The tables have turned. All year long, China has endured criticism of its currency policy that claims it has kept the renminbi undervalued by as much as 40%. In October and November, however, it was the US that was enduring sharp words from Beijing.
With the American economy continuing to struggle despite slowly improving employment and other indicators, the Federal Reserve announced in early November what has been widely dubbed "QE2" – a second round of quantitative easing (QE) to follow an earlier set of policies introduced in March 2009. The earlier plan, which involved the purchase of US$1.4 trillion of debt and mortgage-backed securities, expired after one year.
The new plan will again have the Fed print money and use the new cash to buy up US$600 billion worth of Treasury bonds over eight months. A further US$250 billion worth of assets from the first round of easing, primarily mortgages, will be reinvested.
If all goes well, the injection of liquidity should lower long-term interest rates to spur American businesses and consumers to borrow and spend more, helping to shake the economy out of its funk. It has been a hard sell: Thomas Hoenig, head of the Kansas City branch of the Federal Reserve, called quantitative easing "a deal with the devil."
China’s reponse has been similarly skeptical. "We think the United States, as a major reserve currency issuer, did not recognize its responsibility to stabilize global markets and did not think about the impact of excessive liquidity on emerging markets by having launched a second round of quantitative easing at this time," said Zhu Guangyao, the vice minister of finance. He criticized the US focus on increasing liquidity, noting that financial markets lack confidence, not capital.
China’s criticism was echoed at the G20 summit in Seoul by German and South Korean officials.
Beijing’s stated fear is that even higher levels of liquidity in the global financial system will flow into emerging markets like China, creating or worsening bubbles at a time when asset prices and inflation are already growing concerns. By early November, the Shanghai Composite Index had returned to its highest levels in nearly a year, closing over 3,100 points, though it has since retreated back under 3,000. Property prices in major Chinese cities posted their second straight month-on-month increase in October, rising 0.2% from September and 8.6% year-on-year.
The Consumer Price Index (CPI), already at a 23-month high of 3.6% in September, rose to 4.4% in October, heightening anticipation of further tightening measures by the People’s Bank of China (PBoC). A reserve requirement ratio hike, requiring financial institutions to keep larger reserves of cash on hand, was merely a small step.
Foreign liquidity is attracted to China by a number of factors: a fast-growing economy, the probability of continued renminbi appreciation and the increasingly appetizing interest rate spread between China and the US.
For all the hand-wringing, however, China’s prospects aren’t as grim as they might appear. While frequently cited as a serious inflationary concern, inflows of speculative capital, known as "hot money," aren’t likely to cause the run-up in asset prices that the market has predicted.
"The impact of QE on China actually should be less significant than the impact on other countries because of [China’s] closed capital account," said Yao Wei, China economist at Société Générale (GLE.EPA) in Hong Kong. Andy Rothman, chief macro strategist at CLSA Asia Pacific markets noted that hot money has played a relatively limited role in pushing up asset prices in China in the past, and that inflows this year are equal to less than 3% of domestic household savings.
Beijing is making sure that it stays that way. On November 9, the State Administration of Foreign Exchange (SAFE) announced a series of measures to control capital inflows. These included the introduction of currency provisioning rules, a tightening of banks’ foreign debt quotas and new restrictions on foreign firms investing in Chinese equities.
A day later, the PBoC raised reserve requirement ratios for Chinese financial institutions. The specifics of the move remain unclear – Bank of America Merrill Lynch (BAC.NYSE) China economist Lu Ting said most watchers were "confused," with some banks appearing to have their ratios raised by 0.5 percentage points, while others faced a full percentage point hike. However, Lu said an increase in the requirement was a straightforward way of locking up money flowing into China. It also acts as a further brake on bank lending at a time of rising inflationary concern. Banks lent out US$88.56 billion in new loans in October, higher than market expectations.
Chinese officials will still have to work hard if they intend to dissuade foreign investors from finding ways to bring their money into China. Following October’s 0.25 percentage point interest rate hike, China’s benchmark one-year deposit rate stood at 2.5%, 1.83 percentage points higher than its US equivalent. Further rate hikes would widen the gap further, increasing the country’s appeal.
Nevertheless, given the small threat posed by hot money inflows, Beijing is likely to raise rates again in the coming months to combat its primary fear: inflation. To Chinese officials, record high prices for commodities as diverse as gold and cotton, and sharply rising food prices are much greater threats to prosperity and security at home.
And even if the government keeps speculative capital inflows at bay, the country may face inflationary risks caused by hot money in other ways.
"As conventional investment assets produce too little yield, investors start to look into unconventional products to channel underutilized capital. Food has become increasingly popular in the QE2 world," wrote Citi (C.NYSE, 8710.TYO) economist Ken Peng in a recent note. Speculative investments in agricultural commodities could drive up global prices, adding to inflationary pressures at a time when more expensive food is already a major factor in China’s rising CPI.
Another possible effect of QE2 may be more indirect. The prospect of capital inflows has lured retail investors – whose household savings have risen 17% year-on-year – back into the equity market, pushing up valuations. CLSA’s Rothman noted that the combined bank deposits of businesses and retail investors are worth US$8 trillion, nearly double the combined GDPs of Brazil, India and Russia.
It is domestic liquidity, not foreign liquidity, that’s the problem.
"The fundamental problem is still that the interest rate is too low in China," said Yao at Société Générale. "Eventually the PBoC has to hike more to really contain the borrowing appetite of Chinese companies and the lending appetite of Chinese banks."