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US Fed buying bonds not real source of risk

By Pan Chengfu (China Daily)
Updated: 2009-03-30 07:53

The US Federal Reserve announced on March 18 that it would buy up to $300 billion worth of long-term Treasury bonds in the next six months. It would also spend an extra $750 billion this year - in addition to the originally planned $500 billion - in mortgage-backed securities (MBS).

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This announcement has caused quite a stir in China, which holds more than $1 trillion in foreign exchange reserves. Some Chinese media have called it "the most shameless bailout measure" and "a blow to China's foreign exchange reserves" in their reports. The Internet has been flooded with angry reactions with some people advocating that China stock up on gold.

Those remarks are short of both reasoning and common sense.

The Fed has been running its printing presses for quite some time. In January, the Fed shifted its monetary policy toward quantitative easing, which means printing new money to buy government and corporate debt. It planned to buy $500 billion in MBS, including those issued by Fannie Mae and Freddie Mac, over the next six months.

In addition, it is not an unusual measure for the Fed to buy Treasuries on the open market. It does not buy them "directly" from the Treasury Department. The difference this time, however, is that the Fed buys long-term, instead of short-term Treasuries. No matter what assets the Fed buys, be it Treasury, MBS or even gold, the effect on the economy will be the same.

On the other hand, the value of China's foreign exchange reserves depends on the criteria used in evaluation.

If judged only on book value, the value of other currencies in our reserves will increase in dollar terms, because the Fed purchase of US government bonds helps depreciate the dollar. Also, the prices of Treasuries will rise with the Fed move, leading to an increase in the book value of the bonds that China holds.

In euro terms, the value of China's foreign exchange reserves would shrink. Therefore, exchange rate fluctuations only result in changes in the book value and that should not worry us too much.

What poses a real threat to China's foreign exchange reserves is the rise in commodities prices on the international market, such as crude prices rising to $140 a barrel and the prices of grain and iron ore soaring to shocking highs last year. Of course, the Fed buying of US Treasuries will help buoy the prices of commodities. We do not have to fear the price rise in commodities, for it is a must for the global economy to recover from the ongoing crisis. Otherwise, an economic rebound would be impossible.

Now that the dollar has become weaker, the yuan might well have followed it to depreciate. It would help China's exports or at least keep its current export market share.

Finally, let us go back to the Fed. Does the Fed intend to discharge its debts by printing more greenbacks? Since such a measure would not differentiate Americans from foreign creditors, I do not think the Fed is crazy enough to do that, for it would do no good to the US economy, either.

The Chinese and US economies have been intertwined for a long time. The risks faced by China in its foreign exchange reserves have built up over a long period of unbalanced growth in both economies rather than from the Fed now buying Treasuries.

What should worry us the most is that the Fed might be unable to curb inflation. How to recycle the huge amount of money injected into the market when the economy recovers is a thorny issue. The worst-case scenario is that hyperinflation could hit well before the economy has fully recovered.

The author is an associate professor with Guangdong University of Business Studies. The article was reprinted from Shanghai Securities News