Will FED Balance Sheet Normalization Affect China’s Economy？

By Bian Yongzu, Zhang Jingshuang

After the Federal Open Market Committee (FOMC) meeting on September 20-21, the US Federal Reserve announced a long-term balance sheet normalization plan which was issued after “profound” consideration of the present state of the US economy.

Starting from October this year, Fed will begin to reduce its holdings, including principal of mature national debts, agency securities and principal of mortgage-backed securities (MBS), by 6 billion USD and 4 billion USD separately per month. These figures will gradually increase.

Having gone through 3 rounds of QE, the balance sheet of the Fed has swollen to nearly 4.5 trillion USD, almost 5 times the level before the financial crisis. Even though greater capital liquidity has fueled US economic growth, the overflow of liquidity into the financial market has heightened the risk of asset price bubbles. Since last year, the Dow Jones Index and the House Price Index of the US have both reached historical peaks.

Another reason why the Fed has decided to shed its holdings is the ongoing positive performance of the US economy. According to the latest data, the economic growth rates of the first two quarters were 1.2% and 3.1%. At the same time unemployment kept falling. In September it dropped to 4.2%, the lowest in 16 years.

The reduction of balance sheet shows that the Fed is satisfied with present US economic growth, employment and prices. The Fed plans to gradually transit from passive trimming of its holdings to proactive shedding so as to tighten the balance sheet. This plan also manifests the Fed’s positive attitude towards long-term US economic trends.

Fed implemented an unconventional easing monetary policy after the outbreak of the global financial crisis. As the US economy has now come to the normal growth track, the balance sheet is normalization is not only necessary, but also beneficial for US economy for the following reasons:

• First, it can help to release long-term high quality assets and withdraw speculative capital, which will enhance the stability of the financial system. During the implementation of QE, the Fed bought a substantial amount of financial assets to stabilize price fluctuation. However, this move has drawn capital into the real estate market, expanded the allocation of credit assets, and affected the assets allocation balance, ultimately leading to a fake boom in the real estate market and increasing the risk of speculation. Now by tightening the balance sheet and releasing financial assets, namely national debt and MBS, the Fed can reach its objective of reversing the capital flow to the market, and optimize the asset allocation structure of the financial system, which will effectively improve its stability.
• Second, together with higher interest rates, long-term interest rate can be adjusted and the yield curve can be brought back to normal. Confronted with the problem of low overall interest rates, the Fed can push up the short-term interest rate, and can therefore alleviate the problem of over-liquidity and reduce the supply of speculative capital in the financial market. Meanwhile, a stable release of national debt and MBS can accordingly adjust the long-term asset supply in the financial market and impose further influence on long-term yield curve. This combination can help to restore the Macaulay duration balance.
• Third, the combination is also beneficial for restoring the credit of US dollar, and could provide ample room for the Fed to adjust its monetary policies. The Fed has been pouring US dollars into the market by purchasing national debts and MBS in quantity during the implementation of QE, and the overflowing liquidity has had a damaging effect on the US dollar. Hence, raising the interest rate and tightening the balance sheet will entice capital back to the US, reduce the liquidity of the US dollar, decrease the risk of speculation, and restore its credit.

However, a point worthy of note is that there has been no real and substantial improvement in the US economic structure since the outbreak of the subprime mortgage crisis in 2008, hence tightening the balance sheet could pose potential risks.

In August retail sales and industrial production both dropped compared to July, and the Consumer Confidence Index (CCI) fell in September after a rise. At the same time soaring housing prices are also putting pressure on ordinary Americans.

The main reason for these problems is that even though the Fed had loosened the balance sheet by purchasing assets like national debt and capital was being transferred to financial institutions, due to the rather poor economic environment most of this capital moved into fields like the stock market or real estate.

As a result, it had little impact on the real economy compared with its impact on the virtual economy.

Low overall interest rates since the outbreak of the subprime mortgage crisis have encouraged the growth of companies which depend on this kind of environment, such as the shale oil industry and other related activities. These have become influential in the US economy in recent years.

As the situation changes, it will become much harder for these companies to survive, and this will definitely cause tremors in the overall economy.

What is more, the old US growth model of sustaining high consumption by adding leverage still exists in today’s economy, the difference is that the core element that supports the model has shifted from pre-crisis real estate bubbles to the escalating price of financial assets propelled by the Fed’s post-crisis easing of monetary policy. When the Fed starts to tighten the balance sheet and reduce liquidity, the price of US financial assets is likely to fall. This could hamper the recovery of the US economy and even provoke another financial crisis.

Even though tightening the balance sheet is a progressive move, and the level is mild, uncertainty in the US economy will have both favorable and unfavorable impacts on China.

If the US economy develops as forecast, the Fed’s move will reduce the international liquidity of the US dollar and place considerable pressure on cross-border flows. The same will apply to world commodity trading, financial markets, currency exchange rates, and the economies of some countries.

At the same time, China is strengthening regulation on its domestic real estate market. To tackle these negative impacts China’s decision-makers should focus on domestic demand, push more funds into the real economy, and stabilize China’s economy by implementing its own domestic policies. The lack of liquidity of the US dollar also provides an opportunity for the RMB. The basis of the RMB is sound, so China can promote and enhance its influence in the global financial system.  The overall impact on China’s real economy and financial system should be very limited.

• First, the Fed’s move is a balancing measure. To avoid unpredictable risks, the current reduction plan is mild. The Fed had already flagged its plans several time before the official announcement, so the market has already digested it. The reduction is rather limited too – a monthly reduction of 10 billion USD does not even represent 0.25% of the Fed’s current total assets.
• Second, the reduction will affect the virtual economy more than the real economy. In contrast to the US, whose virtual economy has long exceeded the real economy, the real economy, such as manufacturing industry, is still the mainstay of China’s economy.
• Third, the main impact on China’s economy will be on the cross-border capital flow and the exchange rate of RMB, but given the economic data of the first half-year, China’s economic growth was still steady, the pressure of capital outflow has been greatly alleviated, and the periodical adjustments of the RMB are also effectively leading the exchange rate to the expected level.

More importantly, through its efforts in recent years on supply-side reform, China’s industrial transformation and upgrading has achieved significant results, and the economy is still on a positive trend. Growth in imports and exports reached double digits in the first half of 2017. China is now grasping the opportunity of the new industrial revolution and accelerating the transition of the old drivers to the new ones; new industries and new services are becoming new drivers of China’s economic growth.

Even though the US tightening measures will affect cross-border capital flows, the capital will still flow to regions where the economic development is promising. Therefore, the US reduction of the balance sheet will not have any significant negative effect on China’s economy.
Bian Yongzu, researcher of Chongyang Institute for Financial Studies, Renmin University of China
Zhang Jingshuang, intern of Chongyang Institute for Financial Studies, Renmin University of China

Opinion articles reflect the views of their authors, not necessarily those of China Matters