By Madan Sabnavis
It surely looks like it’s going to rain money across the world. Monetary easing, which was expressed as liberal interest rate cuts to begin with, is now going one step further through a central bank infusion of funds. The European Central Bank (ECB) has announced that it will have an open-ended buyback of paper from any member country with only one pre-condition – they will have to follow the austerity path as defined by the institution.
Across the Atlantic, US Fed Chairman Ben Bernanke has also said that he would not be averse to another round of quantitative easing, which means buyback of bonds in return for cash. Even if this story does not unfold on 13 September, when he speaks next, it is still round the corner. Why is this happening, and just what does it mean for us?
The western world, typified by the US and the European Union, are still struggling – the former to grow, and the latter to slow down the slide. Their central banks have lowered their benchmark rates to close to zero (0.25 for Fed and 0.75 for ECB), and it is not working – the classic Keynesian liquidity trap, when rates cannot be lowered further to boost lending.
The Fed is worried that unemployment is high and, therefore, would like to provide more money. The ECB wants to rescue the eurozone governments as they require the money. It plans to bail out governments through OMT (outright monetary transactions) as against LTRO (long term refinancing operations, which id did earlier). While Germany was the sole dissenter on the ECB decision, the others felt that this had to be done. The end-result is that there will be a lot of liquidity in the system once QE3 also comes in.
One must remember that QE1 and QE2 were meant to pull the US out of a recession and that the situation is nowhere close to that abysmal state. Yet, there is urgency to have things done, which is in contrast to our own situation where we are still not sure if inflation or growth is more important.
Four outcomes may be expected from these measures.
The first is that the bond markets will get distorted in these two regions because market forces are being tinkered with by central banks. Bond prices will no longer reflect their true value. US treasuries will rise as yields will be driven down by the buyback. In the euro region, buying bonds will make them look good in the market – something that is probably not deserved. The credit default swap rates have already come down for Spain and Italy after this announcement. Both ways, interest rates will come down further and money will be available to banks.
Second, these funds will tend to move across the world. In the euro region, where there is a trust deficit, the funds may not really be on-lent, but provide succour to the governments of Spain and Italy to begin with. More likely, these funds will look for better returns overseas. US treasuries will not be attractive at these high prices (as there will be losses to be booked once prices come down when interest rates go up, though the Fed has implicitly promised that rates will not be raised till 2014).
Emerging markets will be the best bet and India can hope to receive some of these flows. This is good news for us considering that the government has made some right sounds on GAAR and retrospective taxation, which were the main hindrances to foreign investors. This augurs well for our capital market too because more money will provide a boost, which in turn can enthuse the government to push through its own disinvestment programme which is presently in limbo.
Third, the currencies will be in for some turmoil. The dollar had been strengthening (it was moving towards 1.20) against the euro as any news of trouble in the PIIGS (Portugal, Ireland, Italy, Greece and Spain) tended to weaken the euro. A whiff of QE3 made the dollar weaken (it moved towards 1.27) because, with such a large supply of dollars floating around, the currency becomes less attractive. But once the OMT kicks in, the euro will again weaken. Therefore, currencies are going to be volatile and these reverberations will be felt in India too as the rupee will be subjected to these wild swings over and above our own fundamentals which are no less volatile. This means more work for the Reserve Bank of India (RBI), which will have to monitor closely what happens in these markets.
Fourth, these two regions may actually start to do better in terms of GDP growth. The euro region forecast has been lifted upwards while the US can do better than the 2 percent growth that has been projected. This is good for the world economy as global trade, which has been hit quite hard by this slowdown, can hope to recover, and the rest can draw on this success. China can look forward for slightly better times again in case this scenario unfolds.
Fifth, the fear that everyone has on inflation cannot be ruled out. Too much money floating around has a dualistic inflationary impact. The first is any recovery in the euro region or faster pace of growth in the US will mean demand from commodities – in particular oil and metals. This will lead to a commodity boom, with prices increasing. Investors in commodities could cheer with gold and crude already increasing.
Gold, in fact, will be a great buy considering that it is a substitute for the dollar and will swing along with the fortunes of the dollar, albeit in the reverse direction. The other impact is the sheer volume of foreign currency flowing into the emerging markets. This has the potential to generate excess liquidity at a time when their economies are not exactly showing high growth – both India and China are slowing down.
So what would it mean for us? On the face of it we should be less influenced by these developments as ours is a domestic economy. But all prices will be under pressure, which will create further conundrums for the government on the policy front. A volatile rupee is the last thing we would like to have, considering that our current account deficit is already under pressure.
More foreign funds will help, but then what about inflation? Everyone is waiting for this number to come down either due to lower prices or high base effect so that the RBI can take action. That can be some distance away with more money coming in. So far, core inflation, or inflation of manufactured products, has been steady and stands the threat of being under pressure once commodity prices rise. Crude oil has always been a problem as we are not quite certain about what we should be doing on the domestic price front with the rising fiscal deficit being a constant reminder that housekeeping should be high priority.
Therefore, while more foreign funds and global recovery are good for all countries, the pressure on policies will tend to get compounded. Are we prepared for it?
The author is Chief Economist, Care Ratings. The views are personal.