Quantitative Easing an unheard phrase five years ago is one of the newest discoveries in macroeconomic policy.
2nd September 2013
Quantitative Easing is a form of open market operations that Federal Reserve uses to achieve its policy targets, literally speaking it is printing of money by the central banks, but rather than printing money Central banks use a more complicated process of injecting funds into their economies. The Federal Reserve in the U.S., Bank of Japan and the Bank of England are three central banks that have spent trillions on Q.E.
How does Q.E work?
The Fed adds credit to the banks reserve accounts in exchange for MBS and Treasuries, the reserve account is the minimum balance to be carried forward by banks after their business closure on each working day. When the fed adds credit by buying the assets of the bank including mortgage securities, bonds, treasury notes etc, banks will have more money than they need in the reserves and can lend to other banks and customers, in this process of unloading their extra reserves, they drop the interest rate. Thus, it increases the money supply because lower rates allow banks to make more loans and stimulate business and provide more employment opportunities.
Why is it used?
This is used as a last resort as the Central Bank has run out of other options including keeping the interest rates to near zero. It works in two ways, it injects more money to the banks allowing them to lend more and it lowers interest rates and gives access to companies for cheaper credit which can be used for their expansion, diversification and to upgrade their technology, which in turn will lead to creation of more job opportunities.
Current Status
Federal Reserve Chairman Ben S Bernanke has provided enough hints that he will probably reduce the central bank’s $ 85 billion in bond purchases, market analysts opine that the first step may be small with monthly purchases being tapered by $ 10 billion to $ 75 billion. The Fed will end the buying by mid 2014.
How does Q.E impact equity prices?
The Fed (or any other central bank) buys government bonds, Gilts and other government securities, as demand for these assets go up, the prices for these will also go up and the yield for these securities will come down ( due to an inverse relationship). People who would have invested in debts such as government securities will earn lesser rate of interest and would naturally look to diversify their investment for earning a better rate of return, thus they will chose Equity, this is called as “Portfolio Re-balancing Effect”, since investments in equities generate higher returns people would start investing m or in equities- as demand rises so does the price.
Q.E increases demand for bonds
↓
Yields go down
↓
People diversify by investing into riskier investments
↓
Demand for Equity will rise
↓
Prices of Equity will rise
Impact of Q.E Tapering on Emerging Markets
The central banks of U.S., BoE, European Union and The Japan Central bank have all undertaken quantitative easing, as explained in the earlier part of the article the central banks of these developed economies resort to large scale asset purchases by their central banks, such as corporate bonds or mortgage backed securities to pump more money into the system. Since interest rates in these economies remain at zero and their economies remain stagnant, it is inevitable that there will be large capital outflows to emerging economies in order to seek a better return on their investments, most of the capital inflows are in the nature of portfolio investments, which are prone to sudden and volatile movement and puts emerging economies at greater risk.
There has been considerable criticism of the G4’s unconventional monetary policies from the emerging economies, including the BRICS (Brazil, Russia, India, China and South Africa). The magnitude of Q.E has had unintended consequences beyond the borders of these developed countries because their currencies are not only convertible but constitute the pillars of the global financial system. The U.S. Dollar, U.K. Pound and the Japanese Yen together constitute the basket of international currencies that the IMF uses to value its Special Drawing Rights. Thus the nature of these currencies and their domination on the international financial market ensures that the stimulus easing undertaken by them has a global impact on economies across our globalized and interconnected world.
Currency devaluation
Countries such as Brazil, India, Indonesia and Turkey are experiencing a steady depreciation of their currencies, investors are pulling out of the markets and the countries are experience a huge current account deficit (CAD). Foreign currencies, dollars in particular are needed by these countries to pay their hugely inflated oil bills and other imports including gold and electronic goods. The Brazilian real has lost 20 percent; Indian rupee has lost around 20 percent and the Turkish Lira is down by 10 percent, this situation re-ignites the possibility of another Asian crisis akin to the one which happened in 1997-98 which forced Thailand to turn to IMF as its currency plunged, while the 97-98 crisis was plagued by the Q.E easing by Japan, the present crisis could be attributed to U.S. Fed which will start “tapering” its bond buying programme and end it completely by mid 2014.
However, there are enough reasons to be optimistic that we are not heading for a repeat of the Asian crisis as most of the countries have enough foreign exchange reserves to meet their demands at least in the shorter run.
International Finance Magazine believes that there need to be a co-ordinated and careful handling of Q.E easing considering the threats to emerging and developing economies, the threat here is not only for the stock markets or the companies but for the common man, for example: students in BRIC economies who have taken loans to study abroad, especially in the U.S. or U.K. will be hugely disappointed to see the currency fall which will increase their expenditure enormously. It is imperative that the Asian representatives of the G20 nations bring this on top of the agenda and discuss this with their western counterparts to overcome the counter effects of the Q.E easing by the Fed when they meet at the Constantine Palace in St.Petersburg next month.