After the end of Quantitative Easing (QE), the monetary policy of the U.S. Federal Reserve will make a transition towards normality. The next topic that will concern the market will be when the an interest rate increase will occur, and the “real pressure” that will be caused by a raise in interest rates. The challenge of how to realize a long-term steady GDP growth and continue job growth still faces many challenges and uncertainties.
At present, the greatest contribution to the U.S. economy mainly comes from overseas demand which contributed 1.3% to the overall 3.5% GDP growth in the third quarter (exports increased by 7.8 % while imports shrank by 1.7%). After the end of QE, the appreciation of the U.S. dollar will directly weaken the U.S. export competitiveness in the world market.
The end of QE will lower the U.S. dollar supply and increase the U.S. bond yields, thus improving the attractiveness of the dollar-denominated assets and allowing international capital to flow back to the U.S. Within fifteen years, the capital drawn from the Euro zone by world investors will reach USD 239 billion – a new high level of capital outflow from the Euro zone1. The already weakened Eurozone economy will worsen and narrow its demand for U.S. goods, which will conversely contain the U.S. economic recovery. To this end, the U.S. Federal Reserve cut its growth forecasts from 2.2% to 2.1% for 2014 and from 3.1% to 2.8% for 2015.
Despite the end of QE, this extraordinary monetary policy tool will not completely disappear but will be stowed in the U.S. Federal Reserve policy toolbox, becoming a policy tool that may be used at any time in the future. It is not out of the question that the U.S. Federal Reserve would again resort to this policy tool when its economy takes an unexpected downward turn in the future.
The IMF believes that the U.S. QE policy has weakened the U.S. dollar, causing the flow of USD 650 billion into the newly emerging markets. For instance, a large amount of USD flowing as “hot money” from Hong Kong to the Chinese mainland for “carry trade” is expected to reach as high as USD 1.2 trillion. Asian Corporate debt denominated in the U.S. dollar has increased from USD 300 billion to USD 2.5 trillion and the global cross-border bank loans have arrived at USD 11 trillion, more than two thirds of which is denominated in the U.S. dollar; much of these loans have not undergone currency hedging, thus it is hard to resist the risk of the U.S. dollar surging in value within the short-term. 2
Past experience reveals that a strong U.S. dollar will cause deflation. A 10% appreciation of the U.S. dollar exchange rate will cut down inflation by 0.5% within one year, creating conditions for carrying out “the European QE” and “the Japanese QE.” The appreciation of the U.S. dollar will make the exchange rate market seek a new balance; the Euro exchange rate against the U.S. dollar could fall to 1.12 and the Japanese yen exchange rate against the US dollar could reach its lowest level next year.
Due to China’s favorable factors, like a consistent current account surplus, huge foreign reserves, a low level of foreign debt, a high domestic savings rate and a practice of capital account control, the U.S. Federal Reserve’s withdrawal of QE will not have an obvious impact on China.
Meanwhile, the end of QE will bring opportunities to China’s economic development. First, the appreciation of the U.S. dollar will revalue China’s foreign reserves to USD 3.99 trillion and increase China’s purchasing power in the market. The U.S. bonds valued at USD 1.3 trillion held by China will enjoy higher yields. About USD 520 billion worth of ST “Fannie and Freddie” assets and other government bonds held by China will be unfrozen and get a high investment returns as the U.S. economy recovers.
Second, a stronger U.S. dollar will reduce the price of international commodities, thus lowering the cost of China’s imports, economic operational costs as well as easing the pressure from imported inflation. With a 25% fall of global crude oil prices in 2014, a great quantity of crude oil China bought at a low price has kept at a strong level of about 8.5%. China can take advantage of low oil prices to reach the international standard of 90 days of strategic oil reserves instead of the current 30-day requirement, so as to enhance the ability to resist an oil crisis in the future. In addition it can also help support the global oil demand that is now weak, and rebalance the international crude oil markets. For example, China’s purchase of oil has supported Dubai’s crude oil market, which is benchmarked on Asian prices.
Besides, the U.S. economic recovery will increase its demand for imports, thus promoting China’s export of capital and commodities. For instance, Chinese high-speed rail companies undertook a USD 3.475 billion rail project in Boston and are now ready to take part in a USD 68 billion project, which will build a rail that runs from Los Angeles to San Francisco, a total length of 1280 kilometers.
Meanwhile, the end of QE will also bring risks to China’s economic development. First, it will make it harder for China to regulate its macro monetary policy. Given that the U.S. has withdrawn the QE while Europe and Japan have pushed out their QE, should China lower its reserve requirements? Should China ease its monetary and credit policy? Should China implement a “directional stimulus”? All kinds of debates about the direction of monetary policy decisions have made the market perplexed. Another “money shortage” like the one in 2013 will severely affect market confidence.
Second, higher dollar interest rates will reduce the appreciation pressure of RMB against USD while forming a RMB depreciation pressure. The appreciation margin of RMB against the Euro and Japanese Yen will be higher than that of RMB against the dollar. This will be unfavorable to China’s commodity export to European and Japanese markets.
Third, the appreciation of the U.S. dollar will normalize the slow growth of Chinese foreign reserves. A discounted exchange rate due to a strong U.S. dollar reduced China foreign reserves by USD 100 billion in the second quarter of 2014. The third quarter again witnessed a RMB 501.7 billion account surplus and RMB 502.1 billion capital and financial account deficit.
Fourth, China’s real estate bubble is directly or indirectly related to the U.S. QE policy to a large extent. The appreciation of the U.S. dollar after the end of QE will cause capital to flow back to the U.S. and will intensify the capital shortage in China’s real estate market to some extent, so in the future there will be a persistent “money shortage.”
Fifth, the end of QE will make it more difficult for Chinese real estate enterprises to raise funds overseas and also increase the financing cost and exchange rate cost for the enterprises. At present, the overseas financing of Chinese real estate enterprises has totaled USD 53 billion. A 5% appreciation of the US dollar will increase financing cost by USD 2.65 billion.
- ECB Data. October 29, 2014
- The Daily Telegraph. November 4, 2014