With Beijing keeping a stable renminbi policy against the US dollar, China will import the effects of the Federal Reserve's quantitative easing (QE) policy. This is positive for Chinese liquidity and asset markets. The US QE affects China's monetary policy and liquidity via the trade and investment return channels: When QE weakens the dollar and Beijing pursues a stable RMB/USD policy, the renminbi will follow the dollar and depreciate in trade-weighted terms. This will help ease China's monetary conditions. When QE lowers the US government bond yields, this will lower the Chinese central bank's return on investment in the US. This will, in turn, help solidify the monetary easing stance of the People's Bank of China.
QE may eventually lead to inflation, which will erode the value of China's dollar investments in its foreign reserves. But I do not think that QE will lead to inflation in the short-term. Also, China is unlikely to diversify its foreign reserves quickly, as a sell-down of its huge dollar holdings would drive down their value and erode the foreign reserves further.
The US has expanded its QE effort recently, with the Fed planning to buy $300 billion of longer term Treasuries over the next six months (which could be extended if needed) and expanding the mortgage-debt purchase programme to $1.45 trillion in total. China will import the effects of the US QE just like any economy with a fixed exchange rate regime will. So in essence, the Fed sets the stage for policy easing and liquidity expansion for China; and it does that via two main channels: trade and investment return.
The trade channel
After allowing the renminbi to appreciate against the dollar by over 20% between July 2005 and June 2008, Beijing has returned to a de facto currency peg against the dollar by keeping the RMB/USD in a very tight trading range since July last year (Chart 1). QE will eventually weaken the dollar and a weaker dollar is also needed as part of the adjustment process to correct the international imbalances. Thus, Beijing's de facto renminbi peg against the dollar will result in renminbi depreciation in trade-weighted terms and help to ease monetary conditions in China. This should also help China's export growth, which may pose a pleasant surprise later this year.
The investment return channel
US QE will also bring down US bond yields, which will lower the return on the PBoC's investment in US Treasuries. And the negative impact on these investment returns will be big. According to the US Council on Foreign Relations, over 70% of Chinese foreign assets are invested in US assets, of which 85% are in Treasury and government agency bonds. To make up for the declining investment returns, the PBoC may want to cut the cost of its liabilities. These include interest rates it pays on PBoC bills and on the banks' required reserves and excess reserves. In other words, QE in the US will exert pressure on China to cut interest rates and the banks' required reserve ratio as the PBoC acts to cut its cost of liability to offset a fall in its investment return. These potential changes will, in turn, lower the cost of funds for Chinese banks and, thus, boost domestic lending.
However, the recent fast loan growth and improvement in some macroeconomic indicators have reduced the urgency for rate cuts. China is a large economy with a closed capital account. Thus, its monetary policy has more independence from the US. Domestic growth and inflation play a larger role in determining the PBoC's policy stance. This means that, unlike a small open economy with a fixed exchange rate, China does not have to import all the US policy moves. Nevertheless, in light of an ongoing global financial crisis and a feeble domestic environment, Beijing will still err towards policy easing by importing some of the US QE impact.
Risks to China's foreign assets
QE is negative for the dollar exchange rate in the medium-term. It will also eventually lead to inflation, with the timing and extent depending on the Fed's sensitivity to the turning point of the inflation dynamics. In other words, QE's medium-term effect on US inflation will depend on how fast the Fed withdraws its monetary stimulus after the economy stabilises. I do not think that QE will lead to inflation in the short-term (the next two years). First, the output gap in the US is quite sizable and will take some time to close after the economy stabilises. Second, the current liquidity demand is not motivated by the desire to spend, but by a wish to offset investment losses and repair confidence in the financial system.
Nevertheless, an eventually weaker dollar and rising US inflation will both erode the value of China's investments in the US, which amounts to an estimated $1.2 trillion in Treasury and government agency debts. In other words, excessive exposure to dollar asset creates risk for China's foreign reserves. This risk is already evident from the sharp drop in those same reserves in January. The decline was not a result of a balance of payments deficit, as China's trade surplus remained large and foreign investment inflows continued. Rather, the large $30 billion decline in the foreign reserves was largely due to a sharp drop in China's holding of US assets, as the US bond and stock markets both suffered sharp declines in January. If the dollar weakens sharply for whatever reasons later on, China's massive holdings of dollar assets will also take a big hit in valuation terms.
Beijing wants to diversify away from the dollar in its foreign reserve holdings. According to Federal Reserve data, China's holdings of Treasury securities rose by 46% in 2008 to $760 billion, making it the largest holder of US sovereign debt (charts 2 and 3). However, diversification is easier said than done because Beijing cannot liquidate its huge holding in a short period of time without destroying much of its value.
In a nutshell
As long as Beijing pursues a de facto RMB/USD peg, as it has been doing since July 2008, China will import the impact of the US QE. This is positive for Chinese liquidity and, hence, GDP growth and asset markets. But China does not have to import all the US policy moves, as its large domestic sector and closed capital account give it monetary policy independence. To the extent that QE weakens the dollar, the renminbi will follow the dollar and depreciate in trade-weighted terms. This is positive for China's liquidity as well as its export outlook. But an eventually weaker dollar and rising US inflation will pose downside risks to China foreign reserves and due to the size of China's holdings of US assets in its foreign reserves, it cannot easily diversify easily away from the dollar.
Chi Lo is a research director at Ping An of China Asset Management (HK). |
