The European Central Bank (ECB) announced Friday it would start buying 60 billion euros worth of bonds from banks each month until the end of September 2016, or longer, in a step called quantitative easing (QE).
QE in theory increases the supply of money, something that keeps interest rates low and encourages borrowing and therefore spending. Here's how it works.
The central bank creates money, which will be used to buy bonds from financial institutions, this in turn will bring interest rates down and spur lending to businesses thus helping people to borrow more. This in turn should enable people and businesses to spend more boosting the overall economy.
But what has been the record of recent QEs in creating growth? The US Fed unleashed its third and biggest QE in September 2012. US growth in 2102 was 2.3 percent, 2.2 percent n 2013 and 2.4 percent in 2014.
Japan unleashed its QE in April 2013, with the BOJ agreeing to add 60-70 trillion yen in a year. What is Japan’s growth? Japan's GDP was 1.5 percent in 2013 and fell to 0.2 percent in 2014.
Recent QE's have not created growth but they have ruffled currency markets. From September 2012 when the US announced its QE3 up to May 2013 when the Fed decided to end QE, the dollar fell from 1.2 to the euro to 1.4, a fall of about 15 percent.
In April 2013 when the Japan QE was announced, the yen was 93 to the dollar, post its QE it has fallen to 118 to the dollar, a fall of 25 percent. Clearly QEs impact markets more than they impact the economy.
To discuss the impact of the ECB QE on the economy and on the markets, CNBC-TV18’s Latha Venkatesh spoke with Manoj Pradhan, Global Emerging Markets Economist at Morgan Stanley and Ankit Gheedia, Equity Derivative Strategist at BNP Paribas.
Below is the transcript of Manoj Pradhan and Ankik Gheedia's interview on CNBC-TV18.
Q: Do you think there can be an economic impact at all in Europe because of the QE?
Pradhan: They have already had a series of measures to increase the balance sheet and expand monetary policy impetus into the economy. Don’t forget we have had a series of long-term refinancing operations (LTROs) and main refinancing operations (MROs), which have pushed liquidities back into the system.
The banks then use part of that money to buy government bond yields. We had the very famous speech by [EBC chief Mario] Draghi, in which he promised to do “whatever it takes” and that together did bring down yields substantially. So, this is not the first installment of QE.
One of the concerns about the impact is whether it can further bring down yields which we have seen it do. It has brought down the euro but most importantly it gives a very strong signal about monetary policy intentions. We call this kind of QE where the central bank balance sheet has expanded proactively as active QE and that tends to give a pretty good signal about monetary policy intentions.
Q: It did certainly reduce yields and practically pulled some of the potentially exiting nations back from the brink but did it really improve the economy? We only see Eurozone getting into near deflationary status and even near stagnation. Do you see any economic improvement because of this 1.14 trillion euros?
Pradhan: There will an impact. How strong is questionable, because what is the role of monetary policy? The basic role of monetary policy is try and smooth cycles out. It cannot change the structure of the economy. If you are trying to compare, say, the US economy to the European economy, the latter has significant structural hurdles.
Part of the reason that is going into a disinflationary and deflationary period is because some of the structural impediments have not been cleared. Monetary policy cannot clear them, but what it can do is it can try to anchor monetary policy and inflation expectations to a higher level and if those inflation expectations are raised to a higher level then deflation and debt deflation then becomes a slightly smaller problem.
So, it is not that you can solve the economy’s problem but you can give it cyclical momentum that can persist for a period of time. Now what the economic impact will be depends on how far yields can go and as I said since yields have already moved down the marginal impact on this might be more a signal that says look, we will do pretty much everything that we can to make sure that inflation expectations move up.
So, yes, there will be an impact, how strong is frankly debatable but keep in mind that as the QE announcement has come in -- the growth story was already starting to lift. The purchasing managers indexes (PMIs) have already come in stronger.
I don’t think we should be attributing this to QE but it might be happy coincidence that the impact on oil prices also brings economic growth a little bit better than most people expect.
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Q: What about the impact from the currency angle? We have seen for instance in Japan the yen going all the way from 93 to 118 largely because of Abenomics and QE. What do you think will be the impact on the euro? We have seen a three tick move. Does euro get to 105 or even parity over the next 18 months?
Pradhan: The level you are talking about is more a question for our FX strategist but I will say that exporting deflation has been a strategy that has been pursued by central banks over the last five years and the ECB is no exception, BOJ is no exception.
In fact it was the US that started doing it first. It is very hard to solve these deflationary problems at home because as we just discussed they contain many structural elements to that, but trying to export some of that is not something that is unheard of.
In fact the opposite has been going on in the US with a stronger US dollar and in fact going along with it both those economies have been importing deflation.
The ECB has engineered a program that will help them to export some of that deflation and in that sense again the point of the euro is to try and manage inflation expectations, to try and push some of those deflationary pressures out and to the extent, we do see -- from our FX strategy point of view -- downside to the euro remaining in place for a while because European banks will start lending outside of the euro area. That is a move that can be sustained. If not there will be pressure on the central bank to do something again.
Q: Do you think that this very strong signal from the central bank at least papers over any exit fears? After all we have this huge anti-austerity move coming in from Greece through its elections? Do you think these political problems will be now papered over literally with more euros?
Pradhan: I do not think these programs are meant to address political issues. What we have seen from the Fed and the Bank of Japan (BOJ) and now the ECB have been responses to economic problems. They have been responses to disinflationary and deflationary pressures which at a very fundamental level challenge the mandate of the central bank. And that is why these monetary policy makers are responding.
Whether it helps to elevate some of the pressure, whether it affects some financial markets -- it lifts asset prices, it tries to give an impetus to economic growth and to that extent it does elevate some of the economic problems. However I do not think these things are meant to look at political problems.
Will it ease a condition for the euro area? Yes, of course it does and to the extent it helps.
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Q: How should the global economy read this event? Are we likely to see maybe such a strong dollar that the Fed will be forced to push back its hiking timetable?
Pradhan: To some extent you are already seeing some of that happening. At Morgan Stanley, we have been looking at the Fed hikes starting not before 2016 for quite a while now and things have obviously moved to do that.
Two things that have helped to reinforce that view: number one is there is a huge decline in oil prices, which has brought deflation into the US again. It is very difficult for the central bank to figure out whether deflation is coming purely because of oil prices whether it is coming