Following the publication of disappointing American economic data last week, capped by a jump in the jobless numbers of 95,000, another round of quantitative easing (QE2) looked imminent.
However, researchers at major global organisations are warning that monetary stimulus such as “the good ship QE2” could prove to be more of a Titanic for financial markets.
Quantitative easing allows central bankers to print money and increases cash holdings in the private sector in exchange for financial assets. In theory, QE2 should increase the supply of money to struggling developed world economies, not only in America, but also in Europe and Japan, which have each implemented their own QE since the financial crisis.
Nevertheless, in its report “Capital Flows to Emerging Market Economies”, the Institute of International Finance last week warned that “a number of emerging market policymakers [have been] expressing concern that upward pressure on their currency could become unduly strong, especially as central banks in mature economies signal increasingly easy monetary conditions,” including quantitative easing. (article continues below)
An IMF working paper in September confirmed this perspective. “Global imbalances have been accompanied by a large global liquidity expansion supported by low policy rates in advanced countries, to which emerging market and developing (EMD) countries had to adapt their domestic monetary policy,” the report says. “The “push” channel of capital flows…suggests that low interest rates in advanced countries have pushed capital, at an accelerated pace in the 2000s, into EMD countries.”
The worrying issue is not that the trend is developing, but accelerating at “undue” and “imbalanced” rates. Translated, the dynamic presents the danger of continued stagnation in the developed world and a bubble in emerging economies.
Although the Federal Open Markets Committee has hinted strongly at such easing recently, nobody can know for certain what it would buy with its “eased money supply”, or printed cash. It has previously bought federal or private sector debt, but it could equally buy non-federal government paper. Research houses such as Meredith Whitney Advisory Group are indicating state governments could need a bailout in the next 12 months.
Issuers aside, however, it does not matter how much QE is authorised. The problem lies not in the quantity of cash in the developed world but where it lies and how it is exploited. “Helicopter drops” to terrified consumers are unlikely to prove effective, while behav- iour in the corporate and financial sectors has hardly been more promising.
According to global equity managers at Invesco Perpetual, Britain’s largest investment house, most cash held by developed-world companies is either sitting on balance sheets, flowing into financial assets or developing fresh initiatives in fast-growing emerging economies. Companies will invest little of it in new developed-world projects and thereby stimulate the anaemic recovery in advanced economies, particularly when the economic risk is so high.
Paul Boyne, the manager of the Invesco Perpetual Global Equity Income fund, says companies are in many cases reluctant to dent short-term profit margins when the long-term outlook is so uncertain, particularly as many companies have already cut costs and boosted margins to record highs.
For their shareholders, it makes more sense to pay out higher dividends, buy back stock, or acquire other companies with strong operations while equities remain cheap. The alternative is to invest in fast-growing economies with substantial returns or maintain – but in most cases not expand – developed world operations.
According to Smithers & Co, an asset allocation specialist, many American companies in particular owe substantial sums and are happy to hoard cash in case borrowing costs rise off very low bases, or simply in case of economic uncertainty, including the historically inflationary effects of QE.
Extrapolating from this outlook, if QE2 goes ahead, the likely result is imbalanced inflation in asset prices and developing world economies. Tony Roberts, a co-manager of the Invesco Perpetual Japan fund, says that in certain respects the situation resembles Japan six years ago, when a banking crisis had led companies to hoard cash and bolster their balance sheets.
Japan embarked on quantitative easing, Roberts says, which produced little economic improvement but a gigantic carry trade, whereby investors borrowed at ultra-low interest rates and invested in financial assets, including in emerging markets. The carry trade was exacerbated by loose monetary policy elsewhere in the developed world, which had been partially caused by low growth. As inflation increased, authorities tightened policy, and the financial system embarked on its downward course.
As emerging economies struggle to contain inflows this time around, their arsenal is proving broadly similar. They may impose capital controls, as Brazil did recently, or buy dollars or other currencies to prevent their currencies appreciating too fast, which is already official policy in China.
However, this time “the good ship QE” is much larger. Japan is a minor participant compared with America and the eurozone, which may have to print more money to cope with its sovereign debt crisis. As China tries to keep its currency appreciating too fast against the dollar and other developed market currencies, which are its main export destinations, the developed world is trying to promote its own exports and push it the other way.
China is caught. If it sells fewer renminbi to buy dollars, its currency could appreciate before it is able to shift away from export-led growth. If it pursues its policy of extremely gradual or zero appreciation, it risks provoking a trade war or a gigantic bubble in American federal bonds, the instrument of choice for its dollar-denominated reserves.
If QE causes higher inflation, investors are likely to sell those bonds and other investment-grade paper. The result could be another crisis in AAA-rated debt, paralleling the previous plunge in AAA-rated asset-backed securities. Although the bubble may be a long time coming, it could yet be the iceberg QE was built to avoid.