China and Hong Kong cannot be happy about the release of liquidity via quantitative easing, even though it appears that the amount of money released is not too high – for now. The second liquidity wave rolling across the Pacific into Asian markets poses two different types of problems to the Hong Kong and Chinese governments. For one, Hong Kong has to worry about potential asset bubbles, particularly in real estate, since, as an open economy it can only react to them in an indirect way. China, on the other hand, faces a dilemma in choosing between becoming less export-competitive by letting the RMB appreciate, or allowing the Chinese economy to heat up even further, with the risk of further increasing inflation.

In Hong Kong, the effects of QE2 are hitting a market already affected by rising asset and consumer prices: the Hang Seng index has grown over 30% in 2010, property prices have increased by almost 50% since the beginning of 2009, and mortgage rates are at a historic low. All of this has fuelled a large number of property transactions until very recently. In November, Hong Kong imposed the most draconian measures so far. In order to cool its real estate markets it raised stamp duty rates on short-term property transactions thereby reducing the possible leverage for private home financing. Since then, property transactions have gone down significantly, but prices have remained high. Still, as Hong Kong is becoming increasingly integrated with China, many rich mainlanders have been taking their money into the Hong Kong property market.

On the Chinese side, inflow of foreign currency is highly regulated, but there are currently 150 billion RMB waiting for investment opportunities at its doorstep in Hong Kong deposit accounts. A testament to this can be found in the significantly higher number of Hong Kong hedge fund license applications in 2010 compared to 2009. In the eyes of Stephen Roach, Morgan Stanley's Asia chairman, the “’Hot money risk is high as China and other developing countries really have no effective ways to stop it.” But it is not only the direct inflow of foreign capital that creates pressure on China. Imported inflation through increased global commodity prices will further fuel the prices of copper, oil, and iron ore, of which China is the world’s largest importer. Consumer price inflation rates have been going up in 2010. Dong Tao, chief economist for Asia at Credit Suisse, projects CPI inflation for 2011 to reach 4.5% to 5%. Additionally, he expects three or four interest rate hikes in 2011.

For the Chinese government, this means having to choose the lesser of two evils: higher interest rates or higher inflation. Both scenarios pose significant risks to the social stability and to providing employment to its large work force. Though the long term effects of QE2 are still not entirely clear, there may be one positive message in this: if China manages to increase its share of domestic consumption over relying too heavily on exports, it may accept a rise in its currency as more production capacity could be used for domestic markets.