(Illustration: Luo Xuan/GT)
The U.S. Federal Reserve decided on Wednesday to lift interest rates by 25 basis points to a range of 0.25 to 0.5 percent. This was the Fed's first rate hike since June 2006, and is expected to mark the beginning of a series of rate increases, with more to come throughout 2016.
Fed officials projected a median of 1.375 percent at the end of 2016, which implies four quarter-point increases in federal rates in the next year.
Historically, each hiking cycle initiated by the US has had a big impact on the global market, and has sometimes triggered turmoil in financial markets. But this time, the three major U.S. stock indices - the S&P 500, Dow Jones Industrial Average and the NASDAQ Composite - all ended conspicuously higher on Wednesday. Just before the Fed announced its widely expected decision, the FTSEurofirst 300 Index also closed up slightly. And the U.S. dollar index rallied before falling slightly. In the commodities market, oil prices continued downward, while nonferrous metals including gold all saw a small increase.
How can we explain this calm market reaction? It might be partly relief that the decision to lift interest rates has finally happened, after months of waiting for it. Also, U.S. stocks and European stocks have already ridden out the bearish sentiment toward the rate rise, just because it has been anticipated for so long. Most importantly, the rate hike indicates that the US economy is growing more robustly than the rest of the world, with its job market having turned in an impressive performance and overall price levels staying within the target range. Given such macroeconomic fundamentals, U.S. stocks have no reason to fall.
The moderation in the U.S. dollar index was mainly because it had risen too much earlier on. It is expected that the dollar will still trend higher after a transient drop.
Having said all that, the rate hike will undoubtedly have a big impact on emerging markets. When the Fed adopted quantitative easing to spur the economy, flooding the market with liquidity and implementing super-low interest rates, the dollar began to fall, as a result of which capital generally flowed to emerging markets in pursuit of investment opportunities. This might have contributed to creating some economic and financial bubbles in emerging markets.
Now that the hiking cycle has begun, capital flows will inevitably do an about-turn, returning to the US from emerging markets. This could burst some financial bubbles in emerging markets, leading to outbreaks of financial risks. China is a big emerging market and it also faces the issue of potentially massive capital outflows following the U.S. tightening of its monetary policy.
China's foreign exchange reserves shrank by nearly $100 billion during August. At that time, the market generally expected the Fed to raise rates in September, only for the Fed to wait and tighten its policy later on. As a result, China saw signs of stabilization in its foreign exchange reserves in September and October.
However, the country's foreign exchange reserves fell sharply again in November, which I believe is because of market expectations for a rate hike in December, leading to massive capital outflows.
For China, this has at least two major effects. Firstly, the depreciation of the yuan will accelerate. When the rate increase was announced, offshore yuan strengthened briefly against the US dollar before retreating quickly. Secondly, capital might start fleeing the country. The fall in November in both the country's foreign exchange reserves and funds outstanding for foreign exchange hints at accelerated capital outflows.
What is to be done? Investors don't actually need to be overly concerned about the impact on China's economy from the Fed's latest move, as China has the confidence and capacity to deal with the worse possible outcomes. Considering that China has $3.4 trillion in foreign exchange reserves, capital outflows won't be too problematic an issue to be handled.
Meanwhile, China still has a considerable trade surplus, so the foundation for it to accumulate foreign exchange reserves remains solid. Furthermore, the country has maintained strong foreign exchange controls. Above all, China will be largely shockproof mostly because the economy is still growing at a relatively rapid rate.
Still, a vicious cycle of sharp falls in foreign exchange reserves and yuan depreciation should be avoided, although central bank intervention in the exchange rate by selling dollars would result in shrinking foreign exchange reserves.
That being said, the fundamental solution for capital outflows is to stabilize the economy and create an open and orderly market based on the rule of law. Also, the central bank should refrain from intervening in the formation of the yuan's value. The yuan should be allowed to depreciate in accordance with the market so as to reach an equilibrium.
Shrinking foreign exchange reserves can cause a decline in funds outstanding for foreign exchange, which then leads to tightened market liquidity, but the central bank could respond by cutting reserve requirements. However, cuts in interest rates should be avoided, as it would increase the drop in foreign exchange reserves.
The author Yu Fenghui is a financial commentator.
