Be Alert to the Spillover Effects of Tightening Global Financial Conditions

With the normalization of the Fed’s monetary policy，another round of global financial cycle has begun，and the following spillover effects must not be ignored. For China，as a pivotal international creditor but at the same time owes huge foreign debts，how to properly manage external assets and debt repayment risks should be paid more attention to.

The Federal Reserve – the U.S. central bank，or the Fed - started to reduce bond purchases in November，thus taking the first step towards normalizing monetary policy. With this as a sign，another round of the global financial cycle has begun.

The environment in this round of global financial cycle is absolutely unique: First，after the outbreak of the COVID-19 pandemic，in order to help people and support economic operations，countries have injected huge amounts of liquidity through monetary and fiscal policies，resulting in extremely loose financial conditions. As a result，the leverage ratio has skyrocketed and asset prices have soared. Second，the global economy remains uncertain and highly differentiated. In the World Economic Outlook released in October，the IMF lowered the growth rate of the global economy next year and predicted that by 2024，the total output of emerging markets and developing economies (excluding China) will still be 5.5% lower than their potential growth rate. Third，various signs indicate that the COVID-19 pandemic is still difficult to be effectively contained in the short term.

Under the three major adverse conditions mentioned above，if major economies begin to tighten monetary policy one after another，global financial conditions will become tighter immediately，and the resulting spillover effects cannot be ignored. In this context，as an important international creditor and debtor country，it is undoubtedly a heavy responsibility for China to properly manage her external assets and debt repayment risks.

Global financial cycle and its implications

As an academic term，the history of the "global financial cycle" is not long. Its creator is Hélène Rey，a professor at the London School of Economics who was born in France. Her speech at the famous Jackson Hole monetary policy annual conference in 2013 was "Global Financial Cycle and Monetary Policy Independence"，which made the term widely known. The 18th IMF Annual Research Conference held in 2017 even specifically focused on the theme of "Global Financial Cycle"，demonstrating the importance of this topic.

So，what exactly is the global financial cycle? In short，it refers to a number of factors that will cause some simultaneous changes in capital flows，asset prices，and credit growth. The surge and contraction of capital flows，and the boom and bust of asset prices are often cyclical in nature. Asset markets in countries with more credit inflows are more sensitive to global cycles. Looking further，what are the determinants of the global financial cycle? Rey believes that it is the monetary policy of central countries，especially that of the United States. Although there is still controversy in academic circles about her view that "U.S. monetary policy determines the global financial cycle"，it seems that there has long been a consensus in the real financial world.

The U.S. monetary policy has just completed a major cycle in the last eight years: the tightening phase began in December 2013 when it announced the reduction of bond purchases，and the scale of bond purchases was reduced to zero in October of the following year. After that，interest rates were raised nine times from December 2015 to December 2018 until it lay in the range of 2.25%-2.5%; the easing phase began in July 2019: the policy rate was cut five times in a row to 0-0.25%，and quantitative easing was restarted which sharply increased the size of the Fed's balance sheet from US$4.3 trillion to US$8.6 trillion.

Another round of global financial cycle emerges

Affected by multiple factors，prices are rising rapidly worldwide. In the United States，more and more people worry that inflation will get out of control. At a meeting held by the Institute of International Finance (IIF) on October 13，Larry Summers，Harvard University professor in economics and a former U.S. Treasury Secretary，criticized major central banks，saying that they were too concerned about social issues，but ignored the largest inflation risks since the 1970s. He believes that the risk of out-of-control inflation in the United States is great，and that the risk in the United Kingdom is even greater than that in the United States. Although the risk in Europe is lower，it cannot be ignored either. Though Janet Yellen，Treasury Secretary and former Fed Chairwoman，opposed the claim that inflation would get out of control，she also admitted that prices in the U.S. would remain high until the first half of 2022.

In the author's view，the reasons leading to higher-than-expected global price increases include demand-driven factors，cost-driven factors，and supply chain bottlenecks. The reinflation efforts of the major central banks，combined with the strong fiscal stimulus，make the outlook for inflation unpredictable.

The major central banks are aware of the danger. The Fed has started to taper in November，thus taking the first step towards normalizing monetary policy. The market currently expects that its bond reduction process will accelerate，and interest rate hikes will come ahead of schedule. According to the forecast given by the federal funds futures contract，the probability of the Fed hiking in June next year is as high as 80%. In addition，the European Central Bank has begun to reduce the scale of bond purchases，and the United Kingdom is likely to tighten monetary policy in the next few months. All of this means that another round of the global financial cycle has emerged.

Be alert to the spillover effects of tightening global financial conditions

After the outbreak of the COVID-19 pandemic，in order to relieve the suffering of the people and support the economy，major countries have injected huge amounts of liquidity through monetary and fiscal policies，resulting in extremely