Two weeks after “Bernanke shock,” the world stock and currency markets have returned to a close-to-normal state. On June 19, when Bernanke gave a clear signal of Fed gradual reduction and ultimate quit of QE3 or quantitative easing (QE), $340 billion evaporated in the world bond market, and world stock markets tumbled.
However, by July 3, the Dow Jones Industrial Average was only 2% lower than its pre-shock high on June 18; the Dow Jones world stock index was 2.6% lower, compared to 5.5% lower on June 23, the bottom after Bernanke shock. The nominal dollar exchange rate index (against major currencies) was 77.5457 on June 28, 3.3% up from the June 19 level before the shock. However, the largest appreciation has happened against the Japanese Yen (up 4.2%), followed by the Brazilian Real (up 1.5%) and Thai Baht (up 1.3%). It rose only marginally against Mexican Peso (up 0.9%) and Chinese RMB (up 0.2%), and fell against the South African Rand (down 0.7%). Interestingly enough, it fell most against the Euro (down 2.9%), although it should move up logically. Hence, the world market seems to be digesting the shock steadily.
A Reverse in World Capital Flows Causes Grave Concern for Emerging Economies
The top concern for emerging economies, including China, is the outflow of capital. According to EPFR Global, which tracks the cross border capital flows, after Fed initiated QE3 in September 2012, roughly $90 billion flew to the emerging economies’ stock markets during the 17 weeks between Sept. 1, 2012 to Jan. 2, 2013, compared to only $15.9 billion in the whole year of 2011. Flooded with a heavy money inflow, the South Korean Won appreciated 8.3% against the dollar, and the Singapore Dollar rose 6.1%, New Taiwan dollar rose 4.3%. The trend started to reverse even before Bernanke shock, with a net outflow of $5 billion from emerging economies in the week ended June 5. China also experienced a drastic change in 2 months, from a warning against hot money inflow in early May to a worry of money outflow in June, and from RMB upward pressure until May to a downside pressure since late June.
The re-strengthening of the dollar may cause even more concerns to the emerging economies. The strong dollar from 1979-1985 contributed to the Latin America debt crisis in the 1980s. A strong dollar again from 1995-2002 also contributed to the Asia financial crisis in 1997 and 1998, the Russian financial crisis in 1998, the Brazilian financial crisis in 1999 and the Argentine financial crisis in 2001. If the dollar appreciates by another 10% in the next 12 months, the leading emerging economies will face serious troubles.
However, as shown earlier, the real shock to the world stock and currency markets so far has been moderate. The further developments in the coming weeks and months need our close following and careful response.
Hard Reason: QE is Short-Term Supportive, but Long-Term Harmful
The Fed’s decision to quit QE is undoubtedly necessary. QE measures do have helped the US economic recovery. The home market, the trigger of the last financial crisis, has seen a steady improvement with both home prices and home sales rising steadily. Freddie Mac and Fannie Mae have been making money again. The stock market is almost booming. The unemployment rate went down to 7.6% in May 2013, from over 9% before QE1 started.
However, QE is harmful to the US and world economy in the long run. The basic function of QE is merely an expansion of liquidity supplies and leverage, instead of supporting innovation and the physical economy.
First, QE has uplifted the stock market by pushing down the government bond rate. DJIA rose by 7.26% in 2012, with a GDP growth rate of 2.2%. It moved up further by 13.8% in H1, 2013, even if hit by Bernanke shock, making it the best H1 performance since 1999. Meanwhile, the manufacturing sector had zero growth during the first 5 months. The overall industrial production index stayed at 98.7 in May 2013, still lower than pre-crisis level (100 in 2007), and even lower than that in March (99.1). Shipments of computer and electronics in May even fell by 4.4% over a year ago. Hence, there is a clear deviation of the stock market from the physical economy, and the asset bubble is shaping up.
Second, it pushed up the home prices just by leveraging mortgage-backed securities (MBS), instead of creating real demands. The Fed has been buying MBS at a rate of $40 billion a month, and has an accumulative $1.1 trillion in MBS so far. If the current buying rate continues to the end of the year, the Fed will hold 30% of the total MBS in the country. This massive purchase has apparently up-lifted the home market. The Federal Home Financing Administration home price index began to rise year-over-year since Q1, 2012, and was 6.72% higher during Q1, 2013. Remember, the Fed did a similar job before the subprime crisis by an extremely easy mortgage liquidity supply at a historic low rate. The same index in Q2, 2006, a year before the subprime crisis, was 7.23% up year-over-year, very close to the current 6.72%.
Both functions mentioned above will not support the long-term substantive economic growth because the fundamental problem in the US economy is the lack of a strong, competitive and innovative physical economy, rather than a monetary one. QE will ultimately delay the necessary restructuring and innovation for a robust, sustainable growth. IMF warned in its World Financial Stability Report of April 2013 that “a prolonged period of extraordinary monetary accommodation could push portfolio rebalancing and risk appetite to the point of creating significant adverse side effects.” In its annual report issued on June 23, 2013, Bank of International Settlements, known as the central bank of central banks, asked explicitly that central banks quit QE, in order to secure the strong and balanced growth of global economy.
China Should Also Quit QE
The Fed QE3 quit schedule announcement coincided with a “money crunch” in China. The “crunch,” though logically absurd, shocked China as well. China has the world’s largest M2 supply, accumulating RMB 104 trillion by the end of May 2013, or 200.4% of its 2012 GDP (67.2% in the case of the US), up 15.6% a year ago (up 4.9% in the US). The industrial production growth fell to a single digit since the beginning of the year, and HSBC manufacturing PMI fell to 48.3 in June, a sign of contraction. On the other hand, real estate prices keep rising in most of the major cities, only supported by excessive liquidities. In other words, China faces a real danger of over dependence on unlimited liquidity supplies to keep the real estate bubble and over investment, to make money out of money by shadow banking, with slow, inadequate technology innovation and structural upgrading. The recent moves by the People’s Bank of China show that China will no longer pursue a QE policy. Instead, the existing money supply must be devoted to supporting the physical economy and structural changes.
International cases in the past three decades have shown that an economy, including its currency, is relatively vulnerable to international fund flows and financial speculation if it does not have a strong, sound physical economy, and thus depends too much on liquidity supplies. Germany, for example, never worries about the US QE or QE quit, it stands firm on its own. China needs to pursue a resolute counter-bubble policy, focusing its financial sources on technology and business innovation, on improving people’s welfare, and take drastic control of the liquidity supplies to the real estate sector. The local governments should suspend land supply for commercial use for six months and shrink the ambitious “town making” fever. The local governments should reduce local debt, and let the market and businesses decide investment projects, based on feasible returns. Only in this way, can China withstand a Fed QE quit and more financial instabilities in the world.
A Soft Approach Recommended
In light of the world market repercussions to the launches and quits of QEs, the Fed needs to weigh the timing and tempo of QE reduction and quit, taking into account not only the US economic situation, but also the world markets. A fast rebound in the US bond interest rates tends to reverse the world capital flows too fast and cause instabilities, especially to the emerging economies. The dollar’s quick rebound also tends to have serious impact on other currencies, and thus should be gradual as well.
The Chinese economy, while shifting to a profound restructuring and upgrading, reducing the dependence to excessive liquidity supplies, should also maintain stable growth. A sharp slowdown in the economic growth tends to affect not only home employment and capital markets, but the Asia stock and currency markets as well. In both cases, a soft quit is recommended.
He Weiwen is Co-director of the China-US/EU Study Center at the China Association of International Trade.