THE U.S. Federal Reserve’s increase in its key borrowing rate — which had been kept at near zero for seven years — narrows the scope for China to balance currency stability with economic growth, and will likely mean more capital outflows from China and a depreciating yuan, according to analysts.

    The U.S. Federal Reserve raised the range of its benchmark interest rate by a quarter of a percentage point to between 0.25 percent and 0.50 percent Wednesday, the first increase since 2006, signaling the end of the era of monetary easing.

    “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 have already factored into China’s forex reserves and the yuan rate. Reserves fell by US$87.2 billion 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 Thursday to 6.4757, the lowest in 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.

    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 Qing-you at Minsheng Securities. “Out-of-control capital outflow is unthinkable,” he said in an analysis note.

    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.

    Last week, China altered how it measures the value of the yuan by moving from an exchange rate that relied on the U.S. dollar to the currencies of its trading partners. The new trade-weighted yuan exchange-rate index measures the yuan’s strength relative to a basket of 13 foreign currencies, including the dollar, the euro and the Japanese yen, according to the trade volume with China.

    By allowing the yuan to fluctuate against the basket of currencies instead of the U.S. dollar alone, China’s central bank has greater flexibility in dealing with the aftermath of a hike in the federal funds rate, said Tailan Chi, a professor at the University of Kansas business school in Lawrence, Kansas.

    “The value of the dollar is likely to rise against other currencies in the basket as the federal funds rate is raised. The PBOC can then let the yuan fall against the dollar and thus make it more costly for Chinese investors to move their money to dollar-denominated assets to benefit from the higher interest rates. This enables them to maintain their current monetary policy and to claim that they are keeping the value of the yuan stable against the basket of currencies,” Chi wrote in an email to China Daily.(SD-Agencies)

    (Read more on P5: HK braces for greater economic challenges)