Global reset – Monetary decoupling (Part 3: Consequences of diverging policies)
Phuah Eng Chye (17 July 2021)
The symbiotic US-China consumption-investment relationship dominated the global economy over two decades. Academics debated on the causality of the global savings glut[1]; whether US consumption and trade deficits caused foreign savings to soar or whether foreign willingness to invest in US debt caused US deficits to balloon. Regardless of whoever was at fault, the indisputable result is a Goldilocks economy of low inflation and interest rates that underpinned a period of rapid global economic growth.
The compounding of imbalances – US deficits and China’s investment in US debt –triggered a powerful political reaction in a lead-up to decoupling. An analysis of the US-China relationship purely from a perspective of mercantilist imbalances paints an incomplete picture. The context needs to be broader. First, the global savings glut is largely created by central bank sterilisation on one side and by private sector financing and intermediation on the other. The global savings glut wasn’t initiated by the Fed but by foreign central banks, investors and corporations seeking a place to park their USD export earnings. Only the USD ecosystem could provide (and create) the necessary supply of assets to satisfy foreign demand. The savings recycling and currency aspects of the relationship are thus important.
Second, monetary profligacy accommodated the boom in information-driven growth that created huge global demand for credit and liquidity. Firms from emerging economies, particularly from China, tapped USD public and debt markets to finance their technology ventures. Thus, the global savings glut underpinned US-China globalisation, the growth of emerging economies, mitigated the effects of the Japanese depression, financed the technology revolution and the revival of American enterprise. Markets became truly globalised with regulators adopting harmonised standards and financial intermediaries popularising financial engineering techniques that connected liquidity in different assets around the world.
Overall, global economic, corporate and market growth would have been stifled if central banks had been tough on balance sheet management or strict in regulating dubious products and frothy markets. Monetary and regulatory permissiveness created a conducive environment for growth. But it also created the conditions that led to crises that is perpetuating the need for further monetary interventions.
In which areas are policies diverging
The symbiotic US-China consumption-investment relationship was nurtured in an amicable atmosphere conducive to policy coordination. However, cooperation has given way to acrimonious bickering among the powerful nations. Nations set policies to protect their self-interests and, at times, at the expense of rivals. The monetary policies of US and China are drifting along diverging paths on several fronts.
First, China has shifted to a strong yuan policy[2]. I should caveat that currency policies are, by nature, ambiguous and therefore needs to be based on personal and generalised perceptions. It was previously perceived China restrained the yuan to promote exports. But China now seems more comfortable with a strong yuan since it shifted to a “dual circulation” strategy that emphasises on domestic consumption, quality and innovation. A strong yuan would assist in improving perceptions on China’s economic power. In this context, the previous strong USD–weak yuan regime can be considered to be complementary. A strong USD-strong yuan will set the monetary policies of the US and China on course for a head-on collision. A strong currency (very much like high share prices) helps a country to make cheaper purchases. New global tensions may emerge if China competes with the US to be the world’s biggest consumer and importer of resources.
Second, aligned with its currency policy, China has resisted letting its interest rates fall towards zero bound and has maintained it at around 3%. The higher interest rate regime may be more appropriate for China at this stage of its financial development as it needs to strengthen market discipline. The divergence in interest rate policies opens up another area where US and China may compete to set the global trend.
Third, China is focused on addressing vulnerabilities in its financial system. William Pesek notes while China’s central bank is not expected “to hike interest rates anytime soon, or even to pursue a generalized tightening of financial conditions. By merely becoming less generous about punchbowl refills, though, the PBOC is signalling Beijing’s latest cleansing campaign is real”. This includes efforts to crack down on property market, shadow banking, fintech giants, fraud and displaying greater tolerance of defaults (including by state-owned enterprises). “China is proving to be the adult in the room as the BOJ and Fed continue to pump giant waves of liquidity into markets…that is the Everest-sized irony casting a giant shadow over capital markets in the world’s three biggest economies. The BOJ and the Fed – the central banks of the world’s leading supposedly capitalist economies – each control far more market assets than the supposedly socialist PBOC. The worry, longer-term, is that policymakers in Tokyo and Washington are rewarding terrible investor behavior and corporate mediocrity”. The emphasis on strengthening financial soundness is intended, in my view, to avoid Japan’s fate from lax financial oversight after the 1985 Plaza Accord.
