Op-Ed Contributors

The domino effect of the US rate hike

By Liu Junhong (China Daily)
Updated: 2010-03-05 07:51

In a move that took global financial markets by surprise, the United States Federal Reserve Board late last month announced a decision to raise its interest rate it charges on short-term loans to banks from 0.50 percent to 0.75 percent.

The move marked the first discount rate increase since December 2008 when the US central bank set its rate at 0.50 percent at the height of the global financial crisis. The unexpected news, although downplayed by the Fed, sent global stock markets into wild fluctuations.

In a statement issued shortly after the announcement, Federal Reserve Chairman Ben Bernanke dismissed the interest rate increase as a sign that the bank will change its relaxed financial policy or that it was the beginning of a US withdrawal from its previous economic stimulus packages. The announcement, however, failed to pacify markets worldwide.

The discount rate is the interest the Fed charges for emergency loans to commercial banks. As the "final creditor", the central bank lending could serve as a crucial tool to help a country maintain financial stability at a time when its domestic commercial banks are facing financing difficulties. Thus, any changes in the discount rate are usually integrated as a prelude to changes to the country's financial policy.

The 0.25 percentage point-increase to some extent indicated the US central bank's restored confidence in the country's financial system. It also reflected the Fed's intention to rein in "dollar carry trade" and safeguard the status of the dollar in the global financial market. Since the financial crisis began, the US has essentially embraced a zero-level interest rate policy and lowered its Fed interest rate to ensure market fluidity. This financial policy has offered more convenience for international investors and speculators to gain access to low-rate US loans and then invest or speculate in emerging markets, the so-called "dollar carry trade". The large-scale inflow of dollar capitals has pushed stock and real estate prices in these emerging countries to an intolerable level.

As a step to rein in the flooding of market funds, the Fed's discount rate increase is expected to help curb dollar capitals overflowing into other markets. It also heralds an upward tendency for the US' long-term interest rate, which will directly fuel appreciation of the dollar. In view of its delicate timing, the Fed's announcement of the discount rate hike is likely to produce larger impacts on world markets than expected. Due to the earlier-than-expected discount rate increase, the US dollar has become stronger against the yen and euro. Since the global financial crisis, the dollar has remained weak and global confidence has steadily declined, which has brought a severe challenge to the long-established leading status of the dollar.

The dollar's stronger position alone against other world currencies is likely to shift the balance between the dollar, yen and euro. A strong dollar has also brought growing pressures on China to revalue its currency. Under these circumstances, it remains unknown whether or not the issue of appreciating the renminbi will be included in the agendas of the US Congress at its upcoming foreign exchange and trade hearing due in April. At his State of the Union address earlier this year, US President Barack Obama vowed to double US exports within five years, of which China is a main destination.

What also remains unknown is what the European Central Bank will do following the Fed's discount rate increase. So far, the sovereign debt crisis in Greece has waned. Economic conditions in the Baltic and Central and East European countries have also turned for the better. Due to their emergency stimulus packages, France and Germany, two leading economies in Europe, have started to show more concerns over inflation.

Moreover, the planned date for European countries to withdraw from stimulus measures by the European Central Bank is approaching. Due to these factors, the possibility can't be ruled out that the central bank will likely follow on the Fed's heels and raise its discount rate. The widespread stimulus withdrawal across the world will possibly halt the world's nascent economic recovery.

As early as last November, the International Monetary Fund warned G20 financial ministers of the risk of a withdrawal from stimulus measures, stressing that any decision should be made after financial institutions in main economies around the globe should become further entrenched. It said that enough coordination among major powers must be conducted to prevent the global economy from becoming the victim of the G20's political games.

The author is a researcher with the China Institutes of Contemporary International Relations.

(China Daily 03/05/2010 page9)