The US Federal Reserve kept the federal funds interest rate
steady at 5.25 percent on May 9, maintaining the rate in place
since last June.
This is the seventh time that the US central bank has decided to
leave the interest rate at its current level since August 2006. The
Federal Open Market Committee explained its decision in a regular
open statement.
The federal funds rate decided by the Federal Reserve is only a
short-term bench-mark interest rate. The long-term interest rate,
which is set by market supply and demand as well as market
speculation on the national economy, is an index of more
importance.
Currently, the 10-year treasury bond has a yield of 4.67
percent, far below the federal funds rate. This unusual difference
in the long-term and short-term interest rates is solid proof that
the market holds a conservative view about the US economy.
The view comes from worry that the double deficits in the US
current account and the national budget are obviously not
sustainable and a major policy change will be inevitable sooner or
later. After all, the US government will not sit idly by doing
nothing to prevent the double deficits' deteriorating into a
recession.
A policy change in the US, the world's leading economy, will
definitely have a global influence, especially on policy-making in
other economies.
If the US raises its interest rate, countries targeting a
capital account surplus will have to raise their own interest rates
to keep attracting the international capital.
Thus, these nations are losing part of their control over the
interest rate, a major economic policy tool.
As an emerging country in the midst of an economic boom, China
is gaining an increasingly important position in the world
economy.
But its economy is not comparable to the US in GDP volume, per
capita income, the maturity of its capital market, or the
establishment of a market economy. Nevertheless, the Chinese
economy is further integrating into the global community.
Therefore, a major policy adjustment in the United States will
have significant influence on the Chinese economy as well as the
capital market here.
The US Federal Reserve will probably cut the federal funds rate
repeatedly in the case of a sudden slump in US economic growth or
an increasingly gloomy housing market. Then large sums of capital
eyeing short-term revenue will flow out of the US. China would be
an ideal hub for this money.
China is seeing an excessive liquidity and price hikes in
capital assets. The authorities should have increased the interest
rates of the yuan as a countermeasure. However, once the rate is
raised, the interest difference between the Chinese deposits and
the US federal funds would be narrowed, which would only attract
more inflow of capital.
Moreover, a narrowed interest difference between China and the
US would also add more pressure to appreciate the renminbi. This
goes against the wishes of the Chinese monetary authorities to keep
currency appreciation steady and gradual.
In other words, the changes in the US federal fund rate will
limit the room of the Chinese authorities in running the economy by
adjusting the interest rate.
Besides the interest rate, the US government will also resort to
depreciating the US dollar as a means of tackling the double
deficits, especially the deficits in the current account. The US
decision-makers will probably prefer this over raising the interest
rate. After all, the dollar depreciation would recover the
international balance more effectively.
The People's Bank of China, the central bank, will have to
maintain the exchange rate between the renminbi and the US dollar
at the level it wants when the dollar softens.
China and other East Asia countries will witness increased
inflow of international capital, swelling their foreign exchange
reserve and lifting their capital price.
The tide of money inflow will recede only after the US dollar
picks up, leaving the East Asian countries a shrinking surplus or
even deficits in the capital account.
There has already been a huge sum of hot money in China after
the high yield in the capital market. This money is unlikely to be
withdrawn from the capital market because of the change in the
interest rate difference. The inflow of the global capital into
China is not going to suffer from the US interest rate change.
On the other hand, if the US dollar depreciates, the flow of
international money in and out of China will certainly cause
dramatic fluctuations in China's capital market.
However, the soaring stock prices are primarily driven by
internal factors, not foreign capital. And most of the foreign
capital here operates through hedge funds.
Therefore, neither the interest rate cut nor the US dollar
depreciation is going to change the natural cycle of the Chinese
capital market.
To sum up, the changes in the US monetary policy and the
exchange policy will both restrict the room of the Chinese
authorities in manipulating the domestic economy with policy tools.
They would also cause fluctuation on the capital market though the
natural cycle of the market may not be altered.
Hence, forecasting the US policy change is an indispensable
element for policy-making here.
Note: the author holds a PhD from the Institute of World
Economics and Politics under the Chinese Academy of Social
Sciences
(China Daily May 17, 2007)