With Wednesday’s release of the minutes from the US Federal Open Market Committee’s April meeting, it became clear the US central bank plans to raise interest rates in June if the economy keeps posting strong numbers. The FOMC is the US Federal Reserve Bank’s policy board.

However, the Fed has a “China problem,” David Lubin, Citi’s head of emerging markets economics, wrote in Thursday’s Financial Times.

“Any effort it makes to tighten policy will, once more, activate the feedback loop and suck capital from China with what are now predictable consequences,” Lubin wrote. “And since net capital outflows are generally unsupportive of growth, the underlying economic problem that China faces can only be made worse by US monetary tightening.”


Lubin says that capital outflows from China have been kept under control the past couple of months with a stable yuan because the Chinese are not falling over themselves to buy dollars.

However, a look back at the past year shows two occasions when China saw large outflows. The first was the devaluation of the yuan on Aug. 11, the second was when the Fed raised rates in December. Lubin said the flows were so big that it was impossible for the Fed to keep raising rates.

With the release of latest FOMC minutes, he asks, “Is it now ‘safe’ for the Fed to tighten US monetary policy?”

“Not quite,” he write in answer to his own question. “Actually, the main reason why capital isn’t flowing from China these days is precisely because of the fact that the Fed hasn’t been expected to raise rates. If that were to change, capital outflows from China would once again become a source of global risk aversion. … US monetary policy and the capital account of China’s balance of payments are joined at the hip. ”

That’s because the bulk of the dollars that China borrowed has come from international banks with rather short maturities. They did this because they could benefit from the carry trade between the dollar and yuan. The accumulation of short-term dollar debt by Chinese borrowers created a feedback loop between US monetary policy and China’s capital account.

Lubin said if the Fed raises rates capital will be sucked out of China, because tighter US monetary policy both strengthens the dollar and cuts the China-US interest differential, giving Chinese borrowers good reasons to unwind their short-dollar positions. The ensuing capital outflows from China fuel global risk aversion, adding volatility to international capital markets. Finally, that volatility makes it too dangerous for the Fed to tighten policy.

A circuit-breaker is at work, then: the Fed’s ability to raise rates is hobbled by the market volatility which is created by the impact that US monetary tightening has on capital flows from China.

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