Exit from the goldilocks economy
Monetary policies operate with long and variable lags and the consequences of diverging policies will only become apparent over time. If the goldilocks economy was ideal for global economic growth, then a shift from the US-China consumption-investment relationship will result in sub-optimal economic outcomes. Below are some scenarios to consider.
- End of global savings glut. Since 2013, China generally halted large-scale accumulation of USD reserves. This marks the end of the global savings glut and the lengthy beginning of an exit from the Goldilocks paradigm of low inflation and low interest rates. The unwinding of the global savings glut may eventually give way to higher inflation, followed by higher interest rates. No replacement paradigm for the recycling of global consumption and savings has emerged. The consequence is a pending acceleration of deglobalisation, and increasing geopolitical and economic stress from unresolved imbalances.
- Localisation of liquidity. Global outcomes were benign when central banks financed US deficits by investing in US debt (sterilisation) because it globalised USD liquidity. It follows that the absence of fresh sterilisation[3] implies the massive QE liquidity in the US and EU will remain partially trapped within their own jurisdictions. Global liquidity would be further reduced by structural repricing of USD debt (via currency devaluation and higher interest rates) leading to a deleveraging in USD-denominated debt and by diminishing cross-border intermediation capacity.
- Inflation. The global economy faces cost-push inflationary pressures from trade conflicts (tariffs, sanctions, boycotts), an appreciating yuan and supply bottlenecks (relocation and logistical interruptions). Geopolitical and pandemic uncertainties are discouraging capacity expansion across the production chain. This implies firms are likely to pass on rising costs to customers. This also means that while fiscal stimulus will aid a recovery in aggregate demand, much of the stimulus would add to inflationary pressures.
- Crowding out. Monetary policy divergence implies reduced international accommodation of expanding US debt. Rising inflationary pressures and sizeable fiscal deficits could set the scene for crowding out – where in a rising interest rate environment, government borrowing starts to crowd out private sector borrowing. This will be even more true in countries where there is limited room for monetary easing.
- Market dislocation. The liquidity created by fiscal and monetary stimulus have seeped into asset prices. High valuations, price volatility and thinning liquidity are raising hedging costs for repos, swaps and derivatives and damaging intermediation capabilities. Events such as a spike in US interest rates or forced-selling will create funding risks or trigger an unwinding of speculative positions. The potential for market dislocation is illustrated by the massive unwinding operation by the Fed. Wolf Richter notes “this morning, the Fed sold a record $992 billion in Treasury securities in exchange for cash, via overnight reverse repos (RRPs), to 74 counterparties…Reverse repos have the opposite effect of QE: They absorb cash…With RRPs now at $992 billion, the Fed has undone over 8 months of QE (at $120 billion per month)…This is a further sign that the financial system is creaking under a huge amount of cash that resulted from the Fed’s massive QE, and this cash[4] has trouble finding a place to go… These cash pressures originated as a result of the Fed’s crazy and continued money-printing binge. Obviously, the real solution to the cash pressures would be to stop QE and then begin unwinding the assets on the Fed’s balance sheet. But that would be too radical a step to take”.
- Depression economics[5]. Once isolated within Japan, there is concern liquidity trap or depression conditions are spreading to the US[6] and Europe. At the moment, low interest rates and aggressive fiscal stimulus do not seem to have revived private sector investment in those countries. Depression dynamics will be set in motion if fiscal stimulus and debt forbearance wears out or if asset prices collapse. If, like in Japan, the private sector never fully recovers its confidence and, despite QE, liquidity is unable to flow to where it is needed to stimulate growth, this would amplify the forces of contraction and hasten a return to depression economics.
