The Time without QE

The United States surprised the world once again. On October 29， 2014， the U.S. Federal Reserve announced that it would completely quit the operation after initiating the purchasing of bonds of US$15 billion at the end of that month. This meant that the four rounds of quantitative easing（QE） in the past six years as of the 2008 financial crisis had come to its official end.

The QE left as unexpectedly as it came. But the past six years with QE of the United States was a sight to behold and memorize as it was unprecedented in size， duration and unconventionality.

The QE has made significant contributions to relieving the crisis and promoting the economic recovery. The U.S. Federal Reserves implementation of QE serves the core goal of boosting the investment and consumption by lower- ing the actual interest rate related to the economic activities. The QE relieves the financial market from the stress of drying-out fluidity and recovered the banks function as the agency. Through buying sovereign bonds and MBS， the Federal Reserve injected a large quantity of fluidity into the market， promoting the fast decrease of inter-bank financing cost and the “de-leveraging” of financial institutions. Meanwhile， the Federal Reserve drove the investors into the market of risky assets， stimulated the assets price in the markets of stock， securities and real estate and provoked the general demand through wealth effect.

However， the QE is believed to have side effect too. It is certain to cause the financial warp and give excessive stimulus to the risky preference. In addition， it has limited stimulus over the credit and increase the potential inflation stress in the future.

The effect of quitting QE means that the U.S. Federal Reserve is going to reinitiate the tight monetary policies. With that change， the emerging countries， which absorbed a lot of global fluidity surplus during the crisis， will see the gradual augmentation of their financial and economic risks due to a series of structural problems they have. And China is one of them.

The Late Crisis

“The United States quitting QE and the interest rate raise in the future will definitely impact the emerging markets， especially those with too much capital inflow，” says Prof. Hua Min with Fudan University.

In his opinion， the U.S. dollar is the principal currency in the world. The United States， the banknote issuer， increased the global fluidity through QE after the 2008 financial crisis. A part of the funds got into the real economy through U.S. Treasury Departments purchasing the preferred stocks of financial institutions and U.S. Federal Reserves buying U.S. sovereign debts to help enterprises lower their leverage ratio and restore the balance sheet. With this， the U.S. economy gradually embarked on the way of recovery.

During the process， some of the fluidity was absorbed by the stock market， which led to the bull market in these years. “Under the prudential principle of the U.S. Federal Reserve， the capital did not move into the credit market. As a result， the credit did not bulge. The U.S. did a good job in handling the entire fluidity recycling system. Therefore， there was no apparent inflation in the United States and the property price remained comparatively stable despite the great money supply.”

Then， the external effect of U.S. QE pushed the fluidity from the United States to countries with high interest rates for arbitrage. When all developed countries began to embrace the QE， emerging countries including China still had a high interest rate.

“Its internal factor is the time-lag of crisis conduction，” says Prof. Hua Min. When the financial crisis found its way to harm the United States in 2008 and then Europe in 2011， there was a lag before it moved to the emerging countries. As a result， the latters economy still grew very fast. Their central banks did not dare to take the easy monetary policies and chose to keep the interest rate high to avoid the increase in the fluidity surplus and prices. The internal and external interest rate gap led to the cross-border flow of capital， which massively moved into the emerging economies. As the time went by， these countries economic growth slowed down too as the global demand weakened. With the recovery of the U.S economy， the international capital flow might be reversed.

No Massive Capital Outflow

Nevertheless， many experts， including Prof. Hua Min， did not believe that there would be massive capital outflow from China resulted from the quitting of QE.

“China still has the foreign exchange control system that and the capital account is not opened，” says Prof. Hua Min. “The hot money flew into China via different channels and it will be hard for the funds to leave in a short while.” In addition， China has comparatively better economical fundamentals as its growth rate at least remained above 7%. The other emerging coun- tries like Brazil， India and Russia did not have good days， so their capital outflow might be more serious. The Chinese central bank also owns a large amount of foreign exchange reserves to support the market.

Prof. Hua Min also says that the recent capital outflow is still small in size（possibly around US$100 billion in the recent one or two years）， but there was data showing that there was net outflow of capital in the last few months of 2014. “The sudden reduction of the foreign exchange reserves might be more or less related to the capital outflow.”

Xue Hexiang， a fellow with Guotai Junan Securities Macroeconomic Institute， says that the core problems of capital flow before 2015 are still the internationalization of RMB， openingup of capital account and the ShanghaiHong Kong stock connection. If all these projects are going well， there might be capital inflow and RMB appreciation. Since there is still a gap between the Chinese and U.S. interest rates which cannot be reversed in a short while， there is still a space for the arbitrage. With the opening-up of the capital market， the stock market of China， which has no systematic bubble risks， will be the main assets pool of attracting foreign capital. He points out that the fast rebound in export and import contained the capital inflow. The launching of ShanghaiHong Kong stock connection， for example， might attract the inflow of overseas capital.

Xue Hexiang also believes that the drastic changes in the foreign exchange reserves do not necessarily mean the capital outflow. Actually，“distributing the foreign exchanges among folks” is also a reason for the decrease in foreign exchange reserves. The appreciation of RMB has made enterprises and individuals more inclined to hold foreign currency deposits. Therefore， the changes in the foreign exchange reserves might be more than the capital outflow.

Real Estate as a Risk Point

Though the end of QE is widely believed to have only a small amount of capital outflow and thus have little influence over the economy， Prof. Hua Min still has the concerns that the domestic assets price in China might be quite sensitive to these changes. The expectation for the capital outflow， particularly， will have a significant influence over the real estate price where huge bubbles exist.“What can affect the assets price include not only the quantity of capital flow， but also the expectation.”

Prior to the end of U.S. QE， the Chinese government already eased the limitations on the house purchasing and housing credit to stabilize the housing price. In the short term the real estate market indeed saw some rebound. However， for the long term， the purchasing power， which has been restricted， is not enough to change the tense fluidity resulted from the capital outflow after being fully released. The housing price will be ultimately exposed to the influence. The research data from some folk institutions shows that 60% of the production of sectors of real economy is related to the real estate. Once this sector deteriorates， the industrial sectors of steel， cement and construction materials will be all influenced. In addition， 60% of the credit loans in China were invested into the real estate. The fall of housing prices will hurt the banking and financial systems.

“The tight monetary policies of the U.S. Federal Reserve could affect the housing price in China in an indirect way and force it to go down， which might ultimately affect the Chinese economy，” says Prof. Hua Min. However， how much the influence is to be cannot be figured out at this moment. The Chinese government also remains silent about what measures it will take to counter the U.S. policies. Even though the impact now is not big， it will get bigger and have influenced more sectors as the time goes by.

Xue Hexiang also says that the stronger U.S. dollar has a big impact over the fundraising of real estate enterprises. In the past few years， the real estate enterprises fundraising channels are limited. The official fundraising channels， including the stock market， refinancing， bonds and securities， did not support the fundraising of real estate enterprises， forcing some of them to turn to the costly trust or the unstable overseas bonds. “When the exchange rate of the U.S. dollar was low， these enterprises could raise a big amount of capital from overseas. However， if there is no shield from the derivatives， the enterprises will be exposed to the negative impact. The longer the borrowing period is， the bigger the impact might be. With the rising exchange rate of the U.S. dollar， the newly-borrowed debts will have a higher cost， which applies certain influence over the capital chains of some real estate enterprises，even though the overseas fundraising cost might be still lower than the one through domestic channels.”

“Generally speaking， the end of QE might have limited influence over China in one or two years. As for the next three or five years， the key is whether China and progress the reform quickly can bring about the reform dividends and internal growth stimulus to keep the economic prosperity under the condition of high interest rate，” says Xue Hexiang.

The Lowered Interest Rate and Base Rate

According to Xue Hexiang， even though the U.S. government ended the QE unexpectedly， it indeed announced the plan of gradually reducing the size of QE from the end of 2013. Therefore， there was still time for the market to prepare for the change. After quitting QE， the U.S. Federal Reserve will choose to stabilize or reduce its balance sheet as the following step. This might be finished in two or three quarters. The market expects the U.S. Federal Reserve to increase the interest as of the second quarter of 2015， which is the third step. The Tea Partys victory in the mid-term election might be a signal that the U.S. Federal Reserve will speed up the implementation of tight policies.

An evaluation report made by U.S. Federal Reserves experts based on the U.S. economic fundamentals， employment rate and inflation shows if the organization increases the interest rate in 2015， the exchange rate of the U.S. dollar will rise from current 0-0.25% to 3.75% by December 2017 with the annual increase larger than 1 percent.

