Fed rate rises, a trade war and US dollar dominance add up to a big headache for Beijing

As the US Federal Reserve raises rates, there are growing concerns over capital flight and financial system meltdowns in emerging markets " and China, in the middle of an escalating trade war with the United States, is no exception.

This week the Fed raised interest rates for a third time this year, reaffirming its outlook for further gradual rises well into next year.

Countries from Argentina to Turkey have already been battered by higher interest rates in the US as US dollar-denominated assets became more attractive, triggering capital flight from those countries that have seen their currencies weaken against the greenback.

Weighed down with US trade tariffs and a domestic debt overhang, China is vulnerable to capital outflow pressure and sell-offs. Already, Shanghai stocks have lost 15.6 per cent this year and the yuan has fallen by 9 per cent against the US dollar since April, an unprecedented pace of depreciation.

Anna Stupnytska, global economist at Fidelity International, said in a note that emerging market economies were already facing tighter financial conditions this year, "which have resurfaced some vulnerabilities as capital flows started reversing".

"With the trade war rhetoric unlikely to de-escalate any time soon, the overall risks to US and global growth are clearly skewed to the downside," Stupnytska said.

The strength and stability of the US dollar has made it the backbone of the world's reserve currency system, maintaining liquidity and a safe haven status during times of volatility.

China 'supports millions of American jobs, makes big profits for US firms'

Despite Beijing's constant complaints about the dollar hegemony over the past decade, the greenback is still the default choice for China's trade settlement, and dollar-denominated assets account for about two-thirds of China's total foreign exchange reserves.

As the trade war intensifies, China has again argued that the dollar's anchor currency status " and not China's trade practices " is the reason the US is running deficits in the goods and service trade with other countries.

In a white paper titled "The Facts and China's Position on China-US Trade Friction" released this week, China argued that the US used "exorbitant privilege", a term coined by former French president Valery Giscard d'Estaing, to levy seigniorage " or profit " on all countries.

"For the US the cost for printing a hundred-dollar bill is no more than a few cents, but other countries will have to provide real goods and services in exchange for that note," the report said.

"On the other hand, as a major global currency, the US dollar supports global trade settlements, and the US supplies US dollars to the world by way of a deficit. Therefore, beneath the US trade deficit lie profound US interests and the very root of the international currency system."

China also argues that low savings and high consumption in the US economy means that the country has to run a deficit to attract a large amount of foreign savings. "The US trade deficit is an endogenous, structural and sustained economic phenomenon," the white paper said.

Economists said the dollar's status was a source of power for the world's largest economy.

But that dominance is not total.

The US dollar's share of currency reserves reported to the International Monetary Fund dropped to a four-year low in the first quarter of US$6.499 trillion, or 62.48 per cent of allocated reserves.

It was the lowest level since it reached 61.24 per cent in the fourth quarter of 2013, according to IMF data. The share of the reserves in euro, yuan and sterling rose during the first quarter.

At the same time, Beijing has various tools at its disposal to avoid any exodus of funds or sharp depreciation in the yuan, including draconian controls over outbound payments and wider channels for inflows.

Frances Cheung, head of macro strategy for Asia at Westpac Banking, said demand for China's onshore government bonds showed that investors were not losing confidence.

Chinese Premier Li Keqiang also promised this month that China would not use the yuan as a weapon in the trade war.

But while China can temporarily shield its financial markets from fallout from the Fed, it could lose an economic war if US dollar dominance continues.

"All America has to do to preserve its economic dominance is to grow 2 per cent a year for the next 20 or 30 years," Huang said. "[This is because] America's gross domestic product per capita is seven times as large as China's. The gap between China and America just gets bigger and bigger."

Additional reporting by Reuters

This article originally appeared on the South China Morning Post (SCMP).

Copyright (c) 2018. South China Morning Post Publishers Ltd. All rights reserved.