China in a Negative Interest Rate Environment

Some observers like to more or less jokingly point out that we are living, from a monetary perspective at least, in a bit of an economic twilight zone in light of the fact that in terms of (one again, especially monetary) policy, we are most definitely in what can be considered uncharted territory. To put it differently, the unprecedented has become accepted as status quo.

To illustrate this, we can try to find articles written during the Dot-Com Bubble aftermath days, articles which expressed concerns with respect to the aggressive measures chosen by the then-Chairman of the Federal Reserve Alan Greenspan to set the economy back on track: lowering interest rates all the way to 1%, for example. All things considered, interest rates ultimately climbed back up as time passed, not all the way to the pre-calamity levels but at a very respectable 5-6%.

As such, after the 2007-2008 Great Recession ruined everyone’s plans, interest rates were at least at a level high enough for Ben Bernanke (the Federal Reserve chairman at that point in time) to have some wiggle room. Unfortunately, lowering them back to 1% was not enough to satisfy the market and as such, a higher “dose” was required in a binomial approach: on the one hand, interest rates were lowered even further (all the way down to zero) and on the other hand, money had to be injected into the system as well (something that did not occur in the aftermath of the Dot-Com Bubble). How much money? $85 billion per month at the height of the so-called Quantitative Easing process or, to put it differently, roughly $1 trillion per year… more in one year than the approximately $800 billion that existed in the monetary base from 1913 all the way to the Great Recession.

Fast-forward to the present and things are… well, tricky.

On the one hand, asset prices were sky-high and we were at historical levels not just when it came to indices such as the S&P 500 but also as far as the time we had without a recession was concerned.

Wasn’t that great news?

Viewed in isolation, yes, that piece of information seemed like excellent news. However, our bubble tends to be burst (both literally and metaphorically) once we understand the PRICE that had to be paid to achieve this status quo:

1. Interest rates hadn’t even meaningfully “normalized” in the United States, the “textbook” example of unorthodox monetary policy success. Yes, they went up a bit but in light of the fact that over a decade had passed since the monetary policy prescription, to say that the sub-par normalization was a cause for concern would represent a severe understatement and 2020’s developments have proven just that
2. Things tend to look even more unsustainable elsewhere, for example over in the European Union with its negative interest rates and QE numbers which exceeded that of the US after EUR amounts were converted to USD… let’s not even refer to Japan (once again, negative interest rates and the entire enchilada in terms of capital injections), the “father” of unorthodox monetary policy, if you will
3. Bubbles abounding across multiple economic sectors, with each being “potent” enough to bring down our grossly over-leveraged financial system

To understand China’s perspective, let us use our imagination and take things one step further.

Let’s assume things would continue moving down in 2020.

From a monetary policy perspective, the implications would be more than obvious:

1. Lowering interest rates to zero would most likely not be enough in the United States, they would most likely need to venture well into negative territory
2. In the EU and Japan, which have already experimented with negative interest rates, they would need to go even deeper into negative territory
3. Contrary to what unorthodox monetary policy enthusiasts believe, lowering interest rates cannot continue indefinitely in light of the fractional reserve nature of the banking system. Does it risk collapsing at let’s say 0.1%? No, as the average investor tends to be far too complacent for that to occur. But what about -1%, -2% and so on? At a certain point, it is difficult to believe the market won’t simply say no

To put it differently, the 2020 economic crisis will most likely result in negative interest rates across the board when it comes to the dominant Western players: less aggressive but still negative interest rates in the US, more aggressively negative rates in the EU and Japan.

Will China join the party?

In terms of interest rates going negative, most likely not. However, it would be a mistake to assume it can simply isolate itself from these monetary mega-trends in light of the interconnected nature of the economy we find ourselves in.

When times are good in a low interest rate environment, investors who are desperate for yield are more than willing to look toward jurisdictions such as China and as such, there are quite a few scenarios which benefit China in one way or another. If or when that changes, however, China becomes a capital flight victim in light of not being considered a safe haven jurisdiction, for reasons which have been covered in a previous article.

To add gasoline to (political rhetoric) fire, we find ourselves as spectators of amusing situations which revolve around China and the West blaming one another for monetary foul play, with China being accused of debasing its currency by Western nations who are creatively doing just that and… of course, the other way around.

If we had to sum up China’s situation in a negative interest rate environment using just one word, “volatility” would be our choice. Simply put, whether it wanted to or not, China ended up becoming a player in a worldwide game of monetary musical chairs and those who believe they can predict the final outcome in an accurate and sustainable manner are, in our view at least, deluding themselves.