Two episodes of quantitative easing (QE) by the United States (US) Federal Reserve Bank (Fed) since early 2009 aroused widespread concerns in emerging Asia and elsewhere because of the possibility that they would weaken the US dollar (so-called “currency wars”) and stimulate capital inflows in emerging economies that might lead to increased inflationary pressures and asset price bubbles. For example, the vice minister of finance of the People’s Republic of China (PRC), Zhu Guangyao, said on 18 November 2010 that “As a major reserve currency issuer, for the US to launch a second round of quantitative easing at this time, we feel that it did not recognize its responsibility to stabilize global markets and did not think about the impact of excessive liquidity on emerging markets” (Reuters 2010).
Now that US growth appears to be slowing again as a result of the eurozone sovereign debt and banking sector crisis, together with sluggish domestic demand, expectations of a third round of quantitative easing by the Fed are increasing. Although the Fed limited its actions on 20 June to expanding its “Operation Twist”1 program by $267 billion, Fed Chairman Ben Bernanke’s recent testimony to the US Congress underlined various downside risks to economic growth, including the eurozone debt crisis, tighter mortgage lending standards, and the drag from contractionary fiscal policy, especially at the state and local level (Bernanke 2012), which means that a revival of QE policy is possible. Does this mean that Asian emerging economies can expect a large wave of capital heading toward their shores in search of higher returns with potentially destabilizing implications?
The Fed and capital flows
The relationship between Fed monetary policy and capital flows is not a simple one. It depends crucially on the risk attitude of institutional investors. If investors are sufficiently concerned about the downside risks to Asian emerging economies of a global slowdown, they may pull capital out of Asia even if US interest rates are well below Asian rates. The course of Asian exchange rates is a clear indicator of the direction of capital flows. Most emerging Asian currencies have weakened since July 2011, with the Indian rupee showing the largest decline. The main exceptions were the Chinese yuan and the Philippine peso. Significantly, almost all of the countries with currency declines experienced them despite declines in their foreign exchange reserves, so their currency weakness cannot be attributed to sterilized currency intervention.
In Morgan (2011), I investigated possible impacts of US quantitative easing policy on Asian economies and financial markets. I defined US quantitative easing as the Fed’s two major programs of outright purchases of US Treasury notes and bonds. The first block of purchases of $300 billion of Treasury coupon securities was announced in the Federal Open Market Committee (FOMC) statement on 18 March 2009 (US Federal Reserve 2009), and is referred to as QE1. It lasted roughly from 25 March 2009 through to the end of October 2009. The second tranche of purchases of $600 billion of Treasuries was announced on 3 November 2010 (US Federal Reserve 2010), and is referred to as QE2. These purchases began shortly thereafter, and were completed by the end of June 2011. In contrast, the Fed’s balance sheet was reasonably stable from November 2009 to October 2010.
The basic approach was to take the period of November 2009 to October 2010, when no quantitative easing took place, as a baseline period against which to compare the effects of quantitative easing on monetary flows during the QE1 and QE2 periods. Figure 1 shows that, with respect to portfolio and “other” capital flows, US capital outflows and emerging Asia2 capital inflows are closely correlated. Moreover, I found that there was evidence of a correlation between the QE policy episodes, US capital outflows and increased capital inflows in emerging Asia. I estimate that about 40% of the increase in the US monetary base in the QE1 period leaked out in the form of increased gross private capital outflows and about one-third leaked out during the first two quarters of the QE2 period. An excess private financial capital inflow to emerging Asia of $9 billion per quarter was estimated for the first two quarters of the QE2 period, which was relatively consistent with the estimated amounts of the excess increases in foreign exchange reserves and the monetary base in the region during that period. However, this amount is relatively small, and hence was unlikely to have had a significant impact on financial markets, economic activity or inflation, because it could be easily absorbed by sterilization policies.
However, Figure 1 shows that portfolio and “other” capital outflows from the US slowed sharply in the second quarter of 2011, despite the continuation of the QE2 policy during that period. This probably reflected the shock effect of the worsening of the eurozone crisis during that period. This is supported by the fact, as shown in Figure 1, that capital outflows from the EU showed a similar pattern. US private capital outflows either had a large net repatriation or a negligible net outflow on a quarterly basis since April–June 2011. Outflows from the EU took somewhat longer to react, but they also slowed, and then registered a large net inflow in October-December 2011. In line with this trend, the emerging Asian portfolio and “other” gross inflows diminished sharply in July–September 2011 and were negative in October–December, i.e., there was a net outflow. This reversal clearly coincides with the weakening tendency of emerging Asian currencies since the middle of 2011. Of course, it is not possible to make a direct link between US total capital outflows and emerging Asia capital inflows. Most outflows from Asia probably went to Europe instead, reflecting repatriation of capital by European banks as a result of the crisis. However, this simply reinforces the point that there is no simple or constant linkage between US monetary policy and Asian capital inflows.
In summary, the continuation of the eurozone crisis has ended, at least for the time being, the normal tendency for the Fed’s quantitative easing policy to lead to larger US capital outflows, emerging Asian currency appreciation and inflationary pressures. Until the eurozone crisis is resolved and other global risks diminish, leading to a recovery of investor confidence, emerging Asian economies probably need to worry more about sustaining growth rather than dealing with excessive capital inflows and inflationary pressures.
1 In Operation Twist, the Fed sells shorter-term US Treasuries and buys the same amount of longer-term Treasuries to flatten the yield curve. However, this does not increase the size of the Fed’s balance sheet overall.
2 I use the sum of the PRC; Hong Kong, China; Republic of Korea; Malaysia; and Singapore, because these are the only economies in the region publishing quarterly balance of payments data. However, they account for about 85% of the total of emerging Asia.
Bernanke, B. 2012. Economic Outlook and Policy. Testimony before the Joint Economic Committee, US Congress. Washington, DC: US Federal Reserve. June 7. www.federalreserve.gov/newsevents/testimony/bernanke20120607a.htm
Morgan, P.J. 2011. Impact of US Quantitative Easing Policy on Emerging Asia. ADBI Working Paper 321. Tokyo: Asian Development Bank Institute. http://www.adbi.org/files/2011.11.18.wp321.impact.us.quantitative.easing.policy.emerging.asia.pdf
Reuters. 2010. Global Economy—Obama returns fire after China slams Fed’s move. 18 November. http://www.reuters.com/article/2010/11/08/global-economy-idUSTOE6A706720101108?pageNumber=2
United States Federal Reserve. 2009. Federal Open Market Committee Statement. Washington, DC: US Federal Reserve. 18 March. http://www.federalreserve.gov/newsevents/press/monetary/20090318a.htm
————–. 2010. Federal Open Market Committee Statement. Washington, DC: US Federal Reserve. 3 November. http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm