The New Fad called QE

Wiki describes QE as monetary policy used by a central bank to stimulate an economy when standard monetary policy has become ineffective. A central bank implements quantitative easing by buying specified amounts of financial assets from commercial banks and other private institutions, thus raising the prices of those financial assets and lowering their yield, while simultaneously increasing the monetary base. This differs from the more usual policy of buying or selling short-term government bonds in order to keep interbank interest rates at a specified target value.

The process of printing and pumping money is not new and has been practised in the past especially during 1945 – 1971 i.e. post war economic upliftment, when most of the countries read US and European were devaluing their currencies to either become more competitive or to reduce their post war debt. This led to Germany going in hyperinflation and finally introducing a new currency in that period. Fast forward this to 2008 where US frantically printed money for monetary expansion to kickstart their troubled economy post crisis. With US Dollar being the dominant world currency and countries like China, Japan, India and other BRIC nations having massive trade with US the responsibility of the Federal reserve increases even further. With the global economy interconnected in more than one ways, a frantic printing of currency will push the inflation in economies other than the US. The recent example being the intervention by RBI to absorb the excess dollars hitting Indian shores and stop the INR appreciation. It’s a matter of time, when US interest rates rise and the hot money flows out, creating a demand for dollar and flooding the market with local currency, increasing bond yields and pushing up the inflation. Not all markets have the depth and capability to absorb the excess dollars, hence they adopt printing local currency to stop any appreciation albeit loss of local industry competitiveness. This creates a domino with all countries in order to remain competitive start printing currencies and hence debase their currencies. Sooner or later one of them, usually the one with least developed or least disciplined financial system crashes; creating hyperinflation and default on its debt, thereby again leading to choking of financial markets and crisis. So is QE good or bad and what is the rationale behind it?

Let’s start with basics of Economics i.e. the GDP or Gross Domestic Product. GDP comprises of 4 components C+I+G+(X-I).

C = Consumption in an economy

I = Investments by Private sector

G = Government spending

X = Exports; I = Imports; (X – I) = Net Exports

The components breaks up for US are: Consumption (~70%); Investment (~14%); Government Spending (~18%); Net Exports (~-2%)

Post the financial crisis of 2008, most of the financial engines were choked with loss of trust and none of the banks willing to lend. As a result, jobs were lost and consumption took a beating, leading to recessionary effect. In order to revive confidence and GDP, the Federal Reserve printed more money so as to increase consumption (this included a valiant effort to distribute Food stamp). However, due to non-availability of jobs and poor credit off take the consumption remained low and hence the effect on GDP was muted. When none of the efforts succeeded, the US government resorted to increase the GDP through Government spending. All of the above are based on the principle of multiplier effect i.e. for every 1 dollar spent by the government or given out as salaries there is a demand generated which is more than the dollar usually about 1.5 (±5-10%). However, the principal of multiplier was a Keynesian concept which worked well in 1945 – 1971 i.e. the post war era. However, this system in post economic crisis era of 2008 holds less significance, given the following reasons:

1)      In post war era of 1945, there was genuine need for liquidity, due to lower peg of Gold to Dollar (as currencies were pegged to Gold and hence due to low peg rate there was less liquidity in the system as compared to what was required) and the need for developing infrastructure post war. In 2008 and post crisis era, the liquidity was already there, however, the confidence of lending was missing. Hence, the trickle-down effect to the BoP was missing, therefore leading to less consumption.

2)      The Government sector in post 1945 era was a major employer as a percentage of total population, hence, the government spending led to kickstart of the local economy and worked well for the Multiplier. The money spent by the government went straight for consumption or investment in real estate by the personnel. Also, the money in the economy was being utilized by the businesses for investment to increase capacity as consumption grew. Post 2008 crisis, the private sector was by large the biggest employer and was not borrowing as they stacked in huge cash reserves and were is no need of more cash or loans. Part of the reason was the vicious circle created due to low consumption, leading to loss of investment requirement for the companies. Government sector employment fell from a high of 22.5m at the beginning of 2009 to 22m in 2013, whereas the private employment fell from 111m in 2009 to 107m in 2010 before recovering to 111m in 2013. The multiplier concept hence had a converse effect i.e. for every Dollar spent in the system the effect was less than 70 cents. Whoever got the dollar either stacked it away or invested some part outside the US. This was partly due to internationalization and interconnections of the world. With developing economies offering higher yields, the dollar found its way in those economies, thereby appreciating their currency and leading to the currency debasement domino as explained above. Else, due to the pressure of shareholder delight, most companies were off-shoring their production or cost lines to low cost destinations, thereby creating a positive multiplier in those countries as opposed to theirs.

The excess money printed by Federal Reserve for kick-starting the economy though has produced better results than EU troubled austerity measures. However, the dollars are finding their way in high yielding economies and the inability of the dollar absorption capacity is either leading to local currency creation or inflation. In the short term due to political influences the local currency appreciation is welcomed by the hoi-polloi, for e.g. in India, the currency appreciation along with rock bottom oil price has reduced inflation (India imports 75% of its oil requirement). However, the Governor of the prime financial regulator (RBI) has issued statements that he would not intervene for bailing out any corporate who have taken non-hedged dollar exposures. The market is flooded with dollars which the government has to stem in order to protect its Net Exports and hence balance of payments. This could be done by further buying dollars and keeping the exchange rate in control. However, that is borrowing inflation from the US and once the demand for Dollar starts to increase or the Hot money flows out, the local currency would fall further and lead to excessive inflation. This phenomenon is being observed from China to Brazil. China, though has large dollar reserves to absorb any shocks, however, for smaller economies like Brazil, South Africa, this might prove detrimental. And with EU starting its bond buying programme or the QE the situation is about to get worse. Is it time for a Gold rally “AGAIN”?