In bringing an end to its quantitative easing, US Fed needs to ensure it does not create global financial instability

Two weeks after the "Bernanke shock", the stock and currency markets have returned to a close-to-normal state. On June 19, when Chairman of the US Federal Reserve, Ben Bernanke, gave a clear signal the Fed would gradually reduce and ultimately quit its quantitative easing, $340 billion evaporated in the world bond market, and world stock markets tumbled.

However, the top concern for emerging economies, including China, is the outflow of capital. According to EPFR Global, which tracks cross-border capital flows, after the Fed initiated its third round of quantitative easing in September 2012, roughly $90 billion flew to the stock markets of emerging economies during the 17 weeks between Sept 1, 2012 and Jan 2, 2013, compared to only $15.9 billion during the whole of 2011. However, the trend had started to reverse even before the Bernanke shock, with a net outflow of $5 billion from emerging economies in the week ended June 5.

The restrengthening of the US dollar may cause the emerging economies even more concern. The strong dollar from 1979 to 1985 contributed to the Latin America debt crisis in the 1980s. A strong dollar from 1995 to 2002 also contributed to the Asia financial crisis in 1997 and 1998, the Russian financial crisis in 1998, the Brazilian financial crisis in 1999 and the Argentine financial crisis in 2001. If the dollar appreciates by another 10 percent in the next 12 months, the leading emerging economies will face serious trouble.

The Fed's decision to quit its quantitative easing policy is undoubtedly necessary. Although quantitative easing measures have helped the US economy recover, they would have been harmful to the US and world economy in the long run. The basic function of quantitative easing is merely an expansion of liquidity and leverage, instead of supporting innovation and the real economy.

Quantitative easing would not support long-term substantive economic growth because the fundamental problem in the US economy is the lack of a strong, competitive and innovative real economy, rather than a monetary one. Quantitative easing would ultimately delay the necessary restructuring and innovation the US needs for robust, sustainable growth.

The International Monetary Fund warned in its World Financial Stability Report of April 2013 that "a prolonged period of extraordinary monetary accommodation could push portfolio rebalancing and risk appetite to the point of creating significant adverse side effects". In its annual report issued on June 23, 2013, the Bank of International Settlements explicitly asked central banks to quit quantitative easing in order to secure the strong and balanced growth of global economy.

The Fed's announcement of its schedule for ending its quantitative easing coincided with a "money crunch" in China, which faces a real danger of over-dependence on unlimited liquidity supplies to keep the real estate bubble from bursting.

International experiences in the past three decades have also shown that an economy, including its currency, is relatively vulnerable to international fund flows and financial speculation if it does not have a strong, sound real economy, and thus depends too much on liquidity supplies. Germany, for example, has never worried about the US's quantitative easing policies. China needs to focus its financial sources on technology, business innovation and improving people's welfare, and it needs to take control of the liquidity supplies to the real estate sector. Local governments should suspend land supply for commercial use for six months and curb their town-making ambitions. They should also reduce their debts and let the market and businesses decide investment projects, based on feasible returns. Only in this way, can China withstand global financial instabilities.

Meanwhile, the Fed needs to carefully consider the timing and speed of its quantitative easing reduction and exit, taking into account not only the US economic situation, but also the world markets. A fast rebound in the US bond interest rates will tend to reverse the world capital flows too fast and cause instabilities, especially in emerging economies. A quick rebound in the dollar will also tend to have serious impact on other currencies, and this should be gradual as well.

The Chinese economy, while restructuring and upgrading and reducing the dependence on excessive liquidity supplies, should also maintain stable growth. A sharp slowdown in its economic growth will not only hit jobs and the capital markets, it will also hit the Asian stock and currency markets as well.

The US should gradually bring its quantitative easing to an end and China should slowly reduce its dependence on liquidity.

The author is co-director of the China-US/EU Study Center at the China Association of International Trade.