Recently the Federal Reserve’s intention to end its quantitative easing policy (QE) has come into focus. Although the Fed’s officials, including Ben Bernanke himself, have repeatedly stressed that the final decision has not been made, based on the current U.S. economic situation and the quitting conditions given by Bernanke, quitting QE within the year is a highly probable.
The economic indicators have been close to quitting conditions as inflation fell below 2% and the unemployment rate fell to 7%. Since April of last year, U.S. annual inflation rate remains low at 1.3-1.9%. Since last December, the unemployment rate has been reduced to 7.6%. Although there is still a gap from 7%, there are reasons to expect the Fed won’t wait for the unemployment rate to slide down to 7%. As long as the unemployment rate declines steadily for three consecutive months, monetary policy adjustments will occur. Of course, other factors, such as second and third quarter GDP growth, fiscal situation, market response, and even pressure from Obama will influence the Fed’s final quitting decision.
More importantly, the Fed has started to emancipate policy signal balloons to test market response, which means the Fed has figured out a retreat strategy. On December 13, 2012, Bernanke first mentioned exit conditions. On May 22, Bernanke said at a congressional hearing, the Fed would consider the scale of QE retreat. On June 19, the Fed issued a monetary policy statement after the FOMC meeting saying, “The scale of monthly equity purchase may be cut later this year.”
The Fed’s QE retreat strategy is reasoned to be step-by-step. At the beginning, the first step is reducing purchase scale, limiting the Fed’s balance sheet expansion. Specifically, the first step is to reduce the current monthly purchase scale from $85 billion to $50-60 billion, and then drop to $30 billion, before finally stopping purchase. In the mid-term, the Fed will adjust its balance sheet structure, gradually raising the benchmark interest rate. In the long term, the Fed will sell out bonds bought under the QE policies.
It seems the Fed has a roadmap for QE retreat, but any negligence may lead to huge economic risks, which is of big concern to American investors. Investors in emerging market countries have more reasons to worry.
Undeniably, QE’s implementation plays a big role in propelling the US economy out of the crisis, which objectively boosts emerging countries’ exports to the US. But it is also undeniable that QE undermines the stability of the economic recovery. Therefore, many Asia-Pacific economies, including China, have to face inflation, asset foaming and a series of major challenges. QE in nature is diluting US debt by releasing extra liquidity, letting other countries share the costs of the US crisis. Ultimately, emerging markets are the biggest victims of QE’s implementation.
But, QE retreat once again makes emerging markets victims. To begin, capital outflows have intensified. The international short-term speculative capitals treat QE retreat as the signal the US economy is going strong, so they sell out Asian assets at a large scale and put them back to US markets. Now, China’s foreign exchange data has mirrored this trend.
The net purchase of foreign exchanges hits a six-month low of 66.86 billion Yuan in May, slumping from April’s 295.35 billion and the average 315.3 billion during the first four months of the year, according to data released by the People’s Bank of China.
Second, external financial market turmoil increased. On June 13, out of fear the Fed’s FOMC meeting would lead to the decision to quit QE, emerging markets fell across the board. China A-shares fell 3%, while Hong Kong stocks fell 2.2%. On June 14, better-than-expected retail sales and employment data boosted emerging countries’ markets sharply. On June 19, after laying out a QE quitting timetable, U.S. stocks fell across the board again. As a result, the Morgan Stanley Emerging Markets Index dropped 4% and the Hong Kong stock market fell 2.88%. Since the beginning of the year, emerging markets have dropped about 20%.
Third, emerging economies’ monetary policy is trapped. On June 13, Indonesia’s central bank unexpectedly announced its intention to raise the benchmark interest rate by 25 basis points to 6%. Only two days ago, the Indonesian central bank raised its overnight deposit rate. Brazil is in the same situation as Indonesia. Within several months, Brazil raised the benchmark interest rate twice. On May 29, Brazil’s central bank dramatically raised the benchmark interest rate by 50 basis points, far beyond expectations. The Financial Times said that Brazil’s “contrarian” interest rate rise was related to the end of QE. Additionally, caused by the scaling down of QE, the Indian rupee’s rapid depreciation was a key reason India’s central bank “reluctantly” kept interest rates unchanged and suppressed the urge to cut interest rates again.
It is out of concerns surrounding the end of QE that the International Monetary Fund, World Bank, European Union and South Korea recently asked the US to deal with the problem carefully to prevent economic and financial risks. On July 11, at the fifth round of the China-US Strategic and Economic Dialogue (S&ED), Chinese Finance Minister Lou Jiwei warned the US should take full account of impacts of QE retreat on the world economy, which is the first time a high-level Chinese official publicly talked about this worry, indicating a real and potentially big impact on China.
China and the US have a common demand to prevent unnecessary risks from the end of QE, which provides a new platform for cooperation. Increasing the transparency of monetary policy, preventing hot money and strengthening financial supervision are tangible tools to enrich a “new pattern of major power relations.” China and the US should grasp this opportunity to deepen China-US relations.
Yu Xiang is a Research Fellow at the Institute of American Studies at the China Institutes of Contemporary International Relations (CICIR).