PERILS OF UNITED STATES QUANTITATIVE EASING PROGRAMMES ON WORLD ECONOMIES

Since the fall of 2008, many of the sovereign economies across the world faced their worst economic crisis in 70 years due to the RECESSION triggered by collapse of massive financial institutions in US.

Federal Reserve (The US central bank) Chairman Ben Bernanke had to take some extraordinary steps to calm financial markets.  Easy fix, he adopted, was to print money and slash short-term interest rates to zero (termed Quantitative Easing or QE), as way out of trouble, which was then praised by the Economists as an aggressive response.

Ben Bernanke made his first step on the Quantitative Easing (QE) ladder in an effort to accelerate the economic activity (increase lending, create more jobs, lower the unemployment rate) and higher home prices. Hence, QE1 was initiated in November 2008 and ran until March 2010. During that time, the Federal Reserve snapped up $2.1 trillion worth of mortgage-backed securities and Treasury bills to push down interest rates, spur the economy, re-finance the cash strapped banks and calm financial markets.

However, contrary to expectations, mortgage rates tumbled and the economy never showed signs of expected recovery.

Hence, Bernanke enacted QE2 and the Federal Reserve printed an additional $600 billion between November 2010 and June 2011. Despite pumping in additional money, the US economy did not respond to these extraordinary steps.

Further, in September 2012, QE3 was announced, and this time, it’s open-ended, which was sarcastically named QE Eternity. Federal Reserve continues to hold interest rates near zero and print an additional $85.0 billion each month to prop up the U.S. economy, which includes $40.0 billion a month to purchase mortgage-backed securities and the rest for swapping short-term securities for longer-term securities.

The US dollar remained the dominant global currency despite its economic travails, thereby resulting in American exports getting costlier and thus further widening US fiscal deficit. The generosity of Federal Reserve’s easy monitory policy for American banks and financial institutions resulted in rally in stock, bond and commodity markets worldwide, stoking higher inflation at the expense of economic growth. At the same time, the easy money from US found its way in to other developed and emerging economies, as short term capital funds which can quickly turn around, thus creating higher interdependencies of the subject central banks with Federal Reserve’s monitory policies. Consequently, the probability of the end of quantitative easing by the Federal Reserve has recently resulted in huge outflows of dollars from stock and bond markets of “Twin deficit” economies (viz, India, Indonesia, Brazil, South Africa etc), thus weakening their currencies and destabilizing the structural stability of subject economies. However, “Surplus” economies like China are greatly unaffected by easy monitory policy stance of Federal Reserve. However, China being the energy and commodity starving country which imports majority of commodities will stand to gain if the commodity prices are normalized due to tightening of easy monitory policy by Federal Reserve (by raising interest rates and tapering Quantitative Easing program).

Hence, during the era of globalization, it became clear that the easy monitory policy of Federal Reserve was ineffective as it could not percolate and remedy the REAL economic health, but in effect, it has only created more structural and cyclical economic bubbles in its economy as well as other inter dependent economies.

 

IS ECONOMIC BUBBLE BURST IMPENDING?

Surprisingly, the financial markets, the central banks and Governments of many emerging and developing economies rejoiced on the outcome of Federal Reserve meeting held on September 17^th and 18^th for not tapering their Quantitative Easing Program, as widely anticipated.

Manish Chokani, CEO of Axis Capital, rightly says “what we are all celebrating is that someone is printing money at a trillion dollars a year in order to achieve a gross domestic product (GDP) growth of USD 300 billion a year. Because that GDP isn’t lifting off they continue to print 3 times the amount of money just to get that one unit of turnover. While financial markets and commodity celebrate that the trillion does not go into the real world and it spills over into commodities or into financial assets. We can’t be celebrating that until the world actually recovers. Therefore, how this whole thing ends is going to be quite ugly.”

Reserve Bank of India (RBI), the India’s Central bank, Governor Raghuram Rajan, summing up the perils of QE programmes, says “There is a danger of bubbles forming around the globe, due to easy monetary policy implemented to steer the world back into a more robust growth path. We seem to be in a situation where we are doomed to inflate bubbles elsewhere. We should wonder whether lower and lower interest rates are in fact part of the problem, I say I don't know. We need to think of the dangers of over stimulation. We need to think of the sustainability of growth created by stimulus measures."

IS FISCAL POLICY, THE RIGHT MANTRA?

