Some investors are concerned about the potential of a US interest rate hike wreaking havoc on China’s economy and financial system just when China’s growth momentum is slowing, its property market is entering a correction and the risk of credit default in its shadow banking market is rising. The logic behind such concerns is simple. When the US finally raises interest rates, probably sometime in the second half of 2015, capital will flow out of China. The resultant downward pressure on the renminbi (RMB) would force China to raise interest rates to protect the currency, adding liquidity stress to an already fragile economy that is struggling with the impact of structural reforms.
Such conventional wisdom misses the point, in our view, and the fear should not be exaggerated. It is far from certain that the US Fed will be able to raise rates as early as expected because the US economy is still stuck with a post - balance - sheet recession adjustment, which could keep its growth below potential for longer than most analysts might imagine 1. Even if the Fed does raise rates next year, the ultimate impact on China may be muted. The magnitude of the potential US rate hike will be limited, with the market expecting no more than 50 bps in 2015. Ceteris paribus, that will still leave a large interest rate spread of four percentage
points to prevent capital outflow from China (Chart 1).