Tuesday, August 11, 2015

Quantitative easing and its effect on World Economy

Quantitative easing and its effect on World Economy
Ben Bernanke introduced a first round of quantitative easing during the worst of the financial crisis, as global markets tumbled and liquidity was sucked out of the system.  Quantitative easing is an unorthodox application of monetary policy by which a central bank, in this case the Federal Reserve, loosens monetary policy further after having dropped the Federal Funds rate to the zero range.  This is done by purchasing longer-term assets, such as 10 year Treasury bonds, in order to push down interest rates further down the yield curve. Quantitative easing, or QE, came into prominence after Japan attempted to prop up its economy after a massive financial and economic crash during the 1990s.  Japan entered what is commonly referred to as the "Lost Decade," where not even QE managed to boost output substantially.  
How QE affects the world economy.
For understanding this we need to understand the long term bond structure (Govt Bond).
A bond has 3 things:
1-Face value:
2-Coupan Rate:
3-Maturity period :
In the market if any financial institution purchases the bonds it will purchase in Market price. Market price may be more than Face value or equal to face value or less than face value. For clearly understood this let take a look on this example:
Suppose a bond has: face value-100 Rs or USD, Coupon Rate -10% and maturity period is 5 year.
If any Financial institute or person buy this bond at market price let say 105 Rs than the yield will be (110-105)/105 = 4.8%
And If any Financial institute or person buy this bond at market price let say 95  Rs than the yield will be (110-95)/95 = 16%
So it is clear from this example that lowers the market price higher the yield and more the fund will go to for buying bond. But What fed Bank did that it buy the bonds of 80 Billion USD per month so Supply of bond reduced in the market which leads to higher market value and financial institute or person may decide not invest on bond, invest in other things like share market. So the double fund (fund of financial institute and fund by Central Bank) is channelized in different share market in the world. And growth rate increases which was not sustainable.
Recently US fed bank decide for tapering of QE, so supply of bond in the market is increases and yield will also increase. So the persons or financial institutions started to invest on bonds so it leads to capital flight from different share market in the world. This leads to depreciate of currency now a days happening in many developing countries.
This is a single country analysis which affects the global economy. When  more developed countries involved in QE than the picture is more worse.
Detailed Analysis
When zero rates of interest have failed to stimulate developed economies (mainly G-4 economy: Japan, USA, Eurozone, UK) , the developed countries have resorted to large-scale asset purchases by their central banks, such as corporate bonds or mortgage backed securities, to pump more money into the banking system.The aim is to extend credit to business and industry and encourage consumption.
In the immediate aftermath of the global financial and economic crisis in 2008, when there was a danger of financial collapse, both advanced as well as emerging economies adopted stimulus packages, to revive demand, maintain trade flows and avoid large-scale unemployment. During the crisis phase of 2008/09, QE played an important role in crisis management, helping advanced and emerging economies alike.
However, while emerging economies have weathered the crisis and seen a revival of growth, the G4 continue to experience economic stagnation, depressed markets and large-scale unemployment. Their response has been to persist with even larger doses of QE as a means of propping up demand, encouraging banks to expand and boosting stock valuations.
Before the crisis, the U.S. held 700 to 800 billion dollars of Treasury notes. The current level is 2.054 trillion dollars. In the latest round, QE-3, the U.S. Federal Bank is committed to the purchase of 40 billion dollars of mortgage-backed securities per month as long as unemployment remains above 6.5 percent.
The European Central Bank (ECB) has pumped 489 billion euros of liquidity into the eurozone since the crisis, while in the United Kingdom QE has reached the level of 375 billion pounds.
Most recently, the Bank of Japan has decided to pump 1.4 trillion dollars in the next two years into its economy, aiming at a two-percent inflation rate by doubling the money supply.
The assets of the G4 central banks have expanded from a figure of 11-12 percent of their gross domestic product (GDP) to the current unprecedented level of 23 percent. These assets were 3.5 trillion dollars in 2007 before the crisis. They are now nine trillion dollars and rising. This is the scale of liquidity expansion we are dealing with.
Since interest rates in the G4 remain at zero and their economies remain stagnant, it is inevitable that there will be significant capital outflows to emerging and other developing economies, in quest of higher risk-adjusted returns.This massive and continuing surge of capital outflows to emerging and other developing economies is having a major impact. Corporations, which have a sound credit rating, are taking on more debt, and increasing their foreign exchange exposure, attracted by low borrowing costs.
Their vulnerability to future interest rate changes in the developed world and exchange rate volatility will increase. Such inflows put upward pressure on exchange rates, stimulate credit expansion, and cause inflationary pressures, which pose a major challenge to policy-makers in the developing world.
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. The volatility one has witnessed in the Indian stock market is a case in point. In general, we may conclude that the overall impact of these capital flows is expansionary and distortionary.
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 QE has had unintended consequences beyond the borders of the G4, especially because their currencies are not only fully convertible but, together, constitute the pillars of the global financial system.
The U.S. dollar is the world’s leading reserve currency, and the euro, the British pound and the Japanese yen together constitute the basket of currencies the International Monetary Fund (IMF) uses to value its Special Drawing Rights. Thus, the nature of the G4 currencies and their significant role in the global financial market ensures that QE undertaken by them has a global impact on economies across our globalised and interconnected world.
It is necessary, therefore, for the G4 to act with great responsibility and to work together with the emerging economies, to minimise the adverse effects of their QE policies. It would be particularly important to forge a consensus on how to handle the potential financial turmoil and disruption that may afflict developing economies once the QE is sought to be retired and interest rates once again become positive in the G4. The sudden and large-scale reversal of capital flows is a likely scenario that would need to be anticipated and managed.
The Asian financial crisis of 1997/98 was, in part, triggered by an earlier version of QE pursued by Japan in the aftermath of the bursting of its property and asset bubble in the early 1990s. Then, too, the large inflow of low-cost yen loans led to the asset price bubbles, inflationary pressures and currency instability in the Asian economies. They paid a heavy price in the bargain.
A larger, more pervasive crisis may await the emerging and developing economies unless there is a much more coordinated and careful handling of the risks that are already building up. The G20 had also this issue at the top of its agenda.


Sandeep Kumar Omre

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