How US Monetary Policy Tamed Chinese Foreign Policy

US Federal Reserve Chairman Jerome Powell. Photo: Getty Images.
US Federal Reserve Chairman Jerome Powell. Photo: Getty Images.

Chinese leaders do like their slogans, and where foreign policy is concerned there are two that have reflected Beijing’s thinking in recent years. The first is tao guang yang hui, usually rendered into English as ‘hide your light and bide your time’, which guided Chinese policy for decades from the 1980s when Deng Xiaoping first established it as a principle of caution in foreign affairs. In late 2013, though, a new slogan was coined by President Xi Jinping to define a more assertive, muscular approach to foreign policy: fen fa you wei or, as it is commonly translated, ‘strive for achievement’.

The drift towards a more assertive foreign policy under Xi has been evident everywhere from China’s declaration of an air defence identification zone over the East China Sea in late 2013, to the creation of ‘facts on the ground’ in the South China Sea, to the development of the Belt and Road Initiative.

But there are signs recently that China might be having second thoughts about its ability to keep striving for achievement. Xi’s government seems clearly to have entered into a concession-making mode in its relationship with the US, and some prominent Chinese academics have begun questioning whether China has been guilty of strategic overstretch. Yan Xuetong, for example, a doyen of Chinese foreign policy scholarship, has recently argued that Xi’s shift in Chinese policymaking has gone too far, and that China should limit its ambitions to a narrower, regional sphere. Another Beijing-based expert, Shi Yinhong, calls for ‘strategic retrenchment’ in Chinese foreign policy.

An easy explanation for this Chinese shift towards retrenchment is Donald Trump, who has applied his own brand of assertiveness to the US-China relationship, with the apparent support of the America’s entire political class and a very substantial chunk of Europe’s. Confronted by the West’s pushing back, it is unsurprising that China is more wary of pushing forward.

But it is also true that China’s current retrenchment owes much to the fragility of its economic performance. As anyone who has travelled recently to Beijing will tell you, the sense of economic pessimism there these days has rarely been so tangibly on display.

To a degree, the sagging of Chinese growth is self-induced. Since Xi declared last year that financial stability is a national security concern, risk-taking by local governments and by the financial sector have generally been frowned upon. Since these have undeniably been the two engines of China’s growth in the past ten years, risk-aversion on the part of provincial officials and financiers has naturally sapped energy from the economy.

Yet there is another, undernoticed, source of China’s economic fragility, and that’s the capital account of its balance of payments.  Since 2014, when China’s foreign reserves began to fall from a $4 trillion peak to their $3 trillion level today, authorities in Beijing have had a number of reasons to be nervous about the risk of excessive capital outflows, and the damage that might do both to China’s economic self-confidence and about its role in the world. In other words, just as Xi was pushing the country to ‘strive for achievement’, the fall in reserves began to throw China’s confidence into doubt.

For any emerging economy, there is an important connection between the health of the capital account and the health of the domestic economy. If money is voting with its feet to get out of the country, how can anyone expect domestic confidence to be strong?

And it is equally true for any emerging economy that the most important single driver of capital flows in and out of the country is the state of US monetary conditions. Loose US monetary policy pushed capital towards China in the aftermath of the 2008 financial crisis, just as it pushed capital towards other developing countries. That’s what helped reserves grow to $4 trillion in the first place: the Federal Reserve’s quantitative easing policies made it profitable for Chinese firms to borrow dollars, and so money flowed to China.

And just as loose US monetary conditions pushed capital towards China, their progressive tightening in the past five years has undeniably helped to suck dollars away from China, causing the country to lose reserves and self-confidence. Chinese corporates tend to repay debt when the dollar is strengthening, because the cost of servicing dollar liabilities goes up. Foreign portfolio investors will be less happy about buying Chinese government bonds when the China-US interest differential narrows, as it has in recent months.

By far the most important reason why reserves haven’t fallen below $3 trillion is because of a network of controls on capital outflows that Chinese policymakers put into place at the end of 2016 and the beginning of 2017. Without those controls, reserves would certainly have fallen further by now, creating an additional source of nervousness for Chinese policymakers. But those controls may not be completely watertight: the entire history of capital flows tells us that when money wants to find a way out of a country, it will.

A fragile capital account and the economic self-doubt it can create are hardly a strong foundation for aggressive Chinese foreign policy. So the next time Donald Trump feels like excoriating his Fed chairman for tightening US monetary policy too quickly, he might pause to consider the role that higher US rates and a stronger US dollar have played in taming China’s self-confidence. A dovish Fed is a gift to Beijing.

David Lubin, Associate Fellow, Global Economy and Finance.

A version of this article was first published by Project Syndicate.

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