End of US monetary easing should spur reform of China's economy

Hu Shuli says that, while weighing the impact of rising interest rates, the government must not shy away from pushing economic liberalisation

PUBLISHED : Wednesday, 15 January, 2014, 11:24am
UPDATED : Wednesday, 15 January, 2014, 11:59pm

The Chinese economy is bracing itself for a fresh round of external shocks.

With the post-crisis macro economy returning to normal, the US Federal Reserve is easing out of its asset-buying programme. This will bring severe challenges for emerging economies, including China. No doubt all eyes will be on the next moves by the Fed's newly confirmed chairwoman, Janet Yellen.

Faced with its worst economic downturn since the Great Depression, the US launched its largest stimulus programme ever to try and revive the economy. Three rounds of "quantitative easing" saw interest rates plummet to between zero and 0.25 per cent and the Fed's balance sheet rise to record levels.

In January 2013, the Fed said it would stick to its policy of zero interest rates until unemployment fell below 6.5 per cent or inflation rose above 2.5 per cent. With the US economy slowly reviving, the Fed this month cut the scale of its bond buying from US$85 billion to US$75 billion a month.

Quantitative easing is finally being wound down.

This will fundamentally affect the world's economies. The pace of the Fed's "tapering" will matter, of course, but its impact is assured. Over the past year, we've already seen how speculation of an imminent tapering has caused an outflow of hot money from once buoyant emerging economies, as their currencies weakened against the US dollar and investors ditched their equities and bonds. The tapering will shake global financial markets.

As interests rates rise in advanced economies, an emerging economy like China - which is at the same time grappling with crucial reform - must brace itself. For some emerging economies, it will probably spell the end of their high growth rates.

How will the Fed's tapering really affect China? Views are mixed, with some warning of significant risks while others believe any impact would be minor. We must strike a balance. China's regulatory authorities must carefully watch global developments and accurately assess the Fed's policy directions and their impact; they must maintain a dialogue with market players and pay attention to the views and findings of economists and other scholars.

The uncertainties of global finance mean that, whatever the eventual risks of a US tapering, China must not underestimate them. This means drawing up contingency plans. In other words, China must have a strategy for dealing with the risks.

More fundamentally, it must undertake major economic and financial reform, according to the directions set out at the Communist Party's third plenum. This means it must liberalise its exchange rate and interest rate systems; open up its capital markets; remove barriers to the outflow of Chinese capital and restrictions on financial transactions; build a sound management system of debt and capital flows with good oversight; and accelerate the pace of renminbi convertibility.

Admittedly, implementing such reforms at a time of global economic uncertainty is risky. But, for China, the risks of shunning reform are greater. China's decision-makers must weigh the need to liberalise the capital account against the macroeconomic risks. They must be alert to every change in the global environment, adjusting the pace and scale of reform where necessary.

The government must also rethink its management of our massive foreign exchange reserves, which currently stand at US$3.7 trillion, with some US$1.3 trillion in US Treasuries. With the expected rise in interest rates, China is likely to see the devaluation of its holdings.

Experts have long warned of the dangers of China's large holdings of US government debt. They say China should diversify its portfolio, shifting its focus to assets with higher returns and gradually reducing its holdings in US securities.

Thus, the Fed's tapering should be seen as a window of opportunity for China to rethink the management of its foreign currency reserves.

Further, the government must restart the reforms that stalled in the immediate aftermath of the global financial crisis, when stimulus measures were rolled out to avert an economic disaster. Over the past few years, local governments have rolled out scores of infrastructure projects. While these provided a needed short-term boost to the economy, thereby stabilising it, their rates of return on capital were poor. The risks of massive local government debt are worrying.

The interbank interest rates have surged since the middle of last year, so that with all the money sloshing around in the system, China's real economy is starved of the funds it needs. Any short-term capital flight in the wake of the Fed's tapering risks triggering a debt crisis.

These many problems should force China's hand in pushing reform. The end of monetary easing in the US will bring unprecedented financial risks to a China already facing slowing growth. China has no choice but to reform its economy.

This article is provided by Caixin Media, and the Chinese version of it was first published in Century Weekly magazine. www.caing.com