According to Raghuram Rajan, right fiscal policy might work better than interest rates to get growth back to a sustainable path.

However, the mute point in question is finding and implementing the right fiscal policies in place could be very difficult, if not impossible, especially in countries like India, where populist measures are pursued by Governments for electoral gains, at the expense of long term growth and structural stability of the economy.

UNDERSTANDING THE CYPRUS CRISIS

Cyprus with a land mass of about 7,800 square miles, is located in the Eastern Mediterranean Sea, east of Greece and South of Turkey. Demographically, the country has a population of 1.1 million with 77% Greek, 18% Turkish and 5% other ethnicities with a median age of 35.
Cyprus economy with an alarmingly high fiscal deficit of 6.3% in 2003, was nurtured to good health by 2009 after it implemented a series of austerity measures that gave it a surplus of 1.2% in 2008. However, the Global economic crisis had hit Cyprus hard as it fell back on hard times because of its large exposure to Greek debt, thus contracting the country's GDP by 2.3% in 2012. Consequently, the country was downgraded numerous times in 2012 with agencies like Fitch giving it a BB- rating and warning of further downgrades, which resulted in Cyprus' borrowing costs higher. Cyprus needs 15.8 billion Euros to bail out of the current financial mess.
According to media reports, the Cypriot banking sector is about eight times the size of the economy with almost $19 billion, or one-third of all deposits, coming from Russian sources. The Russian elite use Cypriot banks to funnel ill gotten money to avoid political uncertainty and corruption in Russia, as Cyprus is known for its policy of turning a blind eye towards capital controls as well as the sources of all capital inflows. Dmitry Rybolovlev, the largest Russian investor, has almost a 10% stake in the Bank of Cyprus equalling $8 billion to $10 billion. However, Cyprus economy was systemically damaged due to its exposure to Greece since the onset of Global financial crisis. Similar to Greece and other EU countries, Cyprus was forced to ask the European Union (EU) for a bailout in the recent times, which was rejected by EU, with Germany (Internal politics dictating a hostile proposal in case of Cyprus, as Germany elections are few months away) taking the lead in suggesting that Cyprus should generate 5.8 billion Euros, a fraction of the 15.8 billion Euros from its internal resources as a front end source for the country's immediate financial bail out requirements.
The Cyprus government, with out much leeway, swung in to action by imposing surprisingly huge taxes on the Euro deposits in their country's banks. The taxes imposed were as high as 9.9% on deposits of more than 100,000 Euros and 6.75% on deposits of less than 100,000 Euros, thus targeting to raise 5.8 billion Euros. The main focus of the government was to generate income by taxing Russian elite who were using Cyprus as safe haven for their ill-gotton (illegally earned) wealth. However, country's ordinary citizens, who were already reeling under the burden of county's financial crisis, were also naturally in the line of fire. As it is anybody's guess, banks customers were queuing up to withdraw their deposits prior to the implementation of Government tax announcements. Sensing the mood of the customers, all the country's state run banks have declared extended bank holidays to permit lobbying by Government for a parliamentary vote to this proposal to convert in to a law. However, majority of the Cyprus parliamentarians were against the tax slab rates as proposed by the government and are lobbying strongly to make the tax proposals slightly sweeter by exempting the first 20,000 Euros from tax and suggesting a reduced tax rate of 3% for savings up to 100,000 Euros. Alternately, they also propose to nationalize Pension schemes as well as issue long term sovereign bonds to generate the required 5.8 billion Euros.
The Governments tax proposals and state run banks attitude towards the investors (Closing of banks abruptly) had eroded the confidence of investors and general public alike, across all countries, as they fear that this precedent could become a contagion to all economies.
Although the crisis in Cyprus may not have any direct bearing on the fiscal health of other economies, the Cyprus developments have certainly eroded the investor confidence across the world, thus making the world stock markets unstable despite huge monetary easing in US and better than expected macro economic data in US, China and Japan. Time to brace up for Volatility in stock, currency and commodity markets, across the world.

 

RELIEF FOR CYPRUS (Updated on 25.03.2013)

10 billion Euro bail out deal is reached between Cyprus and European Union just prior to the dead line. Cyprus has agreed to the following terms set by EU:

a. Holders of Cypriot bonds and people with deposits of more than 100,000 Euros in Cypriot banks will see significant losses in their books due to levy of taxes on those deposits. (Depositors with deposits less than 100,000 Euros are completely spared)

b. Cyprus has to shut down its second largest bank and restructure its other largest banks.

