Fed benchmark rate cut is a blessing and a curse for China


By William Pesek, Bloomberg

As the Federal Reserve cut interest rates by half a point last week, it’s doubtful much thought went into what it would mean for China.

And that’s fine. The Fed has 12 districts around the U.S. and it acts to influence the domestic economy. Globalization has globalized the Fed, though. It’s hardly far-fetched to think of Latin America as the Fed’s 13th district, Russia the 14th, Asia the 15th and so on.

Not surprisingly, the Fed decision was the most anticipated by Asia in many a year. Nowhere were officials watching closer than in Beijing.

It’s not just that China’s currency is still effectively pegged to the U.S. dollar. It’s more about what Donald Straszheim, vice chairman of Newport Beach, California-based Roth Capital Partners, calls the Group of Two. The G-2 — the U.S. and China — is rapidly becoming the most important economic relationship.

It’s getting harder and harder to discern where one economy ends and the other begins. China can’t live without U.S. demand for exports and the vital role the American consumer plays in its poverty-reduction efforts. The U.S. can’t survive without China’s money, much of which is parked in Treasuries and enables the U.S. to finance its excesses.

Yet the Fed’s cut highlighted the extent to which U.S. and Chinese monetary policies are moving in opposite directions. The Fed lowered its benchmark interest rate for the first time in more than four years to 4.75 percent, while China is still working to tighten credit. The U.S.’s adding of liquidity — and the subprime-loan crisis forcing Fed Chairman Ben Bernanke’s hand — is both a blessing and a curse for Asia’s second-biggest economy.

First, the curse angle. China has been shielded from much of the fallout of the credit-market problems that began in the U.S. and spread around the globe. A largely closed capital account and a stable currency protected China from the 1997 Asia crisis and the approach has paid off again in recent months.

As the Fed lowers rates, though, it’s providing liquidity to a global system that seems to find no shortage of ways to channel it to China. That creates a paradox.

The People’s Bank of China can sit back and see if its five rate increases this year curb the fastest inflation since 1996 and damp speculation in stocks and real estate. That’s not a wise choice, given a global increase in price pressures. The other choice may make matters worse. Higher borrowing costs at this point will serve as a more powerful magnet for the so-called hot money that officials in Beijing are trying to contain. And so there you have it: China’s monetary choices range from bad to worse. China must do much more than just raise rates.

Bernanke is less to blame for this predicament than his predecessor, Alan Greenspan. As Greenspan cut short-term rates to 1 percent in 2003, speculative flows rushed to Asia, and China especially. It seeped into all types of Chinese assets, including stocks and real estate. Now that the Fed is cutting rates again, China finds itself in a difficult position.

Looked at another way, the subprime mess that spooked the Fed enough to move could be a blessing for China in the long run.

A hard landing in the U.S. can’t be ruled out, and that would hurt export-dependent China. There’s much chatter about Asia decoupling from the U.S., yet the region is still highly reliant on the world’s biggest economy.

A couple of rate cuts, meanwhile, won’t get U.S. households out of debt. Asia shouldn’t assume the U.S. is about to boom just because the Fed loosens credit. While such a dynamic would be a blow in the short run, it might prompt China to work harder to create a thriving domestic economy. As global investors tighten risk-management guidelines following recent mortgage-market woes, China’s financial system may be forced to grow up. For example, increased risk aversion — if markets get antsy again — could let some air out of China’s stock bubble, reducing risks to the broader financial system.

Also, given the lack of transparency, investors know little about the true magnitude of China’s bad-loan challenge. Throughout the nation there are many cities that want to be the next Shanghai or Dalian with massive skyscrapers, five-star hotels, six-lane highways, international airports, world-class universities and cultural centers.

Those efforts are taking place largely beyond the control of Beijing and financed with easy credit extended by banks. When China does slow, the debt hangover will be quite painful. The upside is that the subprime problems in the U.S. may have Chinese creditors working harder to scrutinize borrowers’ ability to repay loans. That would mean fewer bad loans to clean up if China’s 11.9 percent growth slows to 5 percent. The nation would be better off in the decades ahead.

In the short run, though, China’s challenges are increasing as the Fed acts to calm markets. Balancing the need to raise hundreds of millions out of poverty, while also avoiding an overheated economy, just got a little harder — thanks to the Fed.