Title: The impact of the Federal Reserve’squantitative easing policy on China's

financial market.

Group members: 1212802119 Huang

xinman

Course title: BA 523 International

Financial Management

Catalogue

Introduction

···································································

·························· 1

1. The definition of QE policy

································································

······· 2

2. The U.S economic background before implement QE policies

······························ 3

3. The timeline of quantitative easing policies for U.S

··········································· 4

4. The influence on China by fed's QE policies

··················································· 5

4.1 The influence on China's foreign exchange market

····································· 6

4.2 The influence on China's import and export trade

······································· 7

4.3 U.S QE policy added pressure to China's inflation

······································ 9

4.4 QE policy caused china’s commodities price rose

······································· 11

5. Suggestions of how China responds to QE policy

·············································· 14

Conclusion

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······························ 16

Reference

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································ 17

Introduction:

Nowadays, United State has the strongest economy in the world,

and Federal Reserve as the central bank of United State, any policy

from the Federal Reserve may affect the world's economies. May be

the country with power financial system can reduce the effect from

US monetary policies, but most emerging market countries will be

greatly influenced and may even lead to serious financial crisis

and inflation. So as the second-largest economy-China, what would

happen to China's economic and how should Chinese government handle

the impact from U.S?

1

1. The definition of QE policy.

Quantitative easing is an unconventional monetary policy used by

central banks to stimulate the national economy when a standard

monetary policy has become ineffective. A central bank implements

quantitative easing by buying financial assets from commercial

banks and other private institutions, thus increasing the monetary

base. This is distinguished from the more usual policy of buying or

selling government bonds in order to keep market interest rates at

a specified target value.

Expansionary monetary policy typically involves the central bank

buying short-term government bonds in order to lower short-term

2

market interest rates. However, when short-term interest rates are

either at, or close to, zero, normal monetary policy can no longer

lower interest rates. Quantitative easing may then be used by the

monetary authorities to further stimulate the economy by purchasing

assets of longer maturity than only short-term government bonds,

and thereby lowering long-term interest rates further out on the

yield curve. Quantitative easing raises the prices of the financial

assets bought, which lowers their yield.

Process: If the nominal interest rate is at or very near zero,

the central bank cannot lower it further. Such a situation, called

a "liquidity trap"1, can occur, for example, during deflation or

1 A liquidity trap is a situation described in Keynesian economics in which injections of cash into the private banking system by a central bank fail to lower interest rates and hence fail to stimulate economic growth.

3

when inflation is very low. In such a situation, the central bank

may perform quantitative easing by purchasing a pre-determined

amount of bonds or other assets from financial institutions without

reference to the interest rate. The goal of this policy is to

increase the money supply rather than to decrease the interest

rate, which cannot be decreased further. This is often considered a

"last resort" to stimulate the economy.

2. The U.S economic background before implement QE policies.

In the 5 years prior in 2006, as the US housing market continued

to boom and the low level of interest rate, lead to the rapid

development of the US subprime mortgage market. But with the US

4

housing market cooling, especially the short-term interest rate

rose and subprime mortgage repayment rate has also risen sharply,

buyers repayment burden increase greatly, at the same time, housing

market continues to cool has also made buyers selling house or

through the mortgage housing to refinance become difficult, This

situation directly led to a large number of subprime borrowers

cannot repay the loan on schedule, and even the banks repossessed

houses but cannot sell at a high price, then cause a huge losses

for banks, triggered the subprime crisis. As the subprime mortgage

crisis occurs, an increasing number of financial institutions and

companies face bankruptcy. On September 15, 2008, United States

5

Lehman Brothers apply for bankruptcy protection, greatly increased

turmoil in financial markets. After Federal Reserve implementing a

series of interest rate cuts and capital injection activities, the

quantitative easing policy began to implement.

The influence of subprime mortgage is just one of the reasons

that Federal Reserve implements QE policy, the other hand, The U.S

was in a situation of high unemployment rate and low inflation. The

unemployment directly led the consumption level decreased, and low

inflation may pose a risk to the economy, may even led to

deflation, which would cause long-term economic stagnation. So the

Federal Reserve has to implement unconventional monetary policy in

6

order to stimulate the economy and employment.

The third reason: traditional currency policy space is limited.

