has risen from a low of 3.65% to 4.5%. The threat of higher interest rates and inflation at home has played its part in this move, of course, but so have the effects of rising inflation (or falling deflation in the case of Japan) in Asia, since Asian central banks have lately intervened much less in foreign-exchange markets to stop their currencies rising. (They had been popping the dollars they bought into Treasuries.) As inflationary pressures rise in China, expect the chatter about revaluing the yuan against the dollar—to which it is pegged—to become noisier again.
If the attractions of Treasuries have waned, investors have started to look in horror at emerging-market bonds. The spread of J.P. Morgan’s EMBI+ index over American Treasuries has risen by more than a percentage point from its low on January 8th, a statistic that does not fully capture how badly such bonds have performed, since Treasury prices are themselves a lot lower. Last year’s poster children have become this year’s street urchins. Bonds issued by the likes of Brazil, Turkey and Russia have, to quote one normally sober investment bank, suffered “violent re-pricing”. Down, that is.
Stockmarkets have stumbled everywhere, caught between the joys of heady economic growth and the potential pain of higher interest rates. The riskiest are among the hardest hit. Despite the hoopla surrounding the IPO of Google, the Nasdaq index is lower than it was at the start of the year. Any currencies that had strengthened in recent months from the “carry trade” (investors fleeing low interest rates in America in search of higher yields), such as sterling or the Australian dollar, have weakened sharply. The latter has also been clobbered by falling metals prices, as fears mount that China may not provide an inexhaustible source of demand: The Economist’s dollar metals index has fallen by 6.4% from its peak on April 20th. Worries about the sustainability of Chinese growth have also knocked many an Asian stockmarket.
In America, the fretful will tell you, there are striking similarities to 1994, when inflationary pressures were rising, the Fed was forced to double interest rates (to 6%) and there was widespread carnage in the bond market. The sanguine reply is that the Fed will move rates much more cautiously than last time—and telegraph every move to a market that is all too aware of those similarities. Buttonwood has his doubts: because returns are far lower than in 1994, leverage in the financial system is far higher.
China has also been here before, as it happens at about the same time. In 1993-94, investment grew at over 60%, GDP growth rose to over 15% and inflation peaked at 28%. Things didn’t turn out too well after that. Back then, though, the world probably didn’t care very much because China didn’t play such a big part in either global growth (of which the country has accounted for a full quarter over the past five years, on a purchasing-power-parity basis) or as a source of growth elsewhere. Buttonwood is, of course, aware of the old saw that history never repeats itself, but he can’t help worrying that two of the most important economies in the world are about to start tightening monetary policy at the same time. And no one knows how fast or how far they will have to go.