 

The bail out package may be positive for the stock markets in the short term, but structural economic issues still remain in majority of the countries of European unionapart from possible social unrest due to Governments' austerity measures and tax increases, which possibly can generate head winds for the markets.

MARCH 2013 CREDIT POLICY: A DOVISH STANCE BY RBI

RBI has cut REPO rate by 25 bps to 7.5% from 7.75% and left CRR (Cash Reserve Ratio) unchanged at 4% in its March 2013 Monetary policy review (19.03.2013), which clearly indicates a dovish stance to negate the external pressures on India’s Central Bank, especially when it’s front end macro-economic indicators like Current Account Deficit and Inflation are at alarming levels.
Appropriately, the RBI plans to infuse liquidity in to the system through OMO’s (open market operations) and obviate the necessity of a CRR cut, which is a step in the right direction, as liquidity crunch is expected to ease in April 2013.
RBI Governor has indicated that there is limited head room in future for monetary policy easing to spur growth due to hawkish economic environment, expected to last longer than anticipated by Government and some economists. Moreover, RBI must be sensing that the Current Account Deficit may not narrow, as expected, as Government may not be able to take firm steps in reducing subsidy burden as envisioned in the 2013 budget, due to current political compulsions and developments. Diesel price increase which was widely expected during mid March, 2013, was surprisingly with held raising doubts about Federal Governments commitment and firmness in implementation of tough policy measures to reduce the Current Account Deficit.
Many top bankers are comprehending that this rate cut is not going to percolate to end consumers through a reduction in bank loan rates since the quantum of bank deposits are precariously low and cost of funds for banks are getting higher and higher. Perhaps, this policy stance may be a step to boost the sentiments of stock market domestic and foreign investors rather than to actually prop up the growth of Indian economy.

RBI MONETARY POLICY EASING DEMANDS: ARE THEY JUSTIFIED?

Analysts at leading Indian and foreign brokerages and Stock market traders expect the Indian monetary authority, RBI (Reserve Bank of India) to slash the repo or short-term lending rate and CRR (cash reserve ratio) in its policy review on March 19, 2013. Similar sentiments are echoed by Indian Finance Minister Mr. P.Chidambaram, at a time when Annual CPI (Consumer Price Index) inflation is hovering around 11% month on month. Surprisingly, proponents of rate cuts point out that the inflationary pressure are due to supply side constraints. Contrarily, RBI governor admitted that the inflationary pressures are due to both supply side and demand constraints. Demand constraints are a result of excess liquidity and it generally increases commodity (crude & gold which is the case) imports, which further widens Current Account Deficit. 

Although, rate cuts were affected in Repo rate and CRR during 2012 and in January 2013, reluctantly at times by RBI governor Duvvuri Subba Rao, the outcome is far from the desired and anticipated path of fuelling India’s GDP growth, job creation and reducing trade deficit gap. Loose monetary policy was intended to reduce Industry and consumer borrowing costs, Capex of Industries, accelerate consumption and enhanced investments in infrastructure & revenue generating avenues, thus propelling GDP growth and new jobs creation. Instead, the excessive liquidity in the market, most of the FDI (Foreign Direct Investment) inflows and increased government borrowing was channelled in to non productive (increased gold imports and sky high stock markets which are otherwise in a fundamentally regressive phase with weak earnings) and non growth sectors (Subsidies, irrational social spending) thus spiralling inflation and increased fiscal deficit.  
Effectively, the earlier rate cuts has diminished the value of Indian middle class people’s savings in Fixed deposits, government securities and bonds as the yields are less than 9% pre-tax vis-a-vis CPI inflation of over 10%.

Let us take an example of a middle income person with a tax bracket of 33%:

Amount saved (say): Rs 100,000 in a Fixed deposit with 9% interest.

Returns after one year post tax on interest: 100,000+ 9000*(1-0.33) = Rs. 106,000 (Approximately)

Nett value of capital post inflation (Inflation @11%): 106,000*(1-0.11) = Rs.94,340

Hence the capital is getting depreciated by 5.66% due to high inflation, low yields on government backed securities and high tax rates on such returns.