In the 1930s, at that time the U.S consumption spending, private

investment and net exports are greatly reduced. However, the Fed

thinks this big depression is just a normal economic contraction,

the Fed didn't adopt the right monetary policy to save the economy,

instead it used a currency crunch policy. As a result, in the year

1927-1929, the currency supply growth rate drops from 3.8% to 0.4%.

It is because of the Fed's policy made the weak economy become

worse. So now the Federal Reserve chairman Ben·Bernanke learned a

lesson from it, and implement the unconventional monetary policy

7

which is quantitative easing monetary policy.

3. The timeline of quantitative easing policies for U.S.

QE1 25 Nov

2008

The Federal Reserve announces purchase of

$100 billion in GSE debt and up to $500

billion in MBS.

1 Dec

2008

Chairman Bernanke mentions that the Federal

Reserve could purchase long-term Treasuries.

16 Dec

2008

FOMC statement first mentions possible

purchase of long-term Treasuries.

28 Jan

2009

FOMC statement says that it is ready to

expand agency debt and MBS purchases, as well

8

as to purchase long-term Treasuries.

18 Mar

2009

FOMC announces that it will purchase

additional $750 billion in agency MBS and

increase its purchase of agency debt and

long-term Treasuries by $100 billion and $300

billion, respectively.

QE2 3 Nov

2010

The Federal Reserve announces purchase of

$600 billion of Treasury securities by the

end of the second quarter of 2011.

13 Jul

2011

Chairman Bernanke says, "The Federal Reserve

is ready to ease monetary policy further if

economic growth and inflation slow much

9

more."

QE3 31 Aug

2012

Chairman Bernanke mentions that the Federal

Reserve is ready to additionally act, and

purchase long-term Treasuries.

12 Sep

2012

The Federal Reserve decides to launch a new

$40 billion a month, open-ended, bond

purchase program of agency MBS and also to

continue the extremely low rates policy until

at least mid-2015.

12 Dec

2012

FOMC decides to continue its purchases of

agency MBS and long-term Treasury securities

at a pace of $40 billion and $45 billion,

10

respectively.

June 19

2013

The Fed announced it might start to taper QE

by the end of the year if its economic

targets were being met. It changed its

unemployment target to 7%, while keeping its

targeted inflation rate at 2%. It also wanted

to see economic growth between 2.3% - 2.6% in

2013.

FOMC = Federal Open Market Committee, GSE = government-sponsored enterprises,MBS = mortgage-backed securities, QE1 = first round of quantitative easing, QE2 = second round of quantitative easing, QE3 = third round of quantitativeeasing.

4. The influence on China by Fed's QE policies.

Under the circumstances of highly integrated of global finance

11

and economy, quantitative easing monetary policy may play a

important role of stimulation in the U.S. economy, but it was also

a double-edged sword. which means, to some extent, quantitative

easing would spark asset bubble and threaten the global economic

stability. the world's second largest economy, the impact to China-

the world's second largest economy would be incalculable.

4.1. The influence on China's foreign exchange market

China's foreign exchange market will be greatly affected by

U.S QE policy implementation. Due to U.S dollar depreciated, the

RMB against the dollar Exchange rates are forced to raise, in

the foreign exchange market a large amounts of hot money

12

outflows from US and began to speculate RMB, led to RMB further

appreciation. According to figures released by the U.S.

department of the treasury on April 30, 2013, showed, (table

4.1) the value of foreign holdings of U.S. securities, by major

investing country and type of security, as of June 30, 2012, we

can see China's holdings of US securities total amount up to

$1.59 trillion, holdings of long-term treasury debt have reached

$1.138 trillion, it is the largest holders of U.S. long-term

treasury debt, and base the latest statistics of the People's

Bank of China, China as the world's largest foreign exchange

reserves country, the amount had reached 3.4 trillion dollars in

13

March 2013. Such a huge foreign exchange reserve which means if

there has any change of the monetary policy by the US implement

that will deliver a big impact to China. If dollar depreciate 1%

which means China's foreign exchange losses would reach $15.9

billion. According to the graphic 4.2, the dollar against RMB

has depreciated by 10% from November 2008 ￥6. 83/ ＄ to July 2013

￥6. 13/＄. This trend makes China's foreign reserve continuous to

reduce and weaken the purchasing power. On the other hand, China

as the big holder of U.S treasuries, it will face a great loss

of the foreign reserve if in the future US exits QE policy and

sale a large number of treasuries that cause the treasury prices

14

go down sharply.

