The writer is chief economist for Asia-Pacific at Natixis and senior fellow at the Bruegel think tank
The last few months have been characterized by a growing divergence in monetary policies between the major Western central banks and those in Asia.
Driven by higher-than-expected inflation, the US Federal Reserve made a sharp turn towards a rate hike in March. The same is true for the Bank of England. Consensus also shifted to a hike in the European Central Bank in December.
This rapid monetary tightening contrasts with the People’s Bank of China’s increasingly dovish stance and the Bank of Japan’s stubborn commitment to its quantitative easing program to support markets and cap yields through the purchase of obligations.
Both central banks have good reason to stay the course. The Chinese economy is decelerating rapidly and inflation appears to be under control, at least as far as consumer prices are concerned.
In Japan, inflation remains well below the BoJ’s target, which justifies maintaining such a loose monetary policy. And yet, things are changing rapidly.
For starters, the Fed’s much more aggressive tone, which reflects a sudden awareness of the greater threat of inflation, led to a bond market sell-off and a rapid widening of the spread between bond yields. short and long term interest.
This not only puts upward pressure on European Treasury yields, but also on Japanese government bonds. The BoJ had to intervene on Thursday to ensure that the yield on its benchmark 10-year bond remained within its 0.25% limit. And for China, the spread between its three-year sovereign bond yields and those of the United States has steadily narrowed, from around 3 percentage points to 0.50 now.
Such a narrow yield spread does not bode well for China continuing to attract portfolio inflows — at least not from fixed income securities, which accounted for 60% of such investments in 2021.
Given the strength of the renminbi and China’s large trade surplus, one could argue that a reversal of the still strong portfolio inflows cannot do the country much harm. In fact, a weakening of the renminbi if inflows slow could be helpful in boosting exports given the expected narrowing of the trade surplus over the course of 2022 as the global economy slows.
Still, there are concerns in Beijing, as comments from Chinese policymakers down to Xi Jinping revealed. “If the major economies were to hold back or turn around in their monetary policies, there would be serious negative fallout,” the president said last month.
In other words, no financial market – even China – is completely immune to rapid Fed tightening. Indeed, the dollar’s primary role as a reserve currency is key to understanding how the Fed’s “quantitative tightening” may affect China.
As China is overall a net creditor with more dollar assets than liabilities, a stronger US currency and higher interest rates should create a positive wealth effect for the country despite a lower value of its US dollar holdings. US treasury bonds.
However, this is not true for corporations. Large corporations with access to the offshore market are highly leveraged in dollars, which means their cost of funding will rise after the Fed tightens, and more so if the dollar appreciates with it.
In addition, Chinese banks have stepped up lending to a large number of emerging and developing economies, most of which are in dollars. The consequences of the pandemic highlight the unsustainability of the debt of many of these countries and the need to restructure them. Such trends are clearly not good news for the Chinese economy, which is already experiencing a cyclical, but also a structural deceleration.
As for Japan, a stubborn defense by the BoJ of its yield control strategy will only further weaken the yen. This can be positive for external competitiveness and could even help push up long-depressed inflation. But there would be a significant perverse effect: the purchasing power of Japanese households would contract and wages would have a hard time catching up.
All in all, the divergence of monetary policies between the major central banks will be increasingly difficult.
Either Eastern central banks will accept weaker currencies, and other related consequences, or they will give up following a divergent path. For China, the problem will lie in the external debt of certain large companies as well as in the exposure of banks to developing countries. For Japan, the decline in household disposable income can only slow growth.