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Economic Impact to China After QE3 Essay

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On September 13, 2012, the Federal Reserve announced another round of quantitative easing (QE). Discuss the expected economic impacts of “QE3” on selected East Asian Country. On September 2012, the Federal Reserve announced a new round of open-ended quantitative easing named QE3. Unlike the previous quantitative easing, the Fed decided to continue buying mortgage-backed securities until the economy is improved, rather than creating another fixed endpoint package.

The first quantitative easing was introduced by Fed in November 2008 in order to create credit in the private market to help revitalize the mortgage lending and support housing market as well as lower down interest rate in general. Therefore, Fed purchased a total of $1. 75 trillion in mortgage-backed security, federal agency debt and long-term treasuries. In November 2010, Fed implemented the second round of quantitative easing by purchasing up to $600 billion long term treasuries bills intend to lower overall interest rate to spur consumer spending and business investment (Federal Reserve Bank of St. Louis, 2011).

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The third round of quantitative easing is introduced to seek economic development and reduce the high unemployment rate from 7. 9% to less than 7. 0% in the US economy. Hence, Fed decided to continuously purchase $40 million of mortgage-based security per month and maintain a zero-interest rate policy up to mid-2015 until the labor market shows improvement. Implementation of QE3 in the US economy will have severe impacts on a few aspects in the China economy. First of all, QE3 execution in US economy will create a huge money supply in the economy and also will create a vast flow of hot money throughout the Chinese economy.

Besides, China’s inflation rate will also be affected as well as the China’s currency, Yuan. Third round of quantitative easing by US Federal Reserve will be expected to create a global flow of hot money from developed countries to the emerging markets. According to the (Pearson 2012), emerging markets can be defined as simple as those countries that are not considered developed. Other key attributes of emerging markets are high level of growth rate and high GDP per capita. China has been considered to be one of the biggest emerging markets in the world.

It had an extraordinary growth rate of 10. 475% on average for the past 20 years since 1992 to 2011, calculated from the data provided by the World Bank (GDP Growth (Annual %), 2012). Hence, QE3 will highly expect to generate a vast stream of hot money into China economy. Based on the source above from the research note “Capital Flows to Emerging Market Economies” by the Institute of International Finance, both QE1 and QE2 concurred with a momentous flow of capital. These flows can be seen both from the capital outflow from US and capital inflow into the emerging markets.

This turnaround was particularly sharp at the early stage of both QE1 and QE2 while FED communicated to the public to commence a substantial acquisition of assets. The portfolio outflow had then auxiliary speeded on the first half of implementation phase for both QE1 and QE2. However, it had been slowed down in the late implementation phase. Nevertheless based on past experience, the third round of quantitative easing by the Federal Reserve in this September will create a huge flow of capital from the US economy to the emerging market and the first and foremost economy to be expected to receive this capital inflow is the China economy.

Investor’s demand for investment opportunities in the emerging market portfolio assets began to soar with the low interest rates and diminishing asset investment returns in developed economies, fueled by the favorable global liquidity movement (Kim & Doo, 2008). This favorable global liquidity movement or known as the inflow of ‘hot money’ will create an enormous effect to the China economy in terms of the assets prices. There are three channels that will lead to increase in China’s assets prices.

First, assets price raises due to the increase in demand and this can create a spill-over effect on other financial markets such as real estate markets. Second is the liquidity channel which is capital inflow increases money supply and hence upturn in assets price unless it is fully sterilized. Thirdly, vast capital inflow tends to boost the economy and it also lead to increase in assets and stocks prices. All in all, the third round of quantitative easing will increase the asset price in China as well as exert a simulative impact on the stock market.

