Fed's QE2 poses challenges to China

China Daily, November 5, 2010

China faces the risk of its dollar-denominated assets depreciating and the risk of increasing inflows of international speculative money, following the US Federal Reserve's announcement that it will pump billions of dollars into the economy, the 21st Century Business Herald reported on Thursday.

The Fed announced on Wednesday a second round of monetary stimulus, dubbed QE2, in its latest move to jump start the sluggish recovery of the US economy. It will buy long-term Treasurys worth $600 billion in the coming eight months, and reinvest $250 billion to $300 billion more in Treasurys with the proceeds of its earlier investments, the US central bank said.

The bond purchases aimed at stimulating the economy - a policy known as quantitative easing (QE) - will total up to $900 billion and will be completed by the end of the third quarter of next year, CNNMoney.com reported on Wednesday.

The Fed's upcoming move may add pressure on China to appreciate its currency yuan, Bloomberg reported on Wednesday.

Billionaire investor Wilbur Ross told the Chinese-language Herald earlier that QE2 would lead to a weaker dollar, which may be of help to the economy, and lower interest rate, which may spur spending, but only to a small degree.

Every institution interviewed by the paper, except Morgan Stanley, agreed that the bond interest rates are bottoming out and will start to rebound soon.

James Sweeney, vice-president of global strategy at Credit Suisse Securities USA, said the rebound in bond interest rates may mean a bear market.

A weaker dollar, coupled with a sluggish bond market, may threat China's colossal dollar assets, the newspaper said.

Chinese officials are concerned about the long-term effects of QE on inflation, which is an apparent risk to China's bond portfolios, the paper said, citing David Greenlaw, managing director and chief US fixed income economist at Morgan Stanley.

China remained the biggest foreign holder of US Treasurys, after its holdings rose by $21.7 billion from July to $868.4 billion in August, according to data released by the US Treasury Department in October.

Stephen Roach, Morgan Stanley's Asia chairman, said QE2 will cause excessive liquidity in the US and speculative money may seek high-yield investment opportunities in Asia's developing economies such as China, according to the Herald.

Roach said the "hot money" risk is high as China and other developing countries really have no effective ways to stop it. The Chinese government needs to be highly vigilant to prevent outside liquidity from distorting its own assets market, he added.

Some economists have expressed doubts about the stimulating effects of QE2 on the US economy..

Paul Volcker, former Federal chairman and currently an economic advisor to President Barack Obama, said on Nov 2 that QE2 will not have significant implications on the economy, according to the Herald.

Morgan Stanley's Roach was quoted by the paper as saying QE2 is only "a dream" and will not have much more impact than what little QE1 did.

Roach said the US has learned nothing from the past financial crisis, which originated from easy-to-get mortgages to fund property purchases by Americans.