Global spillover effects from policy divergence
Michele Ca’ Zorzi, Luca Dedola, Georgios Georgiadis, Marek Jarociński, Livio Stracca and Georg Strasser points out “both the central role of US financial markets and the dominant role of the US dollar amplify the global effects of Fed monetary policy”. Hence, Fed monetary policy has large spillover effects on real activities in major and emerging economies, affecting global financial conditions and inflation. “By contrast, spillovers from ECB monetary policy are largely confined to trade. Unlike the bilateral spillovers between the euro area and the US, our findings suggest that ECB and Fed monetary policy actions may give rise to policy trade-offs in emerging market economies if the policy cycles are not in sync”.
Stephen G. Cecchetti, Machiko Narita, Umang Rawat and Ratna Sahay confirmed earlier research that “prolonged U.S. monetary policy easing spills over to other countries, driving up financial system leverage; and that these spillovers are larger than the impact of domestic policy easing. That is, a sustained reduction in U.S. interest rates increases bank and nonbank financial firms’ leverage by more than an equivalent change in the path of domestic interest rates. The global dominance of the dollar means that monetary policy easing in the United States has an impact not only on exchange rates, but on prices of dollar-denominated commodities, cross-border financial flows and the price of risk. Faced with changes in the prices of virtually all assets, financial firms everywhere reoptimize their portfolios”.
In this context, the lack of policy synchronisation between US and China is a major concern. Robert Gilhooly, Carolina Martinez and Abigail Watt notes “the $1.9 trillion American Rescue Plan Act is likely to push up US GDP by around 5-7%. Indeed, it has a started a fierce debate about whether US fiscal policy is becoming too expansionary”. In contrast, China appears to have “already unwound most of its previous loosening…More generally, the authorities have been emphasising that while the PBOC’s main policy rates may not rise, fiscal support is being withdrawn and financial stability remains a key priority”. They argue “US fiscal policy should provide a large boost to the rest of world, but the US fiscal shock is not occurring in isolation. China is withdrawing policy support, reflecting official GDP’s return to its pre-COVID trend, while many other emerging markets are finding it increasingly difficult[7] to continue with support measures enacted in 2020”. This implies “global trade – a key transmission channel – is unlikely to improve as much as you would normally expect given the loosening of US fiscal policy”.
In other words, tighter monetary policy in China can partially neutralise the impetus from US’s aggressive stimulus on the global economy. Sun Guofeng, the head of People’s Bank of China (PBOC)’s monetary policy department, reportedly[8] explained that “due to the time difference in terms of pandemic control and economic recovery, the difference in monetary policies of the US and China is very normal.” In this regard, he says China’s short-term priority lies in sustaining growth, while the United States is focused on reining in inflation. These diverging policies may result in different interest rates and currency exchange rates that could, for example, cause unintended speculative capital flows.
In the past, the diverging monetary policies was aligned through sterilisation. But China is unlikely to resume sterilisation due to decoupling and sanction risks. In the absence of sterilisation, monetary policy divergence could have harmful effects. Countries[9] have deployed various policies in response to the pandemic and now have to consider how to manage the spillover effects from diverging US and China monetary policies.
Conclusion: Two suns in the sky
With decoupling, the monetary policies of the two leading economic powers are likely to be pulling and pushing in different directions. This is giving rise to questions such as (1) How China’s monetary policy would change in relation to the diversification of its global relationships in production, consumption and investments; (2) Whether the US would be able to continue financing its deficits through QE or whether a crisis could erupt to force the US to curb its deficit spending; and (3) How are private sector activities going to recover given the uncertainties generated by policy divergence?
The diverging monetary policies reflect growing competition between powerful rivals to reshape ecosystems around their currencies. The Confucian saying is that “there cannot be two suns in the sky, nor two emperors on the earth.” In the past, the US was the leader in setting global monetary policy with the rest of the world (including China) adapting accordingly. At some point in the future, the policies of the world’s two most powerful economies could collide and whose monetary policy should countries then adjust to? The best possibility for reinstating cooperation is to head towards a strong yuan–weak USD regime. This would represent a re-enactment of the 1985 Plaza Accord.
