In recent weeks, three of the world’s largest central banks namely the U.S. Federal Reserve, the European Central Bank and the Bank of Japan embarked on a new round of monetary easing. This is an unorthodox way of pumping money into the economy and lowering the long-term interest rates in order to combat the recession.
Since interest rates in industrial countries had declined to near zero in the aftermath of the global crisis, the scope for further monetary easing through policy rates became very limited.
Quantitative easing (QE) and other asset purchase programmes have been introduced in modern economic history under exceptional circumstances.
The US started implementing QE in 1932 to combat the great depression (USD 1 billion). However, this did not yield the desired effects. Japan is credited as the first country that started implementing in 2001 the current version of the QE (YEN 50 trillion for 2001-2006). But it wasn’t until the 2008 financial crisis that central banks of developed countries have used QE at such regular space to stimulate their economies, increase bank lending and encourage spending. For instance, some of the post 2008 global financial crisis QE programmes for the U.S., Europe, U.K. and Japan amounted to USD 1.75 trillion (U.S. QE1 2008), EUR 489 billion (Europe Dec 2011), GBP 200 billion (U.K. 2009-2010), and YEN 65 trillion (Japan Feb 2012) respectively.
The real estate bubble which burst in 2007 in the U.S. and caused the 2008 financial crisis, and the more recent Eurozone sovereign debt crisis have obliged leading central banks for such aggressive monetary actions in order to prevent financial instability. The U.S. introduced QE1 in 2008, QE2 in 2010 and “Operation Twist” in 2011, and more recently the third round of QE (QE3) which consisted of a monthly USD 40 billion injection through purchase of mortgage-backed securities. The Fed buys government or other bonds and then makes this money available for banks to borrow, thereby expanding the amount of money circulating in the economy, which in turn reduces long-term interest rates. In Europe, the ECB has implemented three asset purchase programmes since 2011. In Japan, the central bank added YEN 10 trillion to its already existing asset purchasing programme, thus raising the ceiling of the programme to as much as YEN 80 trillion.
Thus, increasing the size of their balance sheets has become the primary means by which central banks in developed countries have intervened to bring relief to the ongoing economic downturn. By adopting unconventional measures of monetary easing, central banks seek mainly to stimulate growth, bring down joblessness to reasonable levels and support their banking systems by pumping more money into the economy to boost spending. However, some critics worry that these measures would fuel inflation and encourage unbridled government spending.
The Fed’s QE3 is expected to widely affect global economies and this announcement caused euphoria in the financial markets, with stock prices reaching post-recession highs in the U.S. In turn, emerging markets received these extraordinary monetary policy responses with scepticism. While central banks in developed economies have deployed monetary easing to ameliorate the impact of the recession, the collective magnitude of monetary easing may have unintended consequences in other countries, especially in emerging countries. As economies are more integrated, the implementation of QE in developed countries can cause excess flow of liquidity in emerging countries and inadvertently disrupt their currencies, exports, inflation levels.
Excess of liquidity and the attractiveness of emerging markets
One major feature of the world economy is the globalisation of the financial markets. Increasingly, emerging economies including those in Africa are integrated with most developed ones mainly through trade ties and capital flows. When an important central bank adopts a QE programme, it expands its monetary base and provides liquidity to the markets thus creating excess liquidity which in part will flow to the developing world for diverse reasons.
This excess liquidity is chiefly attracted by the higher risk-adjusted investment returns offered by the emerging markets compared with the developed world. Over the long term and on risk-adjusted basis, investments in financial emerging markets yield more than in the developed world. Furthermore, emerging markets offer global investors the possibility of portfolio diversification. Lower level of leverage and better ability to take on debts by emerging countries compared with major economies indicate a strong capacity of the developing economies to absorb greater foreign flows to feed their growth without jeopardising their financial viability. In the same vein, liquidity expansion seems to positively affect credit conditions in emerging markets. In fact, while credit availability in advanced economies has not translated into higher borrowing by the banking sector, the credit and lending to private borrowers in emerging countries significantly increased.
Potential impact of QE on the emerging and African countries
As noted above, though QE can boost economic growth in mature economies, it may have unintended effects on emerging economies:
Currency wars: After the launch of QE3 by the Fed, finance ministers of several emerging countries including Brazil, China, and Korea accused the U.S. of intensifying currency and trade wars. The Fed’s monetary easing was regarded as an implicit devaluation of the dollar to unfairly boost U.S. competitiveness vis-à-vis its major trading partners. Thus, the Fed’s QE policies which lower the value of the US dollar may trigger a cycle of currency wars with the emerging world as it was the case with QE1 in 2008 and QE2 in 2010. Currency wars can be very harmful to the global economy as they could destroy wealth and increase price instability.
Exchange rate volatility: In Africa, the flow of ‘hot money’ from the developed world is mainly reflected in volatility of and appreciation of local currencies rather than currency wars. African economies heavily dependent on commodity export revenues could substantially suffer from the volatility or the appreciation of local currencies as a result of volatility or depreciation in the US dollar triggered by QE actions. Although the immediate impact of QE on African economies can be relatively low due to weak integration with the global financial system, more integrated countries such as South Africa, Nigeria, Egypt, and Kenya, may be adversely hit by volatility of exchange rates as evidenced during the 2008 financial crisis. Adverse exchange rate movements can have disruptive effects on industry, trade and long-term investment flows.
Inflationary pressures: Higher liquidity flows to developing countries could raise inflation mainly through commodity prices and the lending capacity of the banking system in developing countries. As most commodity prices are denominated in the U.S. dollar, devaluation of the greenback arising from QE3 could cause a rise in commodities prices. In anticipation of the introduction of the QE3, commodity prices especially oil and agricultural commodities have surged. Although inflation has dipped so far in 2012, it remains a significant threat to emerging and developing countries. This is particularly true in Africa for food items which represent a significant share of the consumption basket.
Monetary easing by the leading economies could also bring good fortunes. By boosting aggregate demand, monetary easing could spur growth. For commodities that are procyclical assets, a new phase of economic growth could boost prices. However, when markets price in the impact of QE on global growth, the impact may be muted.
Mthuli Ncube is the chief economist and vice president of the African Development Bank