The benchmark Shanghai Composite index opened 0. 81% higher and the Shenzhen Composite index rose 1. 27% right after the day of QE3 implemented (China Stock Markets Open Higher on QE3 amid Weaker U. S. Job Data, 2012). This increase in stock and asset price will likely to create “wealth effect” on consumer spending as Federal Reserve Chairman, Ben Bernanke said: “If people feel that their financial situation is better, they are more willing to spend” (Lange & Schnurr, 2012). Thus, China economy will be predicted o have a positive effect as consumer spending will increase the national income. However, continuous increase in these prices will probably lead to bubbles in the stock and real estate market in China. Therefore, China must take precautionary actions to prevent the speculative capital and avert inflow of hot money from fueling the property and stock markets, said Pan Yingli, the dean of the finance department at the Antai College of Economics & Management at Shanghai Jiao Tong University (Asian economies brace for impact of hot money, 2012).

Federal Reserve’s announcement on third round quantitative easing by pumping $40 billion per month into the economy will likely to pose an inflationary pressure to the China economy. After the second round of quantitative easing was introduced in June 2010, China’s consumer price index started rise from 2. 80% to 6. 73% in August 2010 which is the highest inflation rate throughout these recent years. This high inflation rate is mainly due to both the imported and domestic inflation. Under the Chinese law, all foreign exchange flowing into the country must be converted into RMB.

Thus, the inflow of hot money will inevitably increase the Chinese money supply lead to domestic inflation. In order to solve the problems caused by implementation of QE2, the Chinese government had attempted to adopt sterilization by selling more bonds in hope to reduce money supply in the country. However, this results to increase in interest rate and attracts more hot money into the economy (Morrison & Martin, 2008). Second cause to the Chinese inflation rate is the imported inflation due to too much money chasing too few goods in the global world.

Deputy Governor of People’s Bank of China, Yi Gang said that China will be facing an imported inflation as a result of QE3 in terms of commodities, raw materials and energy imports as it is among the biggest importers of commodities (Oprita & Rowley, 2012). Based on the chart presented above, price of crude materials for further processing had increase dramatically since end of the year 2008 when the first quantitative easing were introduced by Fed. The price of crude material had further rose at year 2010 when the second quantitative easing were implemented.

In fact, there are a few immediate impacts on the commodities price right after QE3 was implemented. The U. S. Dow Jones index hit a new high point, prices of crude oil impending $ 100 a barrel and gold price rise steadily higher again. This increase the risk of inflationary pressure to the Chinese economy since it is one of the biggest country to import commodities in order to support its economic development. Although China has successfully achieved to control the inflation rate as low as 1. 94% in this October after the high inflation impact of QE2, its inflation rate will be highly expected to hike up after the latest implementation of quantitative easing based on experience on the previous rounds. High inflation rate in China may impact the economy in a few ways. First, purchasing power of the people will reduce due to the diminish value of money. This has a great impact to the country as China is prominent for cheap labor hence attracts foreign direct investment all over the globe that will create employment and generate economic growth.

However, the increase in cost of living will cause China worker to demand for a higher wages and therefore it will upsurge the cost of investment thus discourage the flow of FDI. Furthermore, the inflation rate will be worsen as this increase in wages will then lead to another round of cost push inflation in the economy. Besides, inflationary pressure due to QE3 can also lead to the loss of international competitiveness of China export goods therefore worsening its balance of payment. Thirdly, Fed announcement on QE3 has another severe impact to the Chinese economy in terms of their currency, Yuan.

Chinese Yuan is predicted to be appreciating after the announcement of Fed purchasing $40 million mortgage-backed security monthly which will significantly increase the money supply in the globe. As explained above, this increase in money supply will be highly likely to flow into the Chinese economy partly due to the strong economic growth and also the relatively higher interest rate compare to the US economy. However with the regulation of Chinese government as capital are not allowed to flow into the country without exchanging to Yuan, demand of the Chinese Yuan will be expected to increase significantly.

Therefore, by applying the law of demand and supply, Chinese Yuan will be appreciating in value due to the increase in demand. On the other hand, one of the consequences of QE3 is to push down the value of the US dollar, and that lead to a relatively higher value of Chinese Yuan (Beam, 2012). As a result, the whole Chinese economy will shrink significantly and the table below shows short-term effects on Chinese key macroeconomics indicators after the appreciation of China currency. As can be seen from the source (Yang et al, 2012), most indicators respond negatively to the appreciation of Chinese Yuan except for the real wage of labor.

