Interdependency between Chinese financial evolution and the U.S. monetary policy requires new global financial governance

13 Oct.

2015

By Ismail Ertürk - The Banking Expert at Alliance Manchester Business School, The University of Manchester.

The global financial markets have reacted very badly to a set of financial developments in China that had started with the stock market plunge in the early summer and ended with the devaluation of renminbi recently. Emerging economies in Asia were particularly hit by the events in China before the developed economy stock markets have caught the financial virus after the renminbi devaluation. Is the world on the edge of another global financial crisis of the 2007 magnitude? I do not think so but what we are witnessing is an overdue correction in both emerging and the developed world currencies and share prices. Loose monetary policies in the US, the UK and in Europe, especially in the US because of the size of its financial sector, that were launched to prevent the collapse of the global financial system in 2007, have created bubbles in global financial system. Cheap dollars issued by the Federal Reserve under quantitative easing have not boosted productive long-term investments in the real economy in the US, but instead have flown to stock markets everywhere and financed debt-driven growth in emerging economies in search for short-term high yield.

China reacted differently to the 2007 crisis by injecting credit to the real economy to build infrastructure and real estate. By doing so China helped global economy to achieve growth as well because China needed to import commodities from emerging economies. Emerging economies benefited from both demand for their commodities from China and flow of capital from the US and Europe. These dual factors have created bubbles in emerging economy currencies and stock markets. The post-crisis growth in emerging economies, therefore, was not sustainable because the dynamics of growth were external and monetary. Emerging economies failed to turn this conjunctural benefit into longer term investments and instead allowed bubbles to happen in their currency, stock and real estate markets.

This happy state of unsustainable affairs in China and emerging economies ended in the summer of 2013 when the Federal Reserve announced that it would consider raising the interest rates because the US economy has recovered and inflationary pressures were needed to be addressed before too late. This was called tapering and it turned into a tapering tantrum as all global financial flows reversed leaving emerging economy markets as the investment strategies and carry trades based on cheap dollars would no longer be profitable. In the summer of 2013 the global financial markets experienced a small tsunamis with emerging economy currencies and stock markets nosediving, bond yields in the developed world suddenly jumping upwards. China suffered too because the financial strategies in China that were based on borrowing in US dollars and investing in appreciating renminmi were no longer profitable. Unwinding the positions caused havoc in Chinese financial markets back in 2003. Since 2013, after the US intentions to raise the interest rates were announced, Chinese financial markets have not stabilised and the Chinese officials failed to come up with a stabilising plan of actions and plans for an orderly transition to the post-tapering global economy. When the Fed reintroduced its strong intention to raise the interest rates in July this year China started to play a poker game with the US by devaluing renminbi to protect its economy. This basically prevented the US from increasing the interest rates because otherwise the life-threatening turmoil in financial markets caused by the expectations of higher dollar interest rates coupled with weak Chinese economy could turn into a major global financial crisis. By devaluing its currency and causing tremor in global financial markets China effectively prevents the US to increase the interest rates.

Since the 2013 US tapering tantrum we have witnessed the start of currency wars in the developed world because the policy needs of the US and other developed countries and China have diverged. The quantitative easing policies of the US, the UK, Japan and the Eurozone have created serious imbalances in the global economy. On top of this China is learning from the experimentation with the internationalisation of its currency and reforming of its financial system. And one would expect the international financial institutions like IMF and World Bank to take a leading role in a much needed policy co-ordination but they do not. There is an urgent need to create a new international financial governance that takes into consideration new realities of global economy and finance. All these point to a very rough ride ahead for the global financial markets and economy where international policy coordination will be desperately needed.

Biography

Ismail Ertürk - The Banking Expert at Alliance Manchester Business School, The University of Manchester.

Ismail is a regular commentator in the broadcast and print media. He has taught corporate finance, bank financial management and international finance on both the School’s MBA and Executive Centre programmes. His research interests are in financialisation and financial innovation.