News Analysis: U.S. rate hike clarifies China's policy challenges

Yesterday's U.S. interest rate adjustment narrows the scope for China to balance currency stability with economic growth.

The U.S. Federal Reserve raised the benchmark interest rate by 25 basis points on Wednesday, the first increase since 2006, signaling the end of the era of monetary easing.

Both the employment and inflationary situations in the United States have improved, complicating the picture for emerging economies, struggling with anemic growth and dimming prospects.

"The key question for China in 2016 could be whether the country can reconcile potentially conflicting imperatives on domestic and external financial stability," said Andrew Colquhoun, head of Asia-Pacific sovereigns at Fitch Ratings.

Rising corporate debt and softening domestic demand in China would justify lower interest rates, but with U.S. rates increasing, rate cuts in China could precipitate a flight of capital in search of better returns, Colquhoun said.

The U.S. rate hike was widely anticipated and most of its effects are have already factored into China's forex reserves and the yuan rate. Reserves fell by 87.2 billion dollars in November, the second-biggest monthly drop since 2011. The yuan central parity rate against the U.S. dollar weakened for the ninth consecutive day on Thursday to 6.4757, the lowest in more than four years.

The Fed's action puts pressure on the yuan and squeezes China's room for reducing interest rates, said Jiang Chao at Haitong Securities. Worse yet, capital outflows could hit a property market that is already depressed, with knock-on effects in shadow banking and on local government balance sheets.

A massive shock, however, would be exactly that: a shock. Third-quarter GDP growth of 6.9 percent is still much better than most other major economies and China's forex reserves are still well above 3 trillion dollars; a huge shock absorber.

While not immune to the effects of the rate hike, China will naturally consume some forex reserves and see currency fluctuations, but the government is ready and willing to intervene if necessary, said Guan Qingyou at Minsheng Securities. "Out-of-control capital outflow is unthinkable," he said in an analysis note.

Financial markets have already priced in the Fed's move and the yuan may "take a breather" in the short term, Guan said. In the long run, he said, the currency will become more volatile as it becomes less dependent on the dollar.

China's central bank has already signaled that the market should view the RMB's strength relative to a basket of 13 currencies, including the dollar, euro and Japanese yen, a move aimed at more flexibility, making the currency less susceptible to Fed policy, according to UBS economist Wang Tao.

With higher U.S. rates, China is under pressure to make its economy more competitive and appealing to foreign investors. To offset capital outflow risk, China should increase returns on domestic assets by stabilizing growth and accelerating structural reform, said Jiang at Haitong. Endi