In a speech in February in Washington, D.C., Federal Reserve chairman Ben Bernanke said that despite various efforts, it could be a long time before employment levels in the country return to more comfortable pre-downturn levels of around 5%. And when asked after his speech whether another round of the Fed's so-called "quantitative easing" would be necessary after the current round (known as QE2) comes to an end in June, Bernanke replied, “The Fed will decide the same way it always does" — by looking at various economic metrics, including the unemployment rate, which has been hovering around 10% for some months. As the number of people out of work in the country remains high, it looks increasingly likely that the Fed will proceed with QE3, a move likely to be met with a chorus of disapproval around the world. Among the loudest critics: China.
As under the first two rounds of quantitative easing (beginning in March 2009 and November 2010) the Fed would print money and use the funds to buy bonds and mortgage-related securities — purchases aimed at lowering borrowing costs in the U.S. and stimulating the nation's economy. But officials in Beijing have echoed criticism heard elsewhere around the world that QE2 has also triggered a sharp increase in world commodity prices and an influx of hot money into their country. They expect more of the same if there is a QE3. Experts are divided whether such concerns are justified.
Tian Suhua, an international economics professor at Shanghai Fudan University, notes that the effect of QE2 has been greater than QE1. “The first round of QE only affected China through the trade channel, while in the second round, the ability of U.S. banks and mortgage companies to issue credit was strengthened, so the effect on China was amplified by the money multiplier,” he says.
The QE2's primary effect is political, counters Charles Freeman of the Center for Strategic and International Studies, a Washington, D.C.-based public policy research center. “It is causing a lot of nervousness in Beijing about the long-term policy of the Fed [concerning] the dollar, and the Chinese administration is worried that the U.S. will pursue a long-term weak dollar policy," says Freeman, a former assistant U.S. trade representative for China affairs. "Recently, China stepped up pressure on the Treasury and the Federal Reserve by asking for reassurance that QE is only a short-term exercise.”
Philip Swagel, former assistant secretary for economic policy at the Treasury Department in the U.S. and professor of international economic policy at University of Maryland, agrees that the economic impact of QE2 in general, and on China in particular, has not been as dramatic as it is often made out to be. “Chinese rhetoric is off the mark,” he says. ““QE2 is mainly a signal that the Federal Reserve will not allow deflation and would act in greater strength had the economy not rebounded. In the end, it will have a modest effect on the domestic economy and the international spillover is also modest.”
Inflation and Aggravation
Yet even relatively small, the spillover comes at a sensitive time for many economies, including China's. Zheng Hui, finance professor at Shanghai Fudan University, says that since the first two rounds of quantitative easing, more U.S. dollars have been circulating in world markets, weakening the value of the dollar against other major currencies. Given that international commodities are priced in dollars, he says, everything from oil to sugar has become more expensive.
In March, for example, the FAO Food Price Index — a measure of the monthly change in the international prices of a basket of food commodities — averaged 230 points, down 2.9% from its peak in February, but 37% above March last year. Oil, meanwhile, hit $120 a barrel — the highest level in more than two years — though the turmoil in the Middle East and North Africa is the big factor influencing oil prices currently.
Nonetheless, Zheng isn't alone in underscoring the extent to which accommodative policies, such as the Fed's, should shoulder some of the blame for the rise commodity prices. As a report by the Bank of Japan notes, “Globally, accommodative monetary conditions have played an important role in the surge in commodity prices, both by stimulating physical demand for commodities and by driving more investment flows into … commodity markets.”
For China, that matters a lot. Its import-dependent economy is feeling the pinch of higher commodity prices amid concerns about major public backlashes about higher fuel and food bills. “China has few choices but to continue importing those global commodities,” says Zheng. “Even if crude oil prices and food prices keep soaring, China is unlikely to reduce its expenditures on these imports.”
Yet according to University of Maryland's Swagel, “China’s own monetary policy is problematic in the first place and the biggest driver of inflation in China is the Chinese monetary policy. The main fact is that China is maintaining a weak yuan and the soft peg to the dollar forces China to have excessive liquidity that boosts inflation.”
