Market Risk Increases as Both China and USA Are Tightening Up

With the arrival of the year of the tiger, the international economic environment is experiencing new changes. Last year, all nations adopted extremely loose fiscal and monetary policies in order to save the economy, resulting in superficial stabilization. However, this year is very different; there are ongoing indications of tightening up. The economy is cyclical; extreme easing will be followed by contraction. Everyone is concerned that this could be the beginning of turmoil.

This year, both the U.S. and China have steered away from easy credit in favor of tightening up. Since China raised the bank deposit reserve rate by 0.5 percent for the first time, another hike of 0.5 percent was implemented yesterday. At the same time, it has set the target for M1 growth at 17 percent for this year. In the month of January, it has already expanded by almost 26 percent; continuous tightening is necessary in order to achieve its goal. Under the macro-monetary tightening policy, China will also introduce a series of micro-regulatory procedures. Private capital flow and project financing arrangements have been made public in order to strengthen the details of risk management. It can be observed that the Chinese government has adopted both macro- and micro-economic strategies to prevent over-lending like last year.

The Federal Reserve’s actions have been even more surprising. It suddenly announced a 0.25 percent increase of the discount rate to 0.75 percent, widening the gap with the Fed fund rate. At the same time, this tremendously reduces the lending window and a reversion to the traditional overnight borrowing mechanism. The move will encourage more inter-bank borrowing, thus reducing dependence on the Federal Reserve. This is a logical step; on one hand, the financial system has stabilized and reduced the demand for discount borrowing. Increased interest rates will not have such an immense impact. On the other hand, this will scale back the Fed’s support to the banking institutions, encouraging them to be independent and profitable. Over the past year, a low interest rate environment has widened the gap between the 2-year U.S. Treasury and 10-year Treasury, allowing banks to profit from the interest rate differential with minimal risk. With this new measure, the Federal Reserve has put an end to this easy profit. The question is whether the inter-bank lending market has truly recovered. Will interest rates shoot up when the market is under pressure? We have to wait and see.

Various central banks have different opinions about raising interest rates. The market understands it as the beginning of an exit strategy and expects the Federal Reserve will raise its fund rate. The Federal Reserve and some analysts point out that this is normalization of its monetary policy or merely technical adjustments; the overall credit-easing policy remains unchanged — in particular, the Fed fund rate remains at a low level. From a political point of view, the chance to increase the Fed fund rate is slim when recovery is uncertain and the unemployment rate remains high. As a matter of fact, the Fed is going to discontinue its emergency support to financial institutions and is looking at ways to divert trillions of excess liquidity from the market. The trend is obviously moving toward contraction for the Federal Reserve.

Monetary tightening will definitely be a test for the global economy; it is unknown whether it will trigger serious consequences. Involved parties can only adopt a piece-meal approach. It is unquestionable that it increases uncertainty and risks. The Chinese situation is better; tightening after economic recovery is deemed appropriate and it is the right timing. The American circumstances are more complicated; the decision on whether to continue to stimulate or exit is like walking on a tight-rope. Europe and Japan are not even in a position to tighten [their monetary policies]. Under such circumstances, the actions and expectations of the U.S. measures will greatly affect the flow of global capital, resulting in the fluctuation of stocks, and the currency and commodity markets. However, the overall picture is hard to predict, causing higher investment risk. The main concern is about a sudden rate hike in the U.S., which may be a consequence of the worsening relationship between China and the U.S., and the subsequent currency competition. Some believe that the sudden rate hike is a measure to support the U.S. currency in case China reduces its holdings of U.S. Treasury bonds. This already complex situation is further complicated by geographic rivalry, resulting in a still more unpredictable future and higher investment risks. In conclusion, the year of the tiger will be full of challenges.