15

Table 4.1: The value of foreign holdings of U.S. securities

Graphic 4.2: CNY/USD from Feb. 25, 2008 to Jul. 1, 2013

4.2. The influence on China's import and export trade

16

The implementation of QE policy by U.S. has made the dollar

against RMB depreciation, which in theory dampened Chinese

product exports to the U.S. market, and expanded China's import

from U.S. We base of the chart for further analysis, the table

4.3 showed that period between years 2008 to 2009. Which is the

period of the U.S. financial crisis and QE1's implementation,

China's imports and exports quantity to U.S. Has decreased in

some degree. China's trade surplus presented a negative growth

situation. combine the graphic 4.2, between the years 2008 to

2009, The exchange rate of RMB is rising trend. So we know that

China's export and import trade have suffered a negative impact.

17

And between the years 2010 to 2012 which is the period of QE2

and QE3. Although China's import and export amount returned to

growth, but the growth rate was felled. Look at the total trade

balance, the amount is growing, but growth rate is falling, and

base the graphic 4.2 we found that this period RMB is in the

appreciation trend too. So we got a conclusion the QE policy has

no a big effect on the growth of China's import and export

trade. It just tends to reduce the growth speed. So the

appreciation of the RMB may not be able to decide the overall

trend of the trade between China and U.S. China is still a big

exporter to U.S and the trade surplus is still in a huge amount.

18

The reason for this situation is from the strong complementary

of industrial structure between China and U.S. Because the most

of the goods export to U.S is Consumer Staples, the price

elasticity is low and it had a limited impact by the exchange

rate fluctuation.

Table 4.3: Import and Export Trade between China and America from the years 2008 to 2012

Years

Imports(Billion $)

Importgrowthrate

Exports

(Billion $)

Exportgrowthrate

Tradebalance

Tradebalancegrowthrate

2008

81.44 17.4% 252.30 8.4%170.86

4.6%

2009

77.44 -4.8% 220.82 -12.5%143.38

-16%

2010

102.04 31.7% 283.30 28.3%181.26

26.4%

2011

122.15 19.6% 324.49 14.4%202.34

11.6%

2012

132.89 8.8% 351.80 8.4%218.91

8.2%

4.3. U.S QE policy added pressure to China's inflation

19

U.S. quantitative easing policy led to the dollar glut.

People's investment and consumption are greatly increased, in

theory, people should take the money engaged the activity of

investment and consumption in the U.S. thus driving U.S.

economic recovery, but in fact many funds in the market

transform to become hot money, the hot money outflow from U.S

and inflow to the emerging market. According to the graphic 4.4,

in December 2008 China's one year interest rate is 2.25%. Until

now the interest rate still remains as high as 3%, and US

federal funds rates remain 0-0.25%. China's interest rates much

higher than the Federal funds rate, and the Federal Reserve is

20

unlikely to increase the interest rate in the short-term, there

is an arbitrage opportunity between US and China's interest rate

spread, so the trend of the hot money inflows will continue. In

addition, the quantitative easing monetary policy had weakened

the attraction of dollar assets to the short-term flowing

capital. Under the expectations of RMB appreciation, driven a

large number of short-term international capital flow into

China, push up asset price and even added pressures to

inflation. In general, inflation can be judged through the CPI

and PPI, A consumer price index (CPI) measures changes in the

price level of a market basket of consumer goods and services

21

purchased by households. A Producer Price Index (PPI) measures

the average changes in prices received by domestic producers for

their output. The graphic 4.5 and 4.6 is the PPI and CPI of

China in the recent years, we can see these two indexes were

fast increase in 2009. It means Federal Reserve’s QE policy

directly cause China's inflationary pressures. Once the U.S.

economy turning to a sustained recovery, however, the Fed will

gradually withdraw from quantitative easing and tightening the

money supply. The federal funds rate and interbank rates will

rise. That will make dollar appreciate and the government bond

yield rise, commodities price will decrease, it may burst the

22

asset bubbles. Hot money will flowing out of China, lead to the

asset price volatility, that will hide some risk to China's

financial stable.

