INDIA ECONOMICS: US Fed Quantitative Easing-II, and what it holds for India
The QE-II measure by US Fed is expected to be largely beneficial for India irrespective of its likely impact on US recovery. At the margin, increased money flow expected to India would ease financing constraints for both Indian corporates and the Government. It is likely to have a more sobering impact on interest rates in different financial market segments. However, it is likely to lead to further rally in asset prices and complicate RBI’s monetary and currency management apart from heightened stability concerns.
The US Fed Measure
- The minutes of the US Fed FOMC meeting and the pronouncement of officials contain an indication that the Fed “is prepared to provide additional accommodation if needed”, widely touted by commentators as Quantitative Easing – II (QE-II). The measure comes on the back of reduced growth estimates by Fed staff.
- However, no indication of timeline or the magnitude of easing has been spelt out. The market appears to have put the November 3 Fed meeting as the date of announcement of ~US$700b purchase of Government securities.
- The financial market has already started discounting QE-II with 10-year treasury yields falling to a new low of 2.42%, dollar losing ground (Dollex at 78) and a rally in commodity prices (e.g. oil around US$84-5).
- The measure is likely to have widespread implication for the world financial market and is being intensely debated. Following is a snapshot of arguments from both sides.
PROPONENTS OF QE-II |
| OPPONENTS OF QE-II |
- It might give visibility to a low interest rate regime for a long time to come. This would encourage producers to demand credit and consumers to borrow again to finance durables. |
| - With NBER announcing an end of recession in June 2009 the economy is likely to recover lost ground slowly if policymakers don’t meddle too much. |
- With concerns over sovereign debt plaguing the market and Government deficit and debt already stretched there is very little room for fiscal policy action. Hence the focus on monetary policy. |
| - A decade of glaring failure of quantitative easing followed by Japan since 2000. |
- With policy rates brought down to near zero levels and the economy still not out of the woods, quantitative easing is the only other form of stimulus left in the armor of the policymakers. |
| - In Keynesian theory the present situation could be described as a copybook situation of “liquidity trap” – that the market would continue to demand any amount of liquidity at low interest rates without creating any real demand. Monetary policy would fail in such a situation with only fiscal stimulus succeeding to correct the situation of demand deflation. |
- While asset prices may rally in the first round, commodity prices may follow, encouraging higher production and finally propelling the economy out of slowdown. |
| - Simply pumping money into the system would lead to asset price bubbles without any material change in general price levels and definitely much lower impact on real production and employment. |
- QE-I can be termed as a reasonable success with troubled companies successfully redeeming their assets ensuring reasonable return. |
| - It’s a risky strategy that might lead to spiraling prices and hyperinflation. |
- The possibility of Fed balance sheet shrinking the QE-I was viewed by the market as a de facto tightening and it became necessary to take incremental easing measure to send a strong message of continuance of policy regime. |
| - It would lead to a sharp correction in the value of dollar and therefore would fuel a world commodity price rally. The policy means an effective devaluation of dollar and de facto US joining the currency war along with China. |
Monetary involution likely if Government securities don’t replace retiring private credit in FED balance sheet
Implications for India
The move will have major implications for India’s financial markets through four channels, viz, i) money flow, ii) interest rates, iii) asset prices and inflation and iv) monetary policy. Needless to add, the expectation channel would act on top of all these and perhaps much ahead of real measure and its consequence being played out.
Money flow
- It has been estimated that global funds have nearly US$1.7t as AUM and close to ~US$300b is dedicated for emerging markets and Asia. Besides, Indian portfolio seems to be undergoing a phase of rebalancing more accurately reflecting its MSCI weight. It is likely that a part of the quantitative easing would find its way through emerging markets this may lead to an increase in FII flows from the current US$2-2.5b per month to US$3-3.5b.
- Excess capital flow would enhance the financing constraint for the Indian corporates directly as FIIs have been actively participating in the huge line up of IPOs of ~US$20b as well as Government securities (due to an enhancement in the regulatory limit on Government securities holding).
- Indirectly, this leads to an increase in the balance of payments surplus that would help creation of monetary base at a time when deposits (~14%) are lagging behind of credit growth (~20%).
Interest rates
- By easing the funding gap, it is likely to have a sobering impact on the interest rates of various segments of the financial market most direct being the impact on Government securities market where the interest rate differential between US and India is ruling close to its historical high and therefore likely to come down.
- Secondly, by reducing the funding gap and facilitating direct substitution of bank credit by foreign sources of funds, the move is likely to put a downward pressure on lending rates as well.
US and Indian yield differential near its historical peak and likely to come down
Asset prices and inflation
- The move is likely to fuel further liquidity driven rally in the Indian markets. Concerns have been expressed in various circles about sharp rise in equity and housing prices, necessitating a cautious approach for both market participants and regulators.
- The dollar going down will have implications for world commodity prices. This means India’s already challenging inflationary situation might be complicated further as the benefit of benign international prices enjoyed so far would no longer be there.
- With oil prices firming up and outlook further hardening it would have a direct impact on India’s inflation and already challenged inflationary expectations. Besides, international food price outlook has also become complicated due to drought and wildfire in Russia and Brazil. These factors may wane India’s high base advantage and the impact of a good monsoon on a significant part of the commodity basket used for compilation of inflation.
Monetary policy in India
- The move complicates conduct of monetary policy a great deal for RBI. On the one hand, RBI’s tightening measures would to some extent be nullified by a super-loose monetary policy in the US through ways described above. On the other hand, it would renew concerns of financial stability leading the Central bank to take incremental regulatory policy (e.g. increasing risk weight of lending to housing, real estate, equities and commodities) in its mid-term review of policy scheduled on November 2, 2010 (just a day prior of Fed meeting and hence not having the benefit of hindsight of Fed measure).
- A second challenge may emanate from hardening outlook for Rupee. India has so far not joined the currency war led by China and joined by many other export oriented countries including Japan, South Korea, and Switzerland. With much higher inflation in India, RBI’s non-intervention is likely to lead to further appreciation of real as well as nominal Rupee, adversely affecting India’s export prospects. However, the move would ease the money creation process and balance of payments position at a situation when an increased current account deficit has prevented accumulation of capital flows.
