“Anyone who spends too much time thinking about international money goes mad.”
Commentary & Analysis
The Mundellian Trilemma, China’s Box, and Dollar Risk Bid
The Mundellian trilemma says policy makers can control only two of the three main variables in global finance, but not all three at the same time.
“…it is not feasible to have at the same time a fixed exchange rate, full capital mobility and monetary policy independence. Only two of the three may co-exist (according to the Mundel-Fleming logic),” writes Helene Ray, of the London School of Business, International Channels of Transmission of Monetary Policy and the Mundellian Trilemma.
That’s the theory. Now take a look at China’s situation for application of the theory. Chinese policy makers seem to be stuck in a tight policy box—the alternatives available aren’t very appealing.
The dynamics of the trilemma for China can be seen in the chart below…
The chart above compares the benchmark 2-year Chinese interest rate (red); to the 2-year United States interest rate (black); to the Chinese currency priced in US dollars (green).
1. The 2-year yield spread between China and the United States is narrowing as the Fed continues to hike the Fed Funds rate, while the Chinese 2-year yield is falling as China attempts to stimulate growth (so far it isn’t working).
2. As the 2-year yield spread narrows between the China and the US, it pushes the value of the Chinese yuan lower; i.e. CNY/USD is moving lower as the spread (red line minus the black line) narrows. Hot money is moving out of China and into the US.
China is facing slowing growth, rising unemployment, and the possibility of a major acceleration in capital flight (as we saw back in 2016).
So, China’s policy choices seem to be these:
1. Raise interest rates and protect the currency (including capital controls) in an effort to avert a capital run. This means China loses control over sovereign monetary policy which calls for lower rates to stimulate growth (add more debt). Unemployment rises under this policy choice and that means China’s efforts to rebalance its economy and shift more resources to the household sector is stymied once again.
2. Let the currency run and lower interest rates in an effort to stimulate local demand. This leads to more household indebtedness. And with China’s current account surplus now at just one percent of GDP, the measure of safety here if capital runs offshore is thin and a plunging currency would be seen by the United States a currency war on top of a pending trade war.
If China chooses #1, we can expect a continued deceleration of Chinese growth; the country’s manufacturing index is approaching stall speed (see the chart below). But, rising rates would help slow the dangerously rising debt formation and be best for global stability, though internally rising unemployment is never popular.
China’s manufacturing index grinding lower – China’s NBS manufacturing PMI fell to 50.8 in September, from 51.3 in August and below the Bloomberg consensus of 51.2. While this was the first September drop since the NBS manufacturing PMI series was released, it was also the 26th consecutive month of prints above the 50-point mark that separates growth from contraction.
If China chooses #2 above and let’s the currency run it risks trigger a major flow of capital not only out of China but emerging markets in general—a contagion trigger if there was one.
But there is a third choice I haven’t shared, but there is a third alternative according to Andrew Polk at Trivium. From the Financial Times:
Makes sense, but the difference is this is 2018, not 2016. The spread has tightened a great deal since then’ it is potentially a more powerful drain on China’s capital given the rising risks of a trade war.
Keep in mind, the sentiment toward emerging market economies is driven in large part by the health of China. EM policy choices are tremendously hampered as they have a lot less control over their sovereign monetary policy than China. EM ex-China lack capital market depth (in addition to other intangibles such as proven fiscal and central banking track records—China has some depth though Hong Kong and lots of reserves).
EM’s still rely primarily on US dollar denominated funding (US dollar denominated debt is estimated from $3+ trillion; likely more); i.e. emerging markets are the periphery; the US and other developed markets are the center. The periphery capital funding flows from the center outward. This simple fact hasn’t changed much since either the emerging markets crisis back in 1997 (after which the IMF urged Asia to develop capital market depth in order to avoid this funding risk; they didn’t) or the credit crunch in 2007.
Effectively, EM ex-China countries have extremely limited sovereign monetary policy; however, they do have floating rate currencies driven by the ebb and flow of global capital. In other words, they are subjected to the whims of free global capital flow across borders seeking the best home. Already their currencies have been under lots of pressure—and said pressure will likely build with each ratchet higher in Federal Reserve rates. Where oh where might that Bancor be?
Take a look at the chart below which compares Emerging Market Stocks (symbol EEM) to Emerging Market Bonds (EMB) to the China-United States 2-yr yield spread. Who leads, who follows? Our guess: EM stocks and bonds follow the 2-year China-US spread. And if true, and this spread keeps widening, there is plenty of room for EM stocks and bonds to fall considering from where they came back in 2009.
The US Fed’s rising interest rate campaign is a wrecking ball to the pretense of a sovereign monetary policy in China at this stage in the cycle; this is especially true for the emerging markets. We don’t see the Fed stopping anytime soon. The question is: What will China do? If this 2-year spread continues to tumble, it likely means the damage we have seen to EM stocks and bonds will look tame compared to the future.
As you know, a run out of EM and China would be extremely dollar bullish as the money runs to US Treasuries and to buy US Treasuries you first have to buy the US dollar. That is part our rationale as to why the buck sees 100 (measured by the US dollar index) before it starts down once again into a long-term bear market sometime in early to mid-2019.