Amid renewed warnings of acting too hastily, one statistic in particular stands out. Economists at RBS noted that of the 15 Organisation of Economic Co-operation and Development central banks to have raised rates since the financial crisis, all 15 have now begun to cut again.
Some still expect the US Federal Reserve to hike later this month. To put it in central banking terminology, the decision remains finely balanced.
For others, the central bank is looking in entirely the wrong direction. Ray Dalio, head of global hedge fund manager Bridgewater, and former US Treasury secretary Larry Summers have both suggested Janet Yellen’s first major policy move should be to ease rather than tighten.
Whatever the validity of the argument against a hike – a call that is backed by many of the UK’s contingent of cautious fund managers – China’s slowdown may have complicated the debate, and not just because of recent volatility.
Analysts at Deutsche Bank have argued that China’s reaction to its domestic troubles has led to a “quantitative tightening” (QT), which is already putting a strain on the global economy.
The bank said in a recent research note: “The bigger picture is what is happening to China’s foreign exchange [FX] reserves. Back in 2003, China started accumulating almost $4trn [£2.6trn] of foreign assets […] with a global equivalent to quantitative easing [QE].
“This may be the first time that a major central bank is effectively unwinding its QE programme.”
This unwind is due to the reduction in China’s FX reserves that has taken place as a result of capital outflows from the country. These outflows have placed a corresponding downwards pressure on its currency, the renminbi.
While China is now happier for market forces to play a role in setting the value of its currency, this commitment only extends so far. As a result, Beijing has been drawing on its reserves, selling dollar assets to defend the renminbi from the impact of the capital outflows.
Deutsche Bank said this development has the effect of reducing global liquidity and can explain much of the recent market volatility, adding weight to the theory that risk assets had only prospered thanks to central bank largesse.
Jean Médecin, a member of Carmignac’s investment committee, agreed: “Our view is that financial markets have been propped up by liquidity from central banks. We may be at the point where there might be less support.
“The risk is if the Chinese central bank keeps digging into its FX reserves, which would be equivalent to a lower monetary base and monetary tightening.”
China’s FX reserves have dropped from a peak of $4trn in 2014 to just under $3.7bn as of the end of June. With much of this pile held in US Treasuries, the net effect is higher bond yields, according to Deutsche Bank. This is adding to the pressure on central banks to hold off on raising rates.
“This force is likely to be a persistent headwind towards developed market central banks’ exit from unconventional policy in the coming years, representing an additional source of uncertainty in the global economy,” said George Saravelos, a strategist at the bank.
However, in an echo of the debate that still swirls around QE programmes, the rationale behind QT is disputed. Economic commentator Frances Coppola said China selling dollars is far from a tightening measure.
“What are market players going to do with the dollars they buy? Why, exchange them for US Treasuries, of course,” she said.
“Thus this alternative is at worst monetarily neutral and could be regarded as monetary loosening due to the increased velocity of money. It certainly isn’t tightening: China would not be able to hold [the renminbi’s peg with the US dollar] if this was tightening, because it would put upwards pressure on the dollar.”
Furthermore, a rejection of the QT theory does not automatically mean backing for an interest rate rise, or vice versa. Ms Coppola has called for further loosening to be considered, and thought that slowing emerging markets were already having a negative impact on the US economy.
By contrast, Mr Médecin – a believer in the monetary-tightening narrative – is concerned about the Federal Reserve becoming stuck in “a kind of QE infinity”, whereby policy normalisation becomes harder to implement with each rate hike postponement.
However, what is certain is that the Chinese currency has become a new focal point for investor concerns. If the renminbi devalues further, the debate over China’s dollar reserves will rumble on. But a more stable currency could be the kind of certainty that investors crave.
Toby Nangle, head of multi-asset allocation at Columbia Threadneedle Investments, identified the renminbi as one of the three major indicators for future market direction.
“We are looking carefully for signs of stability in three places that are at the centre of the international financial market vortex: commodity markets, corporate bond markets, and the Chinese currency market,” Mr Nangle said.
“The prospects for broader market rallies, in our mind, relate meaningfully to prospects in these markets.”