References
Carlos Cantú, Paolo Cavallino, Fiorella De Fiore, James Yetman (March 2021) “A global database on central banks’ monetary responses to Covid-19”. Bank for International Settlements (BIS). https://www.bis.org/publ/work934.pdf
Lyn Alden (14 February 2021) “Economic Japanification: Not what you think”.
Michael Pettis (1 December 2020) “Foreign saving gluts and American financial imbalances”. Carnegie Endowment for International Peace. https://carnegieendowment.org/chinafinancialmarkets/83365
Michele Ca’ Zorzi, Luca Dedola, Georgios Georgiadis, Marek Jarociński, Livio Stracca, Georg Strasser (25 May 2021) “Making waves: Fed spillovers are stronger and more encompassing than the ECB’s”. Voxeu. https://voxeu.org/article/fed-spillovers-are-stronger-and-more-encompassing-ecb-s
Orange Wang (14 July 2021) “China’s economic policy diverging from US while putting own needs first, central bank says”. SCMP. https://www.scmp.com/economy/china-economy/article/3140983/chinas-economic-policy-diverging-us-while-putting-own-needs
Phuah Eng Chye (2015) Policy paradigms for the anorexic and financialised economy: Managing the transition to an information society. http://www.amazon.com/dp/B01AWRAKJG
Phuah Eng Chye (5 June 2021) “Global reset – Two whales in a pond”. http://economicsofinformationsociety.com/global-reset-two-whales-in-a-pond/
Phuah Eng Chye (19 June 2021) “Global reset – Monetary decoupling (Part 1: Sterilisation and QE)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-1-sterilisation-and-qe/
Phuah Eng Chye (3 July 2021) “Global reset – Monetary decoupling (Part 2: Economics of large central bank balance sheets)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-2-economics-of-large-central-bank-balance-sheets/
Robert Gilhooly, Carolina Martinez, Abigail Watt (13 April 2021) “A tale of two shocks: Emerging markets amid US and China cross-currents”. Voxeu. https://voxeu.org/article/emerging-markets-amid-us-and-china-cross-currents
Stephen G. Cecchetti, Machiko Narita, Umang Rawat, Ratna Sahay (July 2021) “Addressing spillovers from prolonged U.S. monetary policy easing”. International Monetary Fund (IMF). file:///C:/Users/user/Downloads/wpiea2021182-print-pdf.pdf
William Pesek (11 December 2020) “China parts ways with US, Japan easy money”. Bloomberg. https://asiatimes.com/2020/12/china-parts-ways-with-us-japan-easy-money/
Wolf Richter (30 June 2021) “Fed’s reverse repos spike to $1 trillion. Cash drain undoes 8 months of QE”. Wolf Street. https://wolfstreet.com/2021/06/30/feds-reverse-repos-spike-to-1-trillion-cash-drain-undoes-8-months-of-qe/
[1] See Michael Pettis for an overview of the debate.
[2] “Global reset – Monetary decoupling (Part 3: Consequences of diverging policies)”.
[3] A reduction in sterilisation by foreign central banks implies fewer players and lower foreign demand for USD assets and this will reduce global USD liquidity.
[4] Wolf Richter explains “over the past few months has been the flood of cash in money market funds, and they are trying to find a place to go with it”.
[5] See Policy paradigms for the anorexic and financialised economy: Managing the transition to an information society.
[6] See Lyn Alden’s analysis on the Japanification of the US economy.
[7] Robert Gilhooly, Carolina Martinez and Abigail Watt explain “one reason many emerging markets are putting in place less supportive policy is that US fiscal policy has pushed up on US yields. This is a natural endogenous reaction to a brighter outlook in the US, but for emerging markets it risks being more akin to an exogenous tightening of financial conditions, unless the real economy spillover is sufficiently positive”.
[8] See Orange Wang.
[9] Carlos Cantú, Paolo Cavallino, Fiorella De Fiore and James Yetman complied a database of central bank responses to Covid-19 in 39 economies.