Why China Hates QE2

In lean economic times like these, it's only natural that rational actors consider self-preservation first and foremost among their priorities. That seems to be precisely what Ben Bernanke was doing when he cited the Federal Reserve's congressional mandate to "promote a high level of employment and low, stable inflation" to justify the Fed's repurchase of $600 billion worth of long-term Treasury securities in a recent Washington Post opinion piece -- a strategy that's since come to be known as QE2. Facing criticism from Germany, Russia, China, and others during his current trip to Asia ahead of the G-20 summit, President Barack Obama reiterated domestic priority, noting that "the Fed's mandate, my mandate, is to grow our economy" [emphasis added].

Given the results of the recent election, it's clear why politicians are focusing on the health of the U.S. economy, but the fact is that QE2 has significant ramifications -- and not always good ones -- for the rest of the world. The question, of course, is should these knock-on effects be considered in the deliberation of domestic economic policy. My answer is that given rapid globalization and the need for cooperation among both developed and emerging economic actors, they very definitely should.

The problem with QE2
The goal of QE2 is to drive down long-term interest rates, thereby making it cheaper for individuals and corporations to borrow money. But interest rates are already historically low, and creditworthy corporations such as Microsoft (Nasdaq: MSFT  ) , Coca-Cola (NYSE: KO  ) , and Wal-Mart (NYSE: WMT  ) have recently taken advantage of these low rates to refinance billions of dollars worth of debt at record low rates, including 30-year notes at just 5%. In fact, the cost of borrowing is so low for these companies, that a commentator at The Wall Street Journal suggested at least one of them -- Microsoft -- become a bank! (Incidentally, Wal-Mart has previously considered entering banking only to be stymied by resistance from the financial community.)

In a world where creditworthy borrowers are already taking advantage of record-low rates, what good does it do to drive rates lower? The answer is that it fundamentally won't do that much good at all. The beneficiaries of QE2 are likely to either be less-than-creditworthy borrowers (the folks who helped create this mess in the first place) or borrowers who will use cheap money to make speculative investments. While both points are worrisome, the latter has the potential to be the most destabilizing -- and it's already occurring. Thanks to cheap money, emerging market stocks are up 30% since June and emerging market bonds are being driven to record-low yields.

Why that's a problem
This matters because volatile capital inflows and outflows have long been a problem with which emerging markets have struggled to cope -- with significant inflows in times of optimism quickly reversing when the market gets pessimistic. This makes long-term planning and sustainable development a tricky thing in the emerging world, and that's one reason why Brazil recently strengthened its foreign capital controls by raising taxes on foreign investment. Similarly, a recent statement by the World Bank noted that Asian economies may need their own set of capital controls to prevent the formation of asset bubbles that might be caused by the cheap money that is likely to flood out of the United States thanks to QE2.

This is one reason why China hates QE2. That country is already struggling to control real estate and stock market bubbles. Although that country already has capital controls in place, the pressure of a new round of hot money could help support prices.

But China's problems don't end there
China's other issues relate to the value of the dollar, a value that could continue to erode given the Fed's clear willingness to print money and potentially spark rapid inflation. The first is that China is the United States' largest creditor, holding nearly $870 billion (or more than 20%) of our public debt at the end of August. Since the U.S. dollar is a reserve currency, this debt is all dollar-denominated -- meaning that no matter what happens, China will eventually be repaid $870 billion regardless of what the purchasing power of those dollars may be at the time of repayment.

Should QE2 spark rampant inflation that causes the dollar to drop relative to gold, other global currencies, and strategic commodities such as oil and food, China stands to be a lot poorer in a few years than it thinks it is today. This is one reason why China has been reducing its ownership of U.S. debt (that $870 billion at the end of August 2010 is down from $937 billion at the end of August 2009). While some might think it's good for China to hold less of our debt, the fact is that if that country becomes reluctant to purchase more of it, it will make it more difficult for the U.S. to borrow or print money in the future. Put in that context, the description of QE2 as the equivalent of a Hail Mary pass in football seems appropriate.

And the last reason China hates QE2
Yet China's concerns aren't just with the value of our currency, but also with the relationship between our currency and theirs, the Chinese yuan. The relative weakness of China's yuan was a hot-button election issue, with many blaming China for depressing its currency to steal American manufacturing jobs. This is a simplistic view of the situation, but one that resonates with voters and makes for a compelling 30-second campaign ad. That reality aside, I've written in the past in this forum that Americans need to chill out about China's currency and explained why China is pursuing a slow and deliberate liberalization of its currency in order to balance domestic and global pressures.

Yet QE2, again in the event that it sparks a run on the dollar, will force China to re-evaluate its own currency policy. See, since China not-officially but-functionally pegs the value of the yuan to the value of the dollar and because the commodities China needs to buy from the world, such as oil and food, are priced in dollars, those commodities China needs stand to become a lot more expensive if the value of the dollar declines and China maintains its unofficial-but-functional currency peg. At a time when one of China's most pressing domestic problems is uneven economic development, the last thing the government wants is for food and fuel to become more expensive for rural Chinese in order to maintain subsidies for China's manufacturing sector.

In other words, QE2 threatens to force China's hand further on the currency issue, and China hates the prospect of having to deal with that pressure.

The global view
There are certainly many in the United States who will be glad to hear that QE2 might force the Chinese government to re-evaluate its stance on its currency. I believe that, however, is short-sighted.

