China should be wary but not afraid of Fed policy

Source:Global Times Published: 2017/9/13 22:23:39

Illustration: Peter C. Espina/GT

Erik Norland. Photo: Courtesy of Erik Norland

The US Federal Reserve is widely expected to make efforts to reduce the US balance sheet soon, and we will find out how much and how quickly they will do this later this month. It is hard to predict the influence this will have on the economy in China and elsewhere in the world, but I believe it won't have a big impact on China.

The reason why I hold this view is that it doesn't appear that the expansion of the balance sheet has had a tremendous impact in the past. The Fed has conducted three phases of quantitative easing (QE) recently. The US economy appeared to recover when QE1 began in 2009, but it is difficult to say because it was not a controlled experiment, and a number of things were happening simultaneously. The bailout of the banking system, the stimulus package, the bailout of the automotive industry and the cutting of interest rates to zero were intermingled. During the second phase of QE, the economy continued to expand at about the same pace as before. And then, the economy experienced a period of growth without QE. When QE3 began, there was still no acceleration of economic growth. In May 2013, the Fed announced that it would begin tapering QE. The financial market reacted to the news dramatically, with bond yields going up very quickly. But the economy didn't care. It kept growing at its slow pace. QE finally ended in the fall of 2014, and there has been no further expansion of the Fed's balance sheet. The economy continued to grow.

From this, we can see that the balance sheet expansion by the Fed had little impact on the economy.  If we accept that the expansion of the balance sheet doesn't matter that much, we can infer that the reduction of the balance sheet probably shouldn't matter that much either.

I think the bigger risk is that the Fed may eventually increase interest rates too much. The Fed's interest rate hike at the end of 2015 upset the global financial markets as it was the first increase in over nine years and greatly impacted China's stock market. So far, the interest rate hikes have been acceptable, but the risk from further rises shouldn't be underestimated.

The best indicator of the economy in any country is the shape of the yield curve. So long as the long-term interest rates are higher than the short-term interest rates, generally speaking, the economy will continue to grow. Currently, the difference between two-year interest rates and 10-year interest rates in the US is 0.9 percent. This indicates to me that the US may not have a recession for at least the next 12 to 24 months. However, if the Fed continues to raise the short-term interest rate another three times, the yield curve for China may become flat or inverted, which may be a sign of a possible recession in one to two years time. I won't say it will be a recession in China with negative GDP growth. But there could possibly be something like a 1.5 percent decrease in GDP growth.

To prevent this from happening, China can do two things. The first is to ease monetary policy to make the yield curve more steep. And the second is to further internationalize the yuan.

Another thing to take note of is that currently the yuan is a little bit overvalued, and it is too closely linked to the US dollar. Once the Fed tightens monetary policy, it encourages policy tightening in China. For the moment, a lot of pressure on the yuan has been alleviated, as the US dollar has started to weaken a bit, while other currencies in emerging markets have strengthened a bit and they have much higher inflation rates than China has. So their currencies are becoming less competitive and that is actually helping China. But this situation could change if the growth in China slows down, if commodity prices decline, and currencies of the emerging markets begin to fall - this would renew the downward pressure on the yuan. While the pressure on the yuan has been temporarily released, close attention is still needed.

This article was compiled by Global Times reporter Bu Yingna based on an interview with Erik Norland, senior economist at CME Group.

Posted in: INSIDER'S EYE

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