8th January 2014

The global economy looks poised to display better growth performance in 2014. Leading indicators are pointing upward – or at least to stability – in major growth poles. However, for this to translate into reality policymakers will need to be nimble enough to calibrate responses to idiosyncratic challenges.

Consider the United States. Job creation has accelerated since last August. Household debt is now US$800 billion less than at the end of 2008, due to liquidation or refinance at lower interest rates. The current housing recovery does not seem exhausted as demand is expected to outstrip the pipeline of housing starts this year. Non-financial corporations have plenty of cash, empowering them to respond to improved prospects. Finally, the agreement in Congress on the federal budget for 2014-15, together with the political weakening of the opposition to adjustments of the public debt ceiling, point to an easing of the fiscal drag that harmed the US recovery last year.

But even with these positive factors there is a challenge as the Federal Reserve starts unwinding  its “quantitative easing” (QE), beginning this month with a reduction of US$10 billion in its monthly asset purchases (currently at US$85 billion). Notwithstanding the limited size of this change – when matched with the US$2 trillion of assets currently held by the Fed – as well as Fed’s “forward guidance” signaling that basic interest rates will remain low for an extended period, the initially muted reaction in bond markets was followed by 10-year Treasury yields crossing the 3% mark at the end of 2013. As 2-year yields also climbed, markets seem to believe that the Fed will be obliged to speed up the unwinding. The Fed thus must be sure to strike the right balance of actions and communication so as to avoid precocious interest rate hikes which could harm the recovery.

In the Euro-area, perceived risks of a currency breakdown and a financial and economic collapse have receded substantially. Despite sticky high levels of unemployment in crisis-ridden countries, the European Central Bank (ECB) forecast of 1.1% (GDP growth) plus 1.1% (inflation) for 2014 has been taken as a signal that the bottom of the crisis has been left behind.

The crisis still casts some shadows, however. The implementation of structural reforms in several member countries has fallen short. The public and private debt legacy in those countries still remains tall. Furthermore, the Euro-area institutional framework, which has now been fully recognized as essential, has not yet been refurbished enough. While the time horizon for tackling these issues will necessarily be long, there is a major immediate task to be faced by policymakers: the health check and prescriptions to which their banks will be submitted this year.

The vicious circle between fiscal fragility and national banks’ balance-sheet deterioration that plagued crisis-ridden member countries has been broken, thanks to fiscal adjustment programs and, especially, the ECB’s promise “to do what it takes” to impede a collapse. Nevertheless, the resurgence of bank credit to the private sector – particularly to small and medium enterprises – will be fundamental to consolidate the recovery. Such resurgence will only take place when banks are once again able to be funded and create credit at interest rates much lower than currently available. Therefore the Euro-area major policy challenge will be to calibrate the “asset quality review”, stress tests, and new capital requirements making them tough enough to ensure that the exercise is credible, while simultaneously avoiding spooking markets.

China will also face the challenge of appropriately calibrating the implementation of its structformural re package. Higher penetration of non-state firms in several sectors, including the banking system, will require some slackening of regulation and phasing out interest-rate controls. Prior to that, however, the central government will need to rein in subnational finance and the “shadow banking” through which local governments have splurged on infrastructure and real estate spending in the last few years. Results from a public debt audit were released last month, showing that the debt of localities had risen 67% from the end of 2010 to June 2013.  In that context, another important consideration when looking ahead is to remember the interbank market turmoil of December, which only ended when the Central Bank of China conceded to providing liquidity.  This illustrated that authorities will have to step cautiously— a stone at a time— to cross the transition river, if an economic growth collapse is to be avoided.

Meanwhile, tax policy will be a key policy challenge in the case of Japan. Aggressive fiscal and monetary stimuli implemented during Prime Minister Abe’s government have jolted Japan’s economy out of its deflationary lethargy.  However, Japan’s public debt has climbed to levels around 250% of GDP. As part of the solution, the consumption tax will be hiked to 8% from 5% in April. There is also a scheduled decision in next November on whether to additionally increase it to 10% as of October 2015. It will be crucial that such a higher tax burden does not countervail the overall anti-deflationary direction of macroeconomic policy.

Finally, there is the case of emerging economies coping with the actual unwinding of QE. Last summer – in between Ben Bernanke’s testimony to the US Congress in May, when he alluded to the eventual unwinding of the currently third round of QE, and the Fed meeting in September postponing its beginning – the so-called “fragile 5” (Brazil, India, Turkey, Indonesia, and South Africa) underwent massive capital outflows and large currency depreciation. Some analysts referred to that turmoil as a potential revival of the emerging-market crises of the 1990s. Those countries shared in common the presence of large, liquid, and integrated financial systems, as well as current-account deficits associated with substantial capital inflows and currency appreciation since the beginning of the US “unconventional monetary policies.”

Now that the unwinding is really starting, the baseline scenario is not one of a repetition of the turbulence, since changes in asset values, exchange rates, and investors’ positions have not reverted. The unwinding is to some degree already priced in. On the other hand, four of the “fragile 5” (Brazil, India, Turkey, and Indonesia) will have major elections in 2014. As they still remain vulnerable to sudden stops in capital flows, their macroeconomic performance will depend on the calibration of their macroeconomic policies and on political risks.

The bottom line is this: there is room for optimism about the global economy in 2014. The key is to temper this with caution given that the success of the global economy will hinge on policymakers’ ability to strike the right balance in several key parts of the world.

Source:World Bank

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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

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People diversify by investing into riskier investments

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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.

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