Uwe Parpart Comments: China Rate Hike Sends Stocks Tumbling
October 20, 2010, Barrons.com
One foot on the gas and the other on the brake is no way to drive. Yet that appears how global monetary policy now is being piloted.
After the People's Bank of China surprised the world Tuesday by raising its key policy interest rates by 25 basis points (a quarter percentage) point for the first time since before the Great Crisis in financial markets in 2008-09, The result was a sharp sell-off in risk assets, including stocks, commodities and gold.That is counter to the trend in most of the developed world, notably in the U.S. where the Federal Reserve has telegraphed its intent to engage in a second round of quantitative easing,dubbed QE2.
The Fed's intent is to reduce unemployment, which is too high,and raise inflation, which it deems too low. While its potential success in achieving the former goal is questionable, expectations of QE2 are bearing fruit on the latter in the form of rising commodities prices.
As noted here on numerous occasions, these policies are being played out in the international currency markets. Anticipated Fed liquidity expansion is driving down the dollar and concomitantly driving up other exchange rates. That's given rise to the so-called currency wars as countries try to hold down their exchange rates in the face of a falling dollar to maintain their export competitiveness.
From a domestic Chinese standpoint, the PBOC move is puzzling, says Uwe Parpart, Cantor Fitzgerald's Asian strategist. Instead of cooling the economy by allowing a further appreciation of the renminbi—which has been pushed by the U.S. and most of the international community—the decision to raise interest rates seems to go counter to the government's goal to boost domestic spending and lessen reliance on exports.
But the global implications were less ambiguous. Stocks tumbled with U.S. markets losing 1.7% Tuesday on the Wilshire 5000, the broadest measure, the biggest drop since Aug. 19. Asian stocks were posting similar losses early in Asia.
The sharp reaction reflects the extraordinary sensitivity to liquidity shocks from dollar bloc countries, observes Lena Komileva, head of G& market economics at Tullet Prebon in London. Indeed, the sell-off in risk assets and the stronger dollar (and consequently weaker gold) was a mirror-image of the reflationary effect from the Fed's anticipated QE2, she adds in a research note. To the extent that continues, prospects of Fed easing will loom only larger.
"Yet the possibility that cheap dollar liquidity from the Fed will encourage tighter money supply management in China, in the absence of stronger yuan revaluation, could lead to a potentially unstable global liquidity environment. The most likely beneficiaries of this are likely to be traditional dollar diversifiers and liquidity safe havens like the euro, the yen and the Swiss franc," Komileva concludes.
The problem, adds Jeffries & Co. strategist David Zervos, is that with the renminbi's virtual peg to the dollar, China effectively imports U.S. monetary policy. So China is put in the uncomfortable position of trying to cool the domestic economy from the stimulative effects from abroad.
"Monetary policy does not work in economies with free international capital mobility and a currency peg," Zervos writes. "The only way for China to take control away from [Fed Chairman Ben Bernanke] is to drop the [renminbi] peg or institute capital controls. The only option, of course, is the former. Maybe, deep down, QE is about Ben (and the administration) trying to force a devaluation. It just may work!"
That, in essence, is what a currency war is about: forcing changes in exchange rates to gain domestic advantages. It is a dangerous gambit, as Tuesday's market action shows.