The recent financial crisis has seen Asia emerge as an economic powerhouse — indeed, as a key driver of global growth. Within five years or so, Asia’s total economy could be as large as that of the US and the EU combined.
Indeed, while Asia is rising, the rich industrial countries of the old G7 have been drifting into a liquidity trap. As the ongoing recession exhausts the traditional instruments of monetary policy, central banks are opting for new rounds of quantitative easing (QE). And, with investors seeking higher returns, more QE — especially by the US — will drive “hot money” (short-term portfolio flows) into high-yield emerging-market economies, which could inflate dangerous asset bubbles in Asia, Latin America and elsewhere.
The US Federal Reserve and US President Barack Obama’s administration remain rhetorically wedded to maintaining a “strong dollar.” However, it is the US dollar’s weakness that has boosted US corporate earnings since the crisis erupted, propelling the Dow Jones Industrial Average above 11,000 for the first time since May. Since early 2002, the US dollar has fallen by one-third against major currencies and recently this decline has intensified.
Since the end of August, when US Federal Reserve Chairman Ben Bernanke argued for another round of QE, the US dollar has plunged more than 7 percent against a basket of half a dozen major currencies. Inflation--protected securities are now being sold at negative yields for the first time ever.
Following the US midterm elections and the resurgence of the Republicans in the US Congress, the Fed’s decision to pump US$600 billion into the economy by the middle of next year is likely to trigger similar actions in the UK, Japan and other advanced economies. Moreover, the Fed has left the door open to more QE next year — a tacit acknowledgement that the recovery will be long and sluggish. However, the effect of a new round of QE on interest rates could be small and limited to an announcement effect, as the Fed’s own research indicates.
In fact, the full impact of the US’ “QE2” will not be domestic, because the net effect will be a weaker dollar as speculators bet on its decline. Successive waves of QE would amount to debasing the value of the US dollar, thus inflating massive US debts.
Meanwhile, developing countries are moving in the opposite direction. Last month, the People’s Bank of China, responding to the twin threats of inflation and asset bubbles, raised its one-year deposit and lending rates by 25 basis points, to 2.5 percent and 5.56 percent respectively — the first increases since 2007.
In the West, concerns about the impact on Chinese growth triggered a fearful selloff in the markets. Right before the Fed acted, the Reserve Bank of India raised its benchmark short-term interest rate by 25 basis points, to 6.25 percent, to fight inflation, and China’s central bank now indicates that it might raise interest rates further.
In Brazil, interest rates remain close to 11 percent. After the Fed’s QE move, Brazil is preparing to retaliate.
Soon afterward, Germany’s finance minister called US policy “clueless,” while his South African counterpart thought that the Fed’s move undermined the G20 leaders’ “spirit of multilateral cooperation.”
Today, a deepening global divide sets the slow-growing US against many emerging-market economies and -commodity--producing countries. The worldwide impact of QE has only aggravated the chasm, reflected by the rifts among the G20 nations. As the Fed exhausts the power of traditional monetary instruments, it is heading into uncharted territory, with the potential of unpredictable outcomes and unprecedented collateral damage.
There is also the risk of a disruptive decline in the US dollar, which could prompt investors to flee US debt.
The impact of the Fed’s policy and hot money has been dramatic. In the third quarter of this year, China’s foreign-exchange reserves increased by US$194 billion, which far exceeded the country’s US$66 billion trade surplus and US$23 billion in inflows of foreign direct investment. At least part of the difference can be attributed to “hot money.”
Most importantly, a disruptive decline of the US dollar (or a disruptive appreciation of the Chinese yuan) could hinder not only China’s growth, but also global recovery. In the 1990s, emerging and developing economies were still dependent on G7 growth. In the past decade, these countries have, as Organisation of Economic Co-operation and Development research has shown, become dependent on Chinese growth. Any decline in China’s growth would thus significantly undermine poverty reduction in the emerging world.
During former US George W. Bush’s administration, unilateral security policies left the US without friends. In the Obama era, unilateral economic policies may have the same result. In a global economy, the decisions of the leading countries’ central banks have global implications and, in a world where the G7 no longer drives global growth, printing money is playing with fire.
Dan Steinbock is research director of international business at the India, China and America Institute, and a visiting fellow at Shanghai Institutes for International Studies (China).
Copyright: Project Syndicate
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