“The increase in the interest rate has much bigger influences than the capital outflow driven by expectations. The end of QE just reduced the money supply while the increase in interest rate directly changes the price. As a result， the yield of USD assets gets higher while the other assets yield is to be lowered. The structural change will allow investors to conduct the recombination of assets. Therefore， if the end of QE by the U.S. Federal Reserve is to bring about the impact to the volume， the interest rate increase will bring the structural impact，” says Prof. Hua Min， who forecasts that the capital outflow of China will speed up after 2015.

A macroeconomic review from the Strategic Planning Department of the Agriculture Bank of China said that the increasing stress of capital outflow caused by the end of QE in the United States might lead to the further decrease or slower increase of funds outstanding for foreign exchange， and simultaneously， causes the expectation of the tense fluidity in the Chinese financial market， which will force the social fundraising cost to rise.

Different from Xue Hexiangs proposition of promoting RMB internationalization， Prof. Hua Min suggests that the Chinese government should manage its cash to prevent the capital flight. Therefore， the capital accounts must not be opened up and the foreign exchange and exchange rate control is to be carried on. The internationalization of RMB， however， cannot go forward too quickly. In addition， it is necessary to increase the productive investment and guide the capital to flow into the real economy to ensure the positive economical fundamentals. Only in that way can the government handle the negative effect brought by the capital outflow.

Prof. Hua Min and Xue Hexiang both advise the central bank of China to lower the social fundraising cost through lowering base rate， mid-term lending facility， short-term lending facility and pledged supplementary lending. At present， the inflation rate in China stands below 2%， creating certain conditions for the central bank to lower the base rate and interest rate. There are also favorable external conditions： the decrease in the price of crude oil and other bulky commodities has almost eliminated the inflation stress from the imports cost. But Prof. Hua Min prefers the reduction in the base rate while Xue Hexiang thinks that the lowered interest rate is more likely to happen.

“A lot of measures （by the Chinese government） after the fourth plenary need a large amount of money. The relaxation of the lending conditions for real estate also calls for the support of easy monetary policies and lower interest rate，” says Xue Hexiang. In comparison， Prof. Hua Min says that the reduction in the base rate could lower the risk since it only changed the money supply instead of the assets price. “But this method has its own defect. The funds released by the lowered base rate flow into the credit market and how the commercial banks will use them are beyond the control of the government.

The reduction in the interest rate can directly lower the capital cost， which is good for the real economy.”

The governments actions prove the vision of these experts. On November 21， 2014， the Chinese central bank decided to lower the base rate for oneyear deposit to 2.75% and the one for one-year credit to 5.6%. Meanwhile， the fluctuation range of the deposit interest rate is increased from 1.1 times to 1.2 times the deposit base rate. This measure is to more effectively reduce the fundraising cost to boost the economy and is expected to be the start of a new period of interest rate reduction.

Miss the Best Time

Though the first two months of 2015 is the window phase of the Chinese central banks reduction of the interest rate and there might be one more time of reduction in the future， Prof. Hua Min still thinks that China is late in the reduction of interest rate as it should do so when the United States was still pushing QE a few years ago. The Chinese government could also harness the tight financial policies to offset the influence over fluidity and credit increase at that time.

However， the Chinese government chose the macroeconomic policy package with expansionary financial measures and tight monetary policies（the said Four-Trillion Stimulus Package） to “let the government， instead of the enterprises， save the GDP”. “Now that the U.S. Federal Reserve began to increase the interest rate， the best time（for China to lower the interest rate） has been missed. The government is deprived of making active choices.”

Prof. Hua Min says that the previous wrong macroeconomic policies were bad for the real economy. The RMB was appreciating； the wage was increasing， the land price was skyrocketing， and the capital cost was rising， but the enterprises profits were decreasing， rendering investors unwilling to invest. Though the domestic fluidity is still relaxed， the investment is not willing to get into the real economy and cannot be turned into output and consumption. It is just recycling in the chain of financial debts without any yield. The central bank used the targeted base rate reduc- tion to bring the fluidity into the real economy， but little effect was seen then.

Therefore， he suggests that the best measure now is to reduce the tax to increase the after-tax profits of enterpris- es. “Since the nominal RMB exchange rate cannot fall， the real exchange rate in the form of salaries could only go up instead of falling with the governments intervention. Therefore， reduction of the tax is the only option， like what the Reagan government did in the United States in the 1970s，” Prof. Hua Min says. “Then， of course， the government needs – and is doing so – to streamline its governance and decentralize its rights to cancel the market access limitation.”