ECB's bond purchases & anticipated US Fed's QE3 to revive Global Economy

ECB( Europe’s Central Bank)  president Mario Draghi unveiled details of a new bond-buying program, known as Outright Monetary Transactions, or OMT’s early last week to reinvigorate and stimulate ailing Euro Zone. 

 It plans to bail out governments through OMT as against LTRO (long term refinancing operations, which it did earlier). While Germany was the sole country against this ECB decision, the others felt that this had to be done.

Also ,speculations are rife in markets around the world that Federal Reserve (USA’s Central Bank) will start third round of Quantitative Easing (QE3) with economic recovery weakening and latest employment figures disappointing the market expectations with only 96,000 jobs created last month against 1,24,000 last yr.

 

As per the Wikipedia definition , Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective.

Its called unconventional because  a central bank implements quantitative easing by buying financial assets from commercial banks and other private institutions with newly created money,  in order to inject a pre-determined quantity of money into the economy as against the more usual policy of buying or selling government bonds to keep market interest rates at a specified target value.

 

 So ,it is the last resort for Major Central Banks  of developed countries stymied by slow economic prospects. Their central banks have lowered their benchmark rates to close to zero (0.25 for Fed and 0.75 for ECB).Looking at its history ,QE1 and QE2 were unsuccessful in achieving its objective to its core ,but QE3 is unavoidable looking at current state of US economy ,biggest growth engine of World economy.

Another positive news came from China , the world's most voracious consumer of raw materials giving  green light for 60 infrastructure projects worth more than $150 billion as it looked to energise an economy troubled in its worst slowdown in three years, fuelling expectations that the world's fastest growing juggernaut  may get a lift from the fourth quarter.

 

Markets reacted drastically with huge positive gains in main stock market indices ,US Dow Jones ,Germany DAX ,Japan’s Nikkei showing gains of  range of 0.5-2 % on single trading day  and rise in prices of Commodities mainly Gold ,the yellow metal which is mainly used as inflation hedge.

 

Outcomes of these measures are expected to create the following conditions :

 

The first is that the Bond markets will get distorted in these two regions (US & Euro region)  because market forces will be influenced heavily under the discretion of  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, these funds might provide immediate liquidity , but major relief  will be given  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 decisions  on GAAR and retrospective taxation, which were the main hindrances to foreign investors. It garners well for our capital market too because more money will provide a boost, which in turn can encourage 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 speculative news 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 inflation will spike . Too much money floating around has a dual impact on inflationary conditions. 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, although  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.

Hence , more foreign funds and global recovery are good for all countries, though it will challenge policies of major countries Worldover.