QE 2 : Whats the big deal about it ?

QE2: What is it and what’s the big deal about it?

QE2 or quantitative easing is printing of currency by the Fed (central bank of US) to buy treasuries (long term government bonds). So let’s see what the exact fact of the matter is as per an international weekly - “The Fed said it will buy $600 billion of treasuries between now and next June at about $ 75 billion a month”. In recessionary times or when the economy slows down from its long term growth trend the central bank intervenes to boost demand and growth by providing liquidity in the markets through an expansionary monetary and fiscal policy. Monetary policy can stimulate demand by cutting interest rates and / or reducing the statutory reserve requirements of the banking system. The rate most likely targeted by the central bank in the monetary policy is the repo/ reverse repo rate which are the overnight rates at which the central bank lends/ borrows from the banking system. In extreme and extraordinary circumstances (much like the present form in the western world) when nominal rates are near zero and real rates are negative there is no more scope with the central bank to make any further cut in rates and stimulate the economy. It instead is left with extreme measures like currency devaluation (by printing currency and increasing money supply) or by directly buying real assets.

What US is doing with QE2 is experimenting with printing currency to buy long term treasuries. Printing currency will increase money supply in the economy which will keep interest rates low and provide liquidity in the system to stimulate demand. Increasing money supply is followed by high inflation but that is not too much of a concern in an economy with a lagging demand. US is currently focusing on stimulating demand and kick staring the economy towards its trend growth rate of around 3.5-4 %. In fact at this stage a though of increasing inflation will signal increase in demand, which Fed can control by raising rates in the medium term.

Emerging and growing economies like BRICs and to a lesser extend Germany are skeptical of QE2 and crying horse over this loose character policy of the Fed. When Fed introduces liquidity in the system by printing currency, investors will look for assets with high yields. With interest rates on treasuries ultra low, investors turn to risky assets like alternative investments, real estate and emerging economies (emerging economy is an asset class in common parlance). A flood of money chases high interest rates and high yields in emerging economies which propels asset bubbles in these economies (I know of a few bubbles already – Brazil’s currency bubble, China’s real estate bubble and India’s stock market bubble). What this also leads to is that the demand for dollar decreases and the demand for foreign currency increases, thus putting downward pressure on dollar and appreciating pressure on the foreign currency. No surprise dollar is on a downward trajectory relative to Real, Rupee and Euro. China with its elephant footed currency peg has prevented Yuan’s appreciation by buying dollar assets and thus amassing huge foreign exchange reserves. Indian and Japanese central banks too have intervened in the currency markets to keep their respective currencies on a crawling peg and not let them rise astronomically.

There’s another more inherent risk with this dreadful depreciation of dollars. Greenback is regarded as the reserve currency of the world and countries around the world are accumulating Dollar reserves to insulate themselves from a sovereign default. Imagine this situation; China has around $ 2 trillion of reserves, now when Fed move make dollar depreciate by 15-20% in the short run, reserve are going to depreciate straight away. Scary, isn’t it?

I can go on and on and on with the explanations and counter explanations in explaining how this complex situation is unfolding and what are the implications for all the counterparties involved. To make it straight and plain, Dollar is going to depreciate which will make dollar exports competitive, foreign currencies will appreciate and the dollar reserves of countries will dwindle.

My solution to this is rather radical and very quick (my wife is frowning as I write this ‘boring’ bit of article on a Sunday evening). First, emerging economies should pressure for a value weighted SDR as the reserve currency of the world; with the currencies of all G20 economies getting weights proportionate to the size of their economies in the SDR. Second countries keeping their exchange rates artificially low (China) and even at some stage US, should be penalized. Third, India in particular, should start accumulating Chinese Yuan as the reserve currency as China is India’s biggest trade partner outside of US and the trade is going to get bigger with both the economies growing in size and scope. Dollar will dwindle and Yuan will appreciate finally, there is no risk whatsoever (though I acknowledge political risk) in accumulating Yuan as a reserve currency, central banks must pay heed to the mind of a radical investment analyst.