The world economy is steaming into uncharted and potentially hazardous waters. At some point in the coming months, very likely in September, America’s central bank, the Federal Reserve, will begin to shrink its balance sheet. That may sound like an obscure and highly technical undertaking, interesting only to monetary wonks. But it is likely to have far-reaching consequences that will be felt especially keenly in Asia.
To understand what Fed chair Janet Yellen is proposing to do and why, it is necessary to go back to the darkest days of the 2008 financial crisis. Faced with mounting debt defaults, a financial system that had seized up completely, and an economy rapidly grinding to a halt, the Fed pulled out all the stops to prevent the US sliding irretrievably into deflation.
Of all economic evils, chronic deflation is the one central bankers fear most. Imagine a widget maker that borrowed money during the boom times to invest in a new factory. As demand dries up and prices fall, the company has to sell more and more widgets to service its debts. But as prices fall, buyers defer their purchases, so widgets become ever harder to sell. Sooner or later the company defaults and goes out of business.
Of course, the widget maker’s workers lose their jobs. That makes it tough for them to pay off their own mortgages and car loans. In turn they and legions of others default, as consumption collapses and the economy slumps into a self-perpetuating downward spiral.
Desperate to avert a depression to compare with the 1930s, the Fed began to print money in an all-out attempt to keep the US economy afloat on a sea of liquidity. The way it did this was to buy both US Treasury bonds and mortgage-backed debt from America’s banks, creating new money to do so. Over the next six years the Fed bought more than US$3 trillion in bonds in three successive rounds of so-called “quantitative easing”.
As Janet Yellen’s Federal Reserve prepares to tighten its belt, the world is poised to feel the squeeze
The Fed stopped making new purchases in 2014. But as the bonds it holds have matured, it has used the proceeds to buy more. As a result, three years after the end of quantitative easing, it still has assets of US$4.5 trillion sitting on its balance sheet, compared with less than US$1 trillion before the crisis. And offsetting those assets, on the liability side of its balance sheet is all the money it printed to buy them.
Almost 10 years after the crisis, the Fed judges that its efforts to avert deflation have been successful. True, by the Fed’s own preferred measure, US inflation is well below the Fed’s target rate of 2 per cent. But price pressures are beginning to emerge. As a result, in effect the Fed has declared its mission accomplished and is planning to shrink its balance sheet once again by ceasing to reinvest the proceeds when the bonds it holds mature.
There are several reasons why the Fed wants to do this. With a smaller balance sheet, it will have a greater ability to respond when the next crisis hits. And by cutting its assets, it will reduce the distortions created in financial markets by the sheer size of its holding. But the real reason the Fed wants to shrink its balance sheet is that it fears becoming increasingly politicised.
In theory, the Fed acts independently of the US government. But as a massive buyer and holder of US Treasury debt, in recent years the Fed has become an important player in the US administration’s fiscal policy. To make it less vulnerable to future political interference, Fed officials badly want to run down their stash of US Treasury debt.
No one knows what will happen when they start, for the simple reason that no big central bank has ever set out to shrink its balance sheet before. For the most part economists and financiers are keeping their fingers crossed that the impact on financial markets and the economy will be small.
Their optimism might be justified. After all, the global economy is much more resilient now than it was just a few years ago, and the Fed isn’t proposing to shrink all the way back to its pre-crisis size.
Nevertheless, it does appear likely that some of the effects of its initial balance sheet expansion will go into reverse. When Treasury bonds mature, the US government issues more bonds in order to raise the cash it needs to repay the holders of the original debt. With the Fed reducing its reinvestments, the Treasury will have to sell more and more bonds to private investors. That suggests the interest rate it pays on its bonds – their yield – will have to rise.
So just as the Fed’s balance sheet expansion suppressed long-term US dollar interest rates, its impending balance sheet contraction looks likely to push long-term US dollar interest rates higher.
That will have big implications for Asia. One of the effects of the Fed’s initial money printing was to trigger a flood of US dollar liquidity into Asia as financial investors sought higher yields than they could earn in the US. Much of that liquidity found its way to Asian corporations, which proved eager borrowers. A good deal made its way into Hong Kong, where the local monetary base grew fivefold, exactly in line with the expansion in the Fed’s balance sheet.
With the Fed now poised to shrink itself again, and with Treasury yields likely to head higher, it makes sense that the tide of liquidity should begin to recede from Asian shores. This implies Asian companies will face higher US dollar financing costs just as some US$200 billion of its US dollar debt is about to mature.
And in Hong Kong it implies that the money which flowed into the city’s financial system when the Fed first fired up its printing presses will begin to flow out again. That will make local financing harder and more expensive to come by. With Hong Kong property prices at such lofty heights, that’s a daunting prospect.
Just as the big run-up in the local property market coincided with the era of low US interest rates and Fed balance sheet bloat, so the next property market slump could coincide with the impending period of higher US interest rates and Fed balance sheet contraction. ■
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 20 years