Rising Interest Rates Challenge China’s Growth Model

(Bloomberg Opinion) -- For years, the Chinese economy has benefited from an unusual dynamic. Because China uses a soft peg to the dollar, its interest rates are tied to the Federal Reserve. Following the financial crisis, as the Fed kept rates exceptionally low for a prolonged period, China was able to set its own rates lower than would otherwise have been necessary, thus underwriting its investment-led growth model.

Now this model is under significant pressure. The People's Bank of China is trying to keep rates low in an overleveraged economy, while the Fed is raising them to keep a lid on inflation. The tightening yield spread between the two countries will threaten the yuan's link to the dollar and pressure the PBOC to raise rates. How China handles this decoupling is of critical importance to its economic future.

Since December 2015, the Fed has raised its benchmark lending rate seven times, from 0.25 percent to 2 percent. During that period, key Chinese borrowing costs have remained mostly stable and the PBOC has left official lending rates to banks unchanged. The 10-year Chinese government bond yield rose only slightly, from 3 percent to 3.55 percent.

This has resulted in a significant narrowing of the spread between the cost of Chinese and U.S. debt. The day before the Fed’s first hike, the China-U.S. spread on one-year government debt was 1.70 percentage points. On Aug. 10, the one-year spread stood at 0.31 percentage point. The 10-year spread has been hovering around 0.50 percentage point over the past few months, implying that investors anticipate further tightening by the Fed.

For China, this presents two big risks.

One is that narrower yield spreads will make it harder to attract capital. It's true that portfolio inflows to China are up 144 percent this year. But this is mostly due to China's inclusion in MSCI Inc.'s benchmark stock indexes and a new program that allows foreign investors access to China's interbank bond market. At only $112 billion, moreover, those inflows remain minuscule for an economy of China's size. With its current account falling into deficit, and a pressing demand for investment to drive growth, China needs foreign capital to buy stocks and bonds.

As yields move toward parity, however, investors are likely to start allocating their capital elsewhere. Foreign direct investment is up only 3.4 percent on the year. China now offers more risk -- industrial and urban-construction bond spreads have nearly doubled from a year ago -- and less opportunity than it once did. Buying Chinese government debt for an extra 50 basis points isn't an attractive proposition.

More fundamentally, narrowing yield spreads suggest that China's growth model is at serious risk. With the Fed raising rates, the PBOC must follow suit to maintain the yuan's soft peg. Yet Chinese corporate debt stands at 156 percent of GDP, compared to 71 percent in the U.S. Raising rates under such conditions bears significant financial risks. The costs it would impose far outweigh any export benefits of a weaker currency.

More to the point, with debt approaching 300 percent of gross domestic product, any interest-rate increase would raise debt-servicing costs substantially and place enormous pressure on Chinese firms. This is exactly why the government is trying to keep rates down and maintain the peg. No country can depend on debt-financed investment to drive growth in an overleveraged economy if interest rates are rising.

This leaves China in a bind. If it wants to retain the soft peg to the dollar, it will need to accept a weaker yuan as spreads narrow, or raise interest rates. If it doesn't want to remain as closely linked to the dollar, it will need to link the yuan to another currency or let it float in some way -- yet this would also imply a weaker yuan and higher interest rates.

In other words, something has to give. China has long talked about moving away from an investment-based growth model but never seriously tried it. The time for talking may soon be up.

To contact the editor responsible for this story: Timothy Lavin at tlavin1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Christopher Balding is an associate professor of business and economics at the HSBC Business School in Shenzhen and author of "Sovereign Wealth Funds: The New Intersection of Money and Power."

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