‘Quantitative Easing variants in Emerging Markets’

The coronavirus-led market rout hit developing economies hard. In order to combat economic pain from the COVID-19 pandemic, more than a dozen emerging markets have adopted quantitative easing.

• Several emerging economies have responded to the financial shock from the COVID-19 pandemic in a rather dramatic fashion.
• The pandemic and the ensuing fallout in terms of twin demand and supply shocks — and all this amid a persistent shortfall in public finances — induced Emerging Market (EM) governments to seek swift and innovative solutions.
• Quantitative Easing (QE) and its variants have been popular for a while.
• Often likened to financing fiscal deficits overnight, QE is meant to prevent unwarranted tightening during times of stress.
• Normally, it is assumed that only the most advanced economies like the US, EU, and Japan would implement it as a last resort for stabilising the economy in the face of recession.
• However, many EM countries have plunged into their self-styled versions of QE programmes with policy rates well over zero, citing the need to quell market dysfunctions and ease liquidity conditions over the short run.
• While some central banks including South Africa and India limited themselves to buying government debt in secondary trading, others such as Indonesia and Ghana launched themselves straight into primary markets, snapping up bonds as soon as they were issued.
• Against this backdrop, EM policymakers have tried to reconcile concerns of inflation and debt sustainability with claims of adequate forex reserves and manageable current account deficits.

What is QE?

• Quantitative Easing (QE) is an unconventional monetary policy that implies printing new money to purchase government debt and other financial assets when interest rates have already hit zero.
• Objective: The rationale behind this is to ‘boost economic activity’ by creating new bank reserves.
  1. These new reserves are meant to normalize credit markets during crunches.
• In QE, central banks generate money to purchase bonds from banks, financial institutions and infuse money supply for increased credit activity.
• Banks and Financial institutions may lend to governments, businesses, individual households at lower interest rates. This results in increased levels of consumption and income.
• Theoretically, when the economy recovers, Central bank sells the bonds and destroys the cash received. This means in the long term there has been no extra cash created.
• But QE is often undertaken by emerging markets under different circumstances altogether.
• In such cases, central banks are called upon when the government faces temporary yet intense fiscal pressures. And this is also where the real risks come in.

QE deployment and the role of ‘core currencies’ and ‘peripheral currencies’

• In the context of QE deployment, it is also important to underscore the difference between the role of
  1. core currencies (say US dollar, the Euro)
  2. peripheral currencies
• Only the former currencies are truly global in the sense that those are demanded by both foreign and domestic market participants while the latter ones are only domestically demanded.
• Peripheral currencies are also often undermined by historical episodes of currency and debt crises, high inflation and limited credibility, and the fragility of financial sectors and political systems.
• This is what instentifies the possible risks posed by QE in EMs (compared to the more advanced economies).
• Instructively, during times of panic, investors rush into the safest assets like US treasury securities.
• This usually happens at the expense of other less mature economies that face significant capital outflows.
• As a result, many EMs face rising bond yields and a higher term premium, which is the extra compensation offered for bonds with longer maturities.

What transpired?

• As a matter of fact, several EM economies faced unprecedented capital outflows and subsequent spikes in bond yields earlier this year caused by a sudden investor panic.
• Simultaneously, most private asset markets, say stocks, bonds, commodities, and property, also came under stress as liquidity dried up.
• At least 20 EM central banks, fiscally stronger and vulnerable ones alike, have since resorted to some form of asset purchases on top of sharp interest rate cuts, to backstop the economy by stabilising financial markets.
• And so far for most EMs, these thick and fast measures have not been counterproductive.
  1. First group: Interestingly, at the time of QE introductions, only Croatia and Chile were close to zero while Polandreached there slightly later.  While this first group of EM central banks chose to engage in QE only after exhausting the space for further rate cuts, a second group dived in with largely fiscal (instead of monetary) objectives.
  2. Second group: Central banks in Ghana and the Philippinescited exceptional circumstances and openly offered lifelines to their governments by purchasing sovereign debt to ward off excessive pressure.
  3. Third group: Lastly, central banks in South Africa, Thailand and Indiaamong others, which constitute the third set, merely undertook the role of a market maker to bolster confidence in private investors. Their intent was not just to raise bond prices, but to simultaneously tighten the spreads (otherwise large gaps between the bid and offer prices) and reduce its volatility.

Isn’t printing currency a good solution to all economic problems?

• Central banks cannot keep printing currency indefinitely by buying bonds to alleviate the stress from deteriorating fiscal dynamics.
• Inflation fears: Printing money beyond appropriate limits may spark inflation fears.
• Erode confidence in local currency: It can also erode confidence in the local currency.
• Worsen exchange rate: The unsustainability of debt monetisation can spook international investors and the resultant outbound capital flows will worsen the exchange rate.
• Currency run: At the extreme, their departure can bring a full-fledged currency run.

Therefore, it is the perception of government solvency which makes the state robust against debt rollover risks.

Why QE is often seen as high-risk advice for Ems?

Notwithstanding the short term gains, it is not difficult to see why QE is often seen as high-risk advice for EMs.

• Damage the credibility of central banks: Intense injections of liquidity can damage the credibility of central banks greatly and cause inflationary shocks, currency runs, and exchange rate instability besides the possibility of debt distress and worsening private sector balance sheets.
• Multiple issues: Intense injections of liquidity also cause
  1. inflationary shocks
  2. currency runs
  3. exchange rate instability
  4. debt distress
  5. worsening private sector balance sheets
• Challenging debt dynamics: At this juncture, Brazil, Colombia, and Costa Ricaare among those facing challenging debt dynamics.
  1. Brazil is perceived to be the riskiest of all, because of its reluctance in adopting reforms amid a high public debt burden (86% of GDP).
  2. Costa Rica, meanwhile, has been facing a steep interest payment burden, reflected by loosening credit spreads, since its economy went into a tailspin.
• Inflationary risk: Similarly, Turkey, Poland, Hungary, and Indiaare among those facing inflationary risk.

Conclusion

Finally, it is worth noting that only strong and credible central banks are able to pull off unconventional policies successfully over the longer run. EM central banks with weak and unstable currencies should understandably be more cautious when it comes to unconventional monetary policies. These are extraordinary circumstances and it may be wrong to assume that investors would continue reacting the same way as intervention becomes routine.