Although our economy could benefit in the near term if some Chinese manufacturing jobs were to return to the states (though this is far from a sure thing; they could just as easily go to Mexico or Cambodia), the fact is that we can only help stabilize the global economy in the long term by promoting the economic development of major emerging markets such as China, Brazil, and India. These three countries are massive population centers, and the development of consumer classes in these countries will be the primary driver of global economic growth for the next few decades. To the extent that our own short-term economic stimulus could deter or put off sustainable development in these countries, it's actually in our self-interest to consider QE2 from a more global perspective.

When one does that, global objections to QE2 actually start to hit home.

Get Tim Hanson's top global stock picks by joining Motley Fool Global Gains. Tim's "Global View" column appears every Thursday on Fool.com.

Tim Hanson is co-advisor of Motley Fool Global Gains. He owns shares of Wal-Mart. Coca-Cola, Microsoft, and Wal-Mart Stores are Motley Fool Inside Value picks. Wal-Mart Stores is a Motley Fool Global Gains selection. Coca-Cola is a Motley Fool Income Investor selection. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Coca-Cola, Microsoft, and Wal-Mart Stores. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On November 11, 2010, at 11:32 AM, madmilker wrote:

    Have you look at the corporate debt lately....

    are for that matter ....just the DEBT of America.

    http://grandfather-economic-report.com/debt-nat-b.htm

  • Report this Comment On November 11, 2010, at 12:19 PM, Anysimplefool wrote:

    Tim:

    Your analysis once again points out the total lack of historical and economic understanding in America. Instant gratification has become the norm. Politicians of both parties seem incapable of thinking beyond the next election. Where have all the long term thinkers and mature voices gone? Now the Republicans want to attack Volcker. Those who speak truth face a tough road. Maybe we will build a coliseum in every major city so we can feed "terrorists" to the lions.

    So much easier than actually working to fix problems. Sad.

    Simple

  • Report this Comment On November 11, 2010, at 12:33 PM, TMFMmbop wrote:

    Phew...for a second there I thought you were talking about me! Thanks for the comment.

    Tim

  • Report this Comment On November 11, 2010, at 12:37 PM, bhessel wrote:

    LOL the U.S. debt pit could never have been dug so spectacularly deep without the enthusiastic “help” of the Chinese, who until recently have been carting away the lion’s share of the dirt.

    If they have lost their zeal to dispose of still more of our dirt—and are instead now reducing the amount of dollar-denominated debt they possess—that is their prerogative, of course.

    But having enabled and encouraged our behavior up to now, they are hardly in any position to decry our compulsion to keep digging—nor to complain when we make alternate arrangements for disposing of the dirt.

    While most definitely no fan of bourgeois convention, I expect even Lenin would have allowed that when your enemy sells you the rope and you’ve already got it around his neck, complaining about the price at that point is just bad form.

  • Report this Comment On November 11, 2010, at 12:45 PM, TMFMmbop wrote:

    Agreed. When it comes to their trade surplus, China could stand to take a more global (and sustainable) view as well.

    Tim

  • Report this Comment On November 11, 2010, at 2:49 PM, Vineconimcs wrote:

    "War Footing", but out of bullets! Please check out "the Economist" page 84, Sept 4-10th. As you point out, the Fed can no longer lower interest rates or if they do, it will trigger speculative habits vs. actual Growth. Our Federal Reserve was designed to stabilize interest rates,unemployment and fight inflation. Deflationary problems we now face with the latest popped bubble were never part of the plan. The Fed is now embarking on more of a Fiscal policy effort vs. Monetary. If anyone should be buying back the bonds, it should be the Treasury Dept. The intent of this QE2 "buyback" is a hope that US citizens will sell off these soon to be even lower priced CD's and buy... something else. Stocks, Houses, Cars. Spur demand in the Economist lingo. The problem, as Mr. Obama is finding out, this action is actually Fiscal policy vs. Monetary and the impacting the folks that hold the bonds, not necessarily American in this day and age. The Chinese especially do NOT need any stimilation of their economy, they want to slowly lower the value of their currency with the US currency, to avoid shock changes to their Economy.

  • Report this Comment On November 13, 2010, at 10:29 PM, susan400 wrote:

    Why was my post deleted?

    There is this defeatist mentality.

    We get lots of stuff and china seems to want

    2.1 % 10 year US paper,

    Who exactly would you want to be ?

    QE II has intent.

  • Report this Comment On November 13, 2010, at 10:59 PM, goalie37 wrote:

    I want to know, with all the negatives of QE2 that have been pointed out in hundreds of articles and blogs, how much is it expected, in the most wildly optimistic scenario, to add to GDP? Do they really think it is worth all this for what will be little more than a blip?

  • Report this Comment On November 17, 2010, at 3:17 PM, TMFRoyal wrote:

    Hi, Tim,

    Where do you get the $870 bn as 20% of the U.S. public debt figure? I've consistently heard that China has some $2 trillion. With gross debt at $13 trillion and public debt (gross minus what the government owes to itself) at $9 trillion, how does China own 20%?

    Thanks.

    Jim

  • Report this Comment On November 18, 2010, at 4:26 PM, TheSecretHistory wrote:

    The Chinese Government is working to curb price inflation, for instance:

    http://english.cpc.people.com.cn/66102/7202872.html

    Everything will be OK as long as the Communist Party of China knows how to successfully direct a market economy, and is intent on developing a middle class complete with a Western-style consumer culture that emphasizes personal choice, individual consumer rights, and strong contract enforcement. Oh, wait.

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