This impact the macroeconomic performance of Chinese economy on a wide spectrum even the appreciation percentage is as low as 5%. Total exports of the country will be affected immensely as well as the overall trade balance. This can lead to a major deterioration on the balance of payment as China relies heavily on its exports. Therefore, this clearly shows that appreciation of Chinese Yuan due to imposition of QE3 will harm the Chinese economy specifically in terms of real GDP, exports, employment and investment in a rather significant magnitude.

Nonetheless, appreciation of Chinese Yuan will lead to some positive impact to the country. Firstly, reduces the cost of imports to benefits importation of raw materials thus might lead to a higher growth rate to the economy. Secondly, domestic residence enjoys a lower cost of travelling abroad as the value of currency rises. Lastly, it can alleviate the burden of external debts to both the people and economy (Impact of RMB appreciation on China’s economy, 2011). All in all, Fed’s decision to impose the third round of quantitative easing is expected to create substantial impact to the Chinese economy on a wide perspective.

As discuss above, negative impacts of QE3 to China are flow of hot money into the economy that causes inflationary pressure as well as stock and real estate bubble. Also, pressure for the Chinese Yuan to appreciate hurts the overall Chinese economy. On the other hand QE3 will also likely to impact China’s economy positively, for instance increase in consumer spending and investment due to increase in stock and property market in addition of the advantages to the economy when Chinese Yuan appreciate.

As a conclusion, negative impacts seem to overweight the positive impacts cause by the third round of quantitative easing to the Chinese economy. Thus, China government should step to take precautionary steps in order prevent the negative impacts mentioned above cause by QE3 from jeopardizing their economy. (1,984 words)

Reference:

Asian economies brace for impact of hot money, 2012, viewed 1st December 2012, http://www. wantchinatimes. com/news-subclass-cnt. aspx? id=20121030000061&cid=1102 Beam, N 2012, Quantitative easing: fears of currency wars, viewed 29th November 2012, http://dawn. om/2012/10/01/quantitative-easing-fears-of-currency-wars/ China Stock Markets Open Higher on QE3 amid Weaker U. S. Job Data, 2012, viewed 30th November 2012, http://english. caijing. com. cn/2012-09-14/112127114. html Emerging Market Defined, 2012, viewed 2nd December 2012, http://www. pearsoned. co. uk/bookshop/article. asp? item=361 Fed Watch: If QE causes commodity price inflation, 2012, viewed 1st December 2012, http://economistsview. typepad. com/economistsview/2012/09/fed-watch-if-qe-causes-commodity-price-inflation. html GDP growth (annual %), 2012, viewed 1st December 2012, http://data. orldbank. org/indicator/NY. GDP. MKTP. KD. ZG/countries/1W? display=default. Impact of RMB appreciation on China’s economy, 2011, viewed 1st December 2012, http://chinawestproducts. com/08/01/impact-of-rmb-appreciation-on-chinas-economy/ Kim, SY & Doo, YY 2008, The Impact of Capital Inflows on Asset Prices in Emerging Asian Economies: Is Too Much Money Chasing Too Little Good? , viewed 30 November 2012, http://www. google. com. my/url? sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0CCwQFjAA&url=http%3A%2F%2Fmacrofinance. nipfp. org. in%2FPDF%2F15_5Pr_Kim_kimyang. df&ei=bf2-UJDHNsHsrAet6oD4Bw&usg=AFQjCNElsR1zviw-wGIYItCBwCDucIh_og Lange, J & Schnurr, L 2012, Stocks, more than housing, seen as initial QE3 winners, viewed 30th November 2012, http://www. reuters. com/article/2012/09/16/us-usa-fed-economy-idUSBRE88F05A20120916 Morrison, WM & Martin, MF 2008, China’s “Hot Money” Problems, viewed 3rd December 2012, http://www. google. com. my/url? sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0CCwQFjAA&url=http%3A%2F%2Fwww. fas. org%2Fsgp%2Fcrs%2Frow%2FRS22921. pdf&ei=eQG_UOqlC8XlrAf0jIHQCA&usg=AFQjCNGwisHV0wh-mYo81LoyQd

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