Graphic 4.4: The interest rate of china from the year 2002 to 2012

Graphic 4.5: China’s PPI from Jan. 2006 to May 2013

Graphic 4.6: China’s CPI from Jan. 2008 to May 2013

23

24

4.4. QE policy caused China’s commodities price rose

Under the expectation of U.S QE policy resulting in rampant

liquidity, dollar tend to be undersold that cause dollar further

depreciation, many investors turn their eyes to commodities,

caused the international market's commodities price continued to

rise. While China's demand for energy, raw materials heavily

depend on imports. The international raw material prices go up

led to China import cost increased. About the international

commodity price, we will use the CRB index for analysis. The

Commodity Research Bureau Index is a global benchmark for

measuring commodity price movement and developed. According to

25

the graphic 4.7, the international commodities price rose

sharply in 2009 to 2011. And there is a small pullback after

2011, but it’s still at a high level. So we found that the QE

policy has a big impact on commodities price through this

situation. Specifically, the graphic 4.8 is the gold price in

recent years, we can see the gold price rose rapidly especially

after the year of 2008 which QE policy had implemented, until

now still keep on the high level. In addition, the graphic 4.9-

4.12 showed that in the years 2009 to 2011 the high grade copper

price rose by 67%, silver price rose by 167%, soybeans and corn

rose by 40.9% and 68% respectively, prices of these commodities

26

rising will directly drive up China's commodities price. We

choose the data of raw materials import from December 2010 to

February 2011. According to the graphic 4.13, the quantity of

coal, iron ore, refined oil and steel is decrease, but the

amount of money is increase, this is the direct impact of the

rise in international commodity prices. And the QE policy is the

main reason for the commodities price rise.

27

Graphic 4.7: CRB index form Apr. 2007 to Jul. 2013

Graphic 4.8: the gold price from Jul. 2008 to Jul. 2013

28

Graphic 4.9:

Graphic 4.10:

Graphic 4.11

29

Graphic 4.12

Table 4.13: Quantity and amount of china raw materials import

30

5. Suggestions of how China responds to QE policy.

1) Accelerate the process of RMB internationalization. QE policy

caused dollar depreciation and dollar depreciation caused

China's foreign exchange reserves book value decreased. If RMB

becomes an international settlement currency, it will be better

for China's trade surplus. Now U.S QE policy would undermine the

credibility of the dollar. Under this situation, China should

find the opportunity to expand the scope and scale of currency

swaps, issue more offshore RMB bonds. And Signed Bilateral Local

Currency Swap Agreement with more countries. This is an

31

important step towards the RMB internationalization. It is the

best way to deal with QE policy’s impact.

2) After the U.S implement quantitative easing monetary policy,

it caused many hot money inflows into China. So China has to

strengthen monitoring and managing the hot money inflow and

outflow. Identify measures to respond and reduce the effect of

hot money. At present China's capital account is not yet fully

open, it is still under control. Only the QFII (Qualified

Foreign Institutional Investors) and QDII (Qualified Domestic

Institutional Investors) can let the money inflow and outflow of

China. Without approval any foreign financial institutions and

32

individuals are not able to invest in China's stock and bond

market. Furthermore residents and companies in China are not

able bring any funds out or invest in oversea financial market

except the way of QDII. But now China's interest rate is 3%, and

the federal benchmark interest rate is 0-0.25%, there is a big

spread between these two countries, combine with the good

performance of China's economy and the expectation of RMB

appreciate, the hot money will try any way to avoid capital

control and enter China. So Chinese government have to

strengthen the control of the capital and stabilize China's

stock and real estate market, reduce the effect of hot money's

33

inflow.

3) Use the measures such as tax cut, loosen the restriction on

market accession , reduce the negative impact to China's economy

by the risen import price of commodities. Because the risen

price of commodities will further worsen China company's life,

most small company will face a problem of high cost and how to

survive. So government must help them reduce the burden, it can

through the tax cut, loosen the restriction on market access and

other method to help companies survive.

4) Manage liquidity to prevent excessive credit expansion, such

as raising the banks' reserve requirements or increase the scale

34

of issue central bank bills and strictly control the size of

bank loans or increased deposits and lending rates in order to

manage inflation, raise the cost of capital and preventing asset

bubbles.

Conclusion:

Through research and learning of QE policy, we can more clearly

understand QE policy has influenced China's financial market in

various aspects, such as dollar depreciation caused China's foreign

exchange reserve shrink; slow china's trade surplus growth speed;

commodities price rose led to export cost increased and hot money

inflow added pressure to inflation. China's financial market even

35

the economy would be shocked by these negative influences. China

needs the scientific management and effective measures do the

largest effort to the negative impact of QE policy, get the

opportunity from QE policy, and further perfect China financial

system.

36

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39

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40

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41