China Gains Most from the Fed’s Balance Sheet Contractions: Goldman Sachs

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Goldman Sachs says that China potentially has the most to gain from the US Fed’s decision to shrink its balance sheet in lieu of pursuing further rate hikes.

The Federal Reserve announced last week that it would begin to reduce its balance sheet “relatively soon,” with some analysts speculating that it could begin as early as September.

Goldman Sachs believes that compared to interest rate hikes, balance sheet contraction  on the part of US Fed will produce the smallest level of negative impact on the Chinese economy.

Analysts from Goldman Sachs took the economic model developed by Lael Bainard, a member of the US Federal Reserve’s Board of Governors, to demonstrate the impact of rate hikes and balance sheet contractions on the Eurozone, and adjusted it to include the Chinese and Japanese economies.

Their amended model assumes that both the Fed and Eurozone follow the Taylor principle in setting their interest rate and balance sheet policies; the Japanese central bank controls the yield curve, while Chinese interest rates remain unchanged.

The results of their modelling found that interest-rate hikes would have a greater impact on the US dollar than balance sheet contractions, as well as US net exports and inflation.

The spillover effects of interest-rate hikes for other economies would also be greater, producing more economic growth and inflation in the Eurozone compared to balance sheet shrinkage.

While any tightening by the US Fed will have a negative impact upon the Chinese economy, its net effects will be weaker in the case of balance sheet contraction as compared to rate hikes.

Goldman Sachs analysts also looked at the impact on China and Japan of tightening policies pursued simultaneously by the ECB and the fed, dividing them into four scenarios: the Fed and the ECB both pursue balance sheet contractions, the Fed and the ECB both pursue rate hikes, the ECB shrinks its balance sheet while the Fed hikes rates, and finally the ECB hikes rates while the Fed shrinks its balance sheet.

They concluded that under all four circumstances China’s economic growth and inflation would suffer negative impacts, with the worst case scenario being interest rate hikes by the Fed in combination with balance sheet contraction by the ECB, followed by simultaneous rate hikes by both central banks.

Balance sheet contraction by the Fed in combination with interest rate hikes by the ECB would have the smallest negative impact on China, followed by simultaneous balance sheet contractions by both central banks.

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