The country's central bank, the People's Bank of China (PBOC), has been trying to combat inflation. In early April, for example, it raised the required reserve ratios of commercial banks and tightened credit, and it raised the benchmark one-year borrowing and lending interest rates by 25 basis points — the second time that it raised the benchmark interest rate this year and the fourth time since the start of last year. Around the same time, the PBOC also said it will allow the renminbi to be traded against a larger range of currencies than the current seven, including the U.S. dollar, which foreign exchange traders says will help reduce the greenback's weight in determining the Chinese currency's value.
As for the U.S., the QE2 was one of several policy levers pulled to improve the country's economy. “Since the responsibility of the Federal Reserve is to regulate the economy, create jobs and move to full employment, the central question is, what means were available to accelerate the recovery [in 2010]?” asks I. M. (Mac) Destler, a professor at the University of Maryland's School of Public Policy. He says the Fed was already keeping interest rates very low, leaving little room to lower rates further. “Another option at that time was a new stimulus bill. However, it seemed to be politically unlikely,” he notes. “Another round of QE was one of the few choices left.”
But the timing of the QE2's unveiling was "unfortunate,” coming as it did just days before the G20 Summit in Seoul in November, says Destler. "But it made sense in terms of U.S. politics. The Fed does not want to look like it is partisan and supports a Democratic administration. Therefore, it announced QE2 immediately after the mid-term elections, which happened to be just before the Seoul summit.” When world leaders gathered in Seoul, several countries, including Brazil, India and South Korea, joined China in criticizing the U.S.'s policy. “QE2 put the U.S. on the defensive in arguing with China to rebalance the world economy," he notes. "Since China was unhappy about the QE, and other countries joined it in criticizing the Fed’s action, it was harder for the U.S. to get these countries to join in pushing China on other issues at Seoul, such as the currency appreciation.”
Destler reckons that Bernanke made a mistake in not giving a serious international justification of QE2 in time, hence putting himself under international criticism. "He should have explained that it was necessary for the Federal Reserve to implement QE2 to stimulate the U.S. economy, that the international spillover was manageable and the world would benefit from a stronger U.S. recovery,” he says.
Third Time Lucky?
Tian of Fudan University warns that the big danger of a QE3 is that it will challenge the credibility of the U.S. dollar. “If countries around the world bypass the U.S. dollar during international trade, dollars will flow back to the U.S and that would be a serious problem for the U.S.,” he says.
Zheng of Fudan University notes that in the event of further easing by the Fed, China will most likely have to allow the RMB to appreciate. “A third round of QE equals another round of competitive depreciation of the U.S. dollar,” he says. “Since the RMB maintains a soft peg to the dollar, the RMB's exchange rate will also depreciate against other major currencies. China’s major trading partners, such as Japan and the European Union, will suffer from an unfair trade disadvantage. In this sense, a third round of QE would exert additional pressure on Beijing to allow a faster pace of the RMB appreciation.”
Enabling the RMB to appreciate further than it has in recent months might be good for China’s economy, adds Swagel. “China should allow the RMB to appreciate,” he says. “A stronger Yuan will effectively reduce credit growth and curb inflation. Even if allowing for faster currency appreciation will have a negative impact on the export sector, China can still take action to keep its economy strong. ”
According to online information provider Finance China, a senior researcher with the Development Research Center of China's State Council recently predicted that the impact of an RMB appreciation on export-oriented enterprises would not be as big as many fear. Though the price of exports would increase, an appreciation would also lower the cost of imports.
As for whether QE3 could trigger more hot money flowing into China, recent data suggests the impact might be muted. A report published in February by FT China Confidential said the Chinese State Administration of Foreign Exchange estimates that the amount of hot money currently reaching China through the capital account has decreased to around US$290 billion from US$1 trillion in 2009, indicating that even with the QEs, China has been able to handle the inflows effectively.
Perhaps more telling about QE1, QE2, and the prospect of QE3, is the war of words unleashed by the world's two largest economic heavyweights as a result. “The two countries are blaming each other for their problems,” says Swagel, “However, the fact is that China is not the main cause of U.S. problems and vice versa.”