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China not to bear the brunt of Fed QE taper

(People's Daily Online)    08:04, December 26, 2013
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Drops in the gold price during April 2013 touched off gold rushes of Chinese damas. (Photo/Xinhua)

The U.S. Federal Reserve finally elected to taper its quantitative easing program on Wednesday, December 18. Economists believe that this decision marks the point at which the Fed will gradually withdraw its third round of quantitative easing, launched on September last year, five years after the financial crisis.

The central bank has announced that it will reduce its bond buying by $10 billion a month to $75 billion by January 2014 after two-day Federal Open Market Committee meeting. Economists believe that the Committee is maintaining its existing policy, though in a moderated fashion.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.Countries are suggested to layout responses to Fed’s future reinvesting principal payments.

Why did the Fed taper?

According to the text of the Fed's 12/18 statement, US economic activity is expanding at a moderate pace. The Labor market has shown further improvement; the unemployment rate has declined to 7% - the lowest this year – although it remains elevated. Fiscal policy is restraining economic growth, although the extent of restraint may be diminishing. Inflation has been running below the Committee’s longer objective, but longer-term inflation expectations have remained stable.

Economic data shows that indicators are approaching the Fed's target, said Guan Qingyou, vice president of Mingsheng Securities Institute. In addition, both the main US political parties agreed to a $63 billion government spending cut in next two years.

Taking into account the extent of federal fiscal retrenchment since the inception of its current asset purchase program, the Committee sees the improvement in economic activity and labor market conditions over that period as consistent with growing underlying strength in the broader economy.

Stocks initially climbed on the news. Although the three major New York stock market indexes fell slightly, this was followed by a strong rebound. The Dow Jones Industrial Average rose 1.84% and closed at 16,167 points; Standard & Poor's 500 index closed at 1810 points, up 1.66%. The Nasdaq composite index rose 1.15 % to 4070 points. Meanwhile U.S. bond yields and the dollar index both rose - reflecting that fact that the Fed's decision was widely anticipated.

Impact on emerging markets

“The decision by the Federal Reserve to slow down its bond buying program was greeted by markets as a sign that the economy is improving in the US,” said Yu Fenghui, the influential Chinese financial commentator. But the market reaction to the pullback is only the beginning, and may not be representative of its future position.

If the all monthly $85 billion purchase of debt ceases by the end of 2014, then according to the money multiplier effect, in theory the scale of monthly tightening of liquidity would be around $569.5 billion. Yu forecasts a sharp rise in U.S. bond yields, a liquidity shortage, and a substantial increase in borrowing costs. The higher U.S. dollar exchange rate will bring capital back to the United States markets. The impact would therefore make itself felt in other economies, especially emerging markets.

“It is obvious that Fed QE tapering had an immediate impact on Chinese dama, who rushed to buy gold.” Yu believes that with the gradual withdrawal of U.S. quantitative easing, the dollar will strengthen, and dollar-denominated gold will enter a long-term decline. He even forecasts a “disaster” in the entire precious metal market. Chinese dama, as major holders of gold, face high risks.

As the real economy hits a downturn, with a prolonged slump in the stock market, domestic and foreign capital flocks to the real estate industry. China's real estate bubble continues to inflate. The impact of such a pullback could be significant for the world's second largest economy, leading to the risk of a liquidity squeeze in China.

A liquidity shortage in the real estate industry, characterized by huge capital accumulation in the Chinese mainland housing market might soon pierce the bubble. But the expansion of liquidity carries its own set of risks.

Further latitude to financial reform

Tapering is not an immediate, dramatic event. Instead, it is likely to take place gradually throughout 2014 so as to create minimal market disruption. And it will remain dependent on economic conditions. The Fed may pull back slightly if the economy continues to strengthen, but it could also increase the program again if the economy slows or the financial markets are hit by any unforeseen crisis.

In light of the recovery among the emerging economies that has followed the 2008 financial crisis, as well as the QE policy carried out by developed countries, stocks and bonds have produced outstanding returns despite economic growth that is well below historical norms.

Cui Rong, a senior analyst of Chinese Guangda Securities Institute, warns that emerging markets should direct more attention to the potential risks brought by their massive capital inflows. He also forecasts that before QE finally tapers out, there will be a year or two which could serve as a buffer for emerging markets to engage in structural reform.

The probability of tapering has existed since QE began. Quantitative easing was never intended to be a permanent solution, since every bond purchase expands the Fed’s “balance sheet” by increasing the amount of bonds it owns. Also, in past communications Bernanke had made it clear that the continuation of the program was dependent on incoming economic data in the statement.

The Fed is expected to manage its QE exit strategy in four phases:
•Slow down the speed of asset purchases
•Completely terminate QE
•Change the long-term low interest rate policy
•Shrink the balance sheet

Fed QE tapering eased the worst fears over liquidity. In the coming year policymakers and the central bank are expected to accelerate financial reform necessitated by the withdrawal. Deleveraging of the financial system and growing production capacity in the real economy have been suggested as measures to avoid a new financial downturn caused by tapering-triggered global liquidity contraction.

“Emerging markets cannot easily avoid liquidity risk, but for China, the impact is not significant,” said Jiang Chao, chief researcher on macro economy of Haitong Securities Institute.

China maintains strict control on its capital account. The Chinese central bank has enough room and ability to adjust currency liquidity, and domestic loans are at a relatively low level. The size of the current account surplus is still considerable.

Taking everything into account, the liquidity risk to China of the Fed's QE tapering is not significant. The risk depends on the following three factors: current account balance of payments, loan ratio, and openness to capital account.

What is Quantitative Easing?

The U.S. Federal Reserve sets short-term interest rates, which in turn influences economic trends and the yield levels for bonds of all maturities. The central bank enacts a low-rate policy when it wants to stimulate growth, and it maintains higher rates when it wants to contain inflation.

In the recent past, however, this approach ran into a problem: the Fed effectively cut rates to zero, meaning that it no longer had the ability to stimulate growth through its interest rate policy. This problem prompted the Fed to turn to the next weapon in its arsenal: quantitative easing.

The Fed, or any other central bank, enacts quantitative easing by creating money and then buying bonds or other financial assets from banks. The banks will then have more cash available to lend. Higher loan growth, in turn, should make it easier to finance projects. These projects put people to work, thereby helping the economy to grow.

(Editor:GaoYinan、Huang Jin)

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