The biggest threat to the global economy is China, the situation where could worsen with the return of inflation in the United States and other parts of the world. According to Morgan Stanley, the debt level in China rose to 279 percent of GDP in the third quarter of this year. We have been arguing for the past year or so that there could be two outcomes,

• First of all, the exchange rate against the dollar would go down as the forex reserves decline but that is unlikely to be very painful for the economy.
• The other one would be an increase in the interest rates, which is slowly taking place in the bond market. Since 16th of this month, Chinese 10-year debt yield has increased by 34 basis points. The 10-year yield has jumped most in 10 months and is currently at the highest level since the summer. As the US Federal Reserve, prepares to hike interest rates in the upcoming meeting, over the next two weeks, China’s 14-day repo rate exploded to 20-month high at 6 percent. Chinese banks are ready to pay 6 percent, compared to just 2.5 percent a day before to ensure liquidity over the next two weeks.

While China’s share of the dollar denominated debt is low, its $28 trillion worth of debt can’t tolerate higher domestic interest rates. We suspect that the next phase of the crisis is set to begin with higher interest rates as the cost of global funding increases.