The Emerging Headache of QE3

The Emerging Headache of QE3
Andy Xie
Caixin Online, 09.24.2012




The Fed’s latest quantitative easing may cause problems for countries grappling with inflation and should prompt China to press ahead with economic reforms

The Fed has promised to purchase US$ 40 billion worth of mortgage-backed securities (MBS) per month until it is satisfied with the economy. By all accounts an unemployment rate above 7 percent is not satisfactory to the Fed. Its own analysis doesn’t expect the unemployment rate to fall below 7 percent in two years. That suggests that QE3 will last for over two years, and the total amount of MBS purchases will exceed $1 trillion, more than QE1’s US$ 1 trillion.

Through its purchases of MBS, the Fed provides direct support to the housing market and banks. The housing market is still wobbly. No economic recovery can be strong without a strong housing market. The Fed’s purchases will narrow the spread between the treasury yield and housing financing cost. The 10-year treasury yield is 1.8 percent. If the mortgage interest rate is decreased to such a level, it provides ample refinancing opportunity, which alleviates the debt burden for the heavily indebted household sector.

The United States’ household sector is US$ 12.9 trillion in debt, down nearly US$ 1 trillion from the peak, partly through bankruptcies. The pressure for reducing the debt is considerable. It is a major factor in keeping the economy weak. Through decreasing the interest burden, QE3 is likely to lessen the deleveraging pressure.

The United States’ household real estate value has declined by 30 percent from the peak in 2006. The current aggregate value of US$ 16 trillion is slightly above 100 percent of GDP and still high by historical standards. If the market adjusts naturally, it may well fall another 30 percent. The Fed’s actions so far have decreased its decline. QE3 is likely to continue this support. However, the artificial support can’t reverse the trend. It merely allows the nominal GDP to grow while keeping housing value stable. It cushions the downturn, but also saps the recovery strength.

The Fed is unhappy with the strength of the economic recovery. It has itself to blame. The monetary and fiscal stimulus prevented a thorough cleansing of the inefficient economic activities that built up during the bubble economy. The economy didn’t reach its natural bottom in the downturn. Therefore, the upturn is weak too. Many unproductive economic activities still take up a significant chunk of resources. Finance and health care, in particular, are still highly inefficient and take up nearly one-fourth of the economy. The Fed’s monetary policy cannot substitute for structural reforms. QE3 will not create a strong economy.

Stagflation in Emerging Economies

In anticipation of QE3, commodity prices, especially oil and agricultural commodities, have surged. The most direct path from QE to inflation is through commodities. This inflation angle hits emerging economies and low-income people hard.

The share of commodities in the consumption basket declines with income. Hence, developed economies are less affected than emerging economies when the prices of commodities rise. Emerging economies already suffer from slowing growth and sticky inflation. QE3 may force emerging economies to tighten their monetary policy despite weakening growth.

In the inflation calculation, the U.S. economy comes out ahead of others. Its natural gas price is exceptionally low due to the shale gas boom. Its economy is shifting to gas from oil. Hence, it suffers much less from rising oil prices than during QE1. The United States is a net exporter of agricultural commodities. While there is an internal distribution issue, the United States as a whole benefits from food inflation. Because it is less inflation prone and benefits from inflation as a whole, the Fed won’t waver on QE3 despite inflation rising around the world.

During QE1 there was a huge wave of hot money flowing into emerging economies. There was only a trickle during QE2. Hot money is unlikely to be significant during QE3. The reason is bad fundamentals in emerging economies. The QE1 hot money created a huge bubble in emerging economies. It has weakened the fundamentals there. Inflation, bad loans and a deflating property bubble are afflicting emerging economies. Hot money does not flow to sick economies.

The emerging economies are already in a stagflationary situation. QE3 is pushing them further in that direction. The stock markets in emerging economies have performed poorly relative to the United States’. This divergence will likely continue during QE3. Indeed, the relative underperformance of emerging market stocks may escalate capital outflow in emerging economies, triggering financial crises like in 1998.

Escalating Protectionism
The Obama administration is filing a complaint against China at the WTO over autos and auto part subsidies. That action is obviously part of presidential election politics. Even though the administration can claim credit for saving General Motors, employment in the industry is considerably lower than a decade ago, partly due to import competition. The Obama camp wants to preempt the Romney side on this issue.

The irony is that, while the Obama administration claims credit for saving GM, China actually did. GM sold 2.5 million vehicles in China in 2011. Moreover, these cars were sold at high prices. China probably has accounted for over 100 percent of GM’s profits over the past five years, i.e., it is losing money elsewhere.

