How the Fed policy change affects China
December 23, 2013, 1:08 pm

The United States Federal Open Market Committee announced Wednesday that it will start drawing down its multibillion-dollar quantitative easing policies in 2014, tapering its monthly purchase of Treasurys and Treasury mortgage-backed securities by $10 billion in January. Since the real economy in the US is steadily recovering now, it was only a matter of time before the Fed decided to taper it off. But, this announcement took many analysts by surprise.

The US Federal Reserve announces plans to slow its stimulus effort by $10bn a month [Getty Images]

However, while the shocks towards developed countries can be isolated, those investors who have experienced turmoil in emerging markets this year will still worry about the impact of the Fed’s policy change, and the mild market response this time just shows that the impact will slowly emerge like the proverbial “slow-boiling frog”.

For the world economy, the direct effects will be a faster fall in the prices of primary commodities and the flow of capital out of emerging economies toward developed countries.

Those emerging countries and developed countries with abundant resources, such as Australia and Canada, will likely suffer the most. More importantly, for the emerging economies, it may reverse their rise in the international political and economic sphere and aggravate the polarization among them.

When it is comes to China, the good news is the Fed’s policy change may present China with some advantages because China’s economic structure is quite different from other emerging economies. China is the world’s largest manufacturing economy and one of the biggest importers of primary commodities. So the falling prices of primary commodities will benefit the Chinese economy. The other emerging countries are highly dependent on exporting their commodities to boost their economies.

Moreover, China’s macroeconomic stability is much better than most advanced economies and other developing countries, such as the other BRICS countries (Brazil, Russia, India and South Africa). For one thing, China has maintained a surplus in both its commodity trade and its current account for more than 20 years, accumulating huge-scale foreign exchange reserves, which can guarantee the Chinese currency greater stability. For another, the fiscal situation in China is better than in many other large countries as there is no risk of a national debt crisis. Therefore, such strong stability can prevent any simple economic shocks from causing serious damage to China’s economic growth.

Finally, the country enjoys higher social stability than many countries, which means it has the ability to prevent the risks from social contradictions from intensifying or getting out of control.

But despite these advantages, Chinese policymakers should not ignore the shocks that will come from the Fed’s move, and they must be prepared for them.

As emerging economies account for half of China’s trade nowadays, and are also the major markets for the country’s foreign direct investment and most foreign projects, the changes may have a strong bearing on China’s exports, FDI, and overseas engineering projects.

To be more specific, there are three impacts to be aware of. First, domestic inflation will derive more from the rising cost of labor and other costs in the domestic market instead of being led by imported inflation as before. Second, with capital flows returning back to advanced economies, the liquidity from external input will decrease, so some bubbles in the asset market, such as the overheating real estate sector, will likely suffer considerably in the near future. Finally, the prices of some domestic raw materials and resources will decline because of the falling prices of international primary commodities. Most natural resources in China, such as minerals, have lower quality but higher mining costs compared to other similar international products. So if it is a bull market globally, such resources can make some profit, while in a bear market, those domestic industries and companies will likely suffer from losses, such a situation will be especially severe in the northwest of China.

However, the economic transition also offers China an opportunity, as it will enable it to have a better handle over imports of primary resources and thus strengthen China’s dominance over the international resource market. China is already the largest importer of primary products, and one of China’s core interests is to maintain a stable supply of foreign resources. However, since the turn of this century, many resource-rich countries or regions have launched a wave of “resource populism”. Various parties and groups try to share the benefits from the exploration of resources without giving enough thought to their sustainable development. In the international market, the rising number of cases in which exporting countries have violated contracts has brought about losses to importing countries. Now, with the on-going decline in primary commodity prices, China can take the opportunity to solve the problem and build a healthier trade environment.

This article was first published in China Daily.