Hence, the Indian middle class has become highly disillusioned with saving instruments which are subjected to higher taxes and found a refuge in GOLD and real estate which are a natural hedge against inflation.

The diversion of domestic investments in to non-productive and unaccountable areas is apparent from the increased Gold imports and sky rocketing property prices. Less public deposits have led to increased cost of funds for banks and hence, their inability to pass on the rate cut benefits to Industries and consumers. Also the increased Gold imports led to India’s increased trade deficit, thus further widening country’s Current Account deficit as well as Fiscal deficit. This led to devaluation of Indian currency, which is further escalating Indian macro economic weakness.

Let me admit that I have highest regard for hard working, highly focussed and growth centric Finance Minister Mr.Chidambaram. He rightfully acknowledged that "Indian promoters are RICH, but their promoted companies are POOR". This summarises where all the fiscal & monetary loosening is leading to. However, he appears to be deviating from addressing core issues of supply side constraints that are fuelling inflation, increasing effectiveness of savings in government securities, bonds and fixed deposits thus reducing demand for Gold, effective channelizing and implementation of government spending and programmes respectively. Instead he appears to be championing for further monetary policy easing, which may satisfy FII’s, brokerage houses and rating agencies but neither the Indian middle class citizen nor the macro health of the economy.

Considering the dichotomy of growth and CPI inflation, it is the CPI inflation which needs to be addressed immediately, as its reach and implications are vast and varied in the short term, especially during an election year when lots of unaccounted BLACK MONEY penetrates in to the Indian economic system, which can have detrimental effects on Inflation. Hence, considering the high current account deficit which stood at 4.65 in the first half of this fiscal, which will likely remain elevated in the near term along the CPI inflation, it is prudent for the central bank to overpower all the external pressures to not to affect rate cuts.

ADDENDUM: RBI Governor Duvvuri Subba Rao expressed his desire of seeing inflation between 4 to 6% and sees monetary stance as the front end tool to control inflation, which is a positive apolitical view. He also feels that the GDP growth can be accelerated through a string of logical economic & social reforms by federal government instead of relying on Monetary policy measures.  

EFFECT OF INDIA'S CENTRAL BANK RATES ON RETAIL INVESTORS

The Reserve Bank of India (RBI) raised benchmark rates thirteen times since March 2010, only to reduce them in April 2012. Consequently, speculation is rife among the economists that RBI may cut REPO rates (rate at which banks borrow from RBI) and Reverse REPO rates by 25bps in its monetary policy review meeting in January 2013.   

As a retail investor, let us broadly examine the repercussions of interest rate fluctuations. The interest rates prevailing in the economy have the following impacts on a retail investor:

a.     EMIs we pay, will be in direct proportion to the RBI’s bench mark rates.

b.     Returns that we generate on our small savings, will be in direct proportion to the RBI’s bench mark rates.

c.      Prices we pay for commodities (Demand & supply will have a major bearing) will be in inverse proportion to the RBI’s bench mark rates and

d.     The yields we generate on our fixed income portfolio, debt market and stock market performance. The chart below illustrates the bond yield and stock market dynamics surrounding changing interest rates.

Hence, the returns a retail investor generates out of his investment portfolio is a function of the prevailing interest rate and are well advised to be abreast with the interest rate fluctuations and monetary policy statements by RBI.

FITCH RATINGS: NEGATIVE OUTLOOK FOR MAJOR ECONOMIES IN 2013

There is a high probability of Major economies including US, UK and France to be downgraded in 2013, unless the twin deficits of their respective economies are narrowed.

 

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NOURIEL ROUBINI: 'PERFECT STORM' COMING FOR GLOBAL ECONOMY IN 2013

Nouriel Roubini is an eminent economist, who predicted the 2007-2008 Recession that shook the world.



Definitely, the world is not in an economic comfort zone. Discretion in speculative investments and spending is paramount for individual investors, in 2013 & 2014.
Control of TWIN DEFICITS; Current Account & Fiscal deficits will be necessary for all developed and emerging economies, for the long term health of their economies, which translates to higher taxes and less spending by sovereign governments. The world economies are highly coupled than ever before and effects of isolated economic tectonics, will be felt by other economics.
This scenario can, in a way, dent the GDP growth prospects and elevate the unemployment levels for many world economies including India.

 Disclaimer: Shared this video, available in PUBLIC DOMAIN, in public interest.