While the auto example seems purely political, protectionism is likely to rise and soon. QE3 may increase demand in the United States, especially for housing related goods. However, the demand is likely to be met with imports, mainly from China. In addition, China is suffering from overcapacity in most industries. An export push is quite likely. The reactions in Europe and the United States would be very negative.

Multinational companies have led globalization, as they can influence politics in the demand countries. The debt crises of the past years are changing politics in Western economies. Corporate influence is waning as a result. Protectionism may follow.

Amplifying Uncertainty

The Fed has been complaining that the corporate sector, while sitting on record levels of cash, is not investing as much as it should. Hence, the employment situation doesn’t improve as much it could, which keeps demand weak and justifies the cautious investment attitude. The Fed believes that this “vicious” cycle can be broken through its policy. A major goal of QE3 is to convincing the corporate sector that the Fed will deliver a good economy through unlimited QE. If the corporate sector believes that the Fed will succeed, it should invest now, which would create a virtuous cycle. QE3 is partly a confidence trick; if the market believes, it is self-fulfilling.

I doubt that the Fed will succeed in the confidence trick. QE creates its own uncertainty. Ben Bernanke is a follower of Milton Friedman, who famously remarked: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” The Fed reassures us that, when inflation becomes a problem, it will take back the excess money to stop it. However, such an act would trigger a massive recession. The promise may not be credible, i.e., the Fed may accommodate it and let all the QE money become inflation. The binary nature of the QE eventuality is a huge uncertainty.

Keeping cash may be the best choice for businesses. Even though the investment process may create a virtuous cycle, it may not last. The Fed’s subsequent tightening could cause a massive recession and losses for businesses stuck with overcapacity. Hence, it doesn’t make sense to invest even though business could be good in the short term.

Financial investors are responding to the uncertainty in extreme fashion. Some are holding bonds despite near zero interest rates because they believe that the Fed would crack down on inflation. Some are holding gold to hedge against the scenario that the Fed would accommodate. Hence, the gold price screams inflation, while bond prices say deflation. Such extreme and opposed views among investors cannot be good for the global economy.

Inflating Bubble

The Fed’s QE has already created a bubbly situation in Internet stocks. Private equity is another QE-related bubble. Agricultural commodities could become a big bubble this time.

The global economy remains weak. QE3 won’t change that. Hence, industrial commodities are unlikely to become a bubble again. Indeed, industrial commodities may continue to deflate. For example, I think that the iron ore price could fall to US$ 50 per ton from a recent high of US$ 190. The spike in copper prices may not last either. The price of oil can go higher, as Saudi Arabia controls all the excess capacity and won’t increase production even if price goes up another 20 percent.

The price of gold may go very high this time. QE3 is like a river. The flow may be small for any given day, but it adds up over time. As competing commodities cannot inflate due to weak demand and oversupply, the liquidity into gold could be far bigger than in QE1 and QE2.

If agricultural commodities become a bubble this time, which I think is likely, it could trigger global political crises. The effect of QE1 on food prices was an important factor in triggering the Jasmine Revolutions in the Middle East. QE3 has the potential to propel food prices to even higher levels. The fundamentals in the emerging economies are worse than during QE1. High food prices will have bigger impact also. If food riots occur in Africa and South Asia, the Fed is partly to blame.

China and Reform

The continuing outperformance of the U.S. stock market may increase China’s capital outflow. If the U.S. property market begins to rise again, the outflow may become a torrent, triggering a banking crisis in China. There is an urgency for China to become more attractive for international and domestic capital.

The returns on capital in China are very low and getting lower. Measures to boost GDP won’t change the situation. In the past five years, land appreciation has been the main source of profit. This bubble economy is deflating. The property market in tier-three cities has virtually crashed. The situation is spreading to tier-two cities. The suspension of property construction, due to collapsing sales, is the main factor in China’s economic weakness now. There are many efforts by the government and property industry to cover up the situation. Such efforts are surely to backfire.

China urgently needs to cut taxes to improve demand and increase the effective returns on capital. It is possible that the United States will eventually boom with capital redistributing from China to it. The economies of China and the United States may move in opposite directions. Who goes up depends on relative attractiveness. If China doesn’t want to suffer a crisis, it must reform and become more attractive than the United States.


The Emerging Headache of QE3
The Fed’s latest quantitative easing may cause problems for countries grappling with inflation and should prompt China to press ahead with economic reforms
By Andy Xie
Caixin Online, 09.24.2012 11:36

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