QE 'taper-off' to cause liquidity problems

Emerging economies vulnerable to fund outflows; nation urged to take 'defensive measures'

Despite some concerns over the outlook for the United States economy in the second half, and with no fixed dates proposed, the United States Federal Reserve is getting ready to taper its massive bond-buying stimulus program.

Experts said the Fed's move poses liquidity outflow pressures for all emerging economies, including China, which should take defensive measures against a possible money exodus.

"China's high-rising debt, as well as increasing signs of faltering productivity, make it increasingly vulnerable to an external shock," said Liu Yuhui, a researcher with the Institute of Finance and Banking at the Chinese Academy of Social Sciences.

Faltering productivity has already been reflected in the decline of the current account surplus as a share of GDP since 2008, according to Liu.

Funds outstanding for foreign exchange - an indicator of capital inflow - have been declining, showing the momentum for foreign capital inflow is fading.

"In the second half of the year, the slowdown in funds outstanding will be difficult to reverse. On the contrary, it could become even worse. That could pose heightened liquidity problems for China's high-leveraged economy," Liu said.

The release on Wednesday of the minutes of the Fed's late July meeting showed that US policymakers are preparing to scale back the $85 billion-a-month program to buy government bonds and mortgage-backed securities - the so-called Quantitative Easing round 3 - which was launched to hold down long-term interest rates and boost the economy.

The official summary, however, showed that the 12 members of the Federal Open Market Committee, or FOMC, offered no hints on the timing for the tapering. From the Fed's previous indications, September and December are considered as the most likely months when it will take place.

"A few members emphasized the importance of being patient and evaluating additional information on the economy before deciding on any changes to the pace of asset purchases," according to the minutes.

US stocks fell after the minutes were released while long-dated US government bond yields rose, with the dollar gaining against the yen and the euro.

"The minutes have not shed much light on when the Fed will start to taper, though the market appears to be pricing in a September start, and the Treasury yield is just under a two-year high," said Joseph Lake, an economist with the Economist Intelligence Unit in New York.

Lake said that the decision to taper will be guided by economic data, which could still change the narrative between now and the next FOMC meeting in September.

Sophii Weng, an economist with Standard Chartered Bank in New York, said the minutes support the view that the Fed will "reduce bond-buying in the September meeting".

Weng said the reason was that "there seems to be a consensus building behind Bernanke's tapering timeline within the FOMC".

"The FOMC still awaits more signs (data) of a pick up in growth," said Weng.

Regarding demand, FOMC members do not seem worried about higher mortgage rates, she added.

The minutes also showed that the Fed is discussing a possible reduction in the unemployment threshold - currently at 6.5 percent - for an increase in interest rates.

"The minutes show 'support' for the current thresholds for forward guidance for the federal funds target rate, although some members still see potential modification as a possibility if additional accommodation is needed," Weng added.

A sign of tapering was first brought up by the Fed's chairman Ben Bernanke in June when he indicated the stimulus program could be scaled back later this year with the aim of halting it by mid-2014, if the economy continues to improve.

But the Fed's chief message left investors - at home and abroad - speculating and even worried immediately after the message.

Chinese shares responded with a strong slump as the Shanghai Composite Index dropped in one day to its lowest point in nearly seven months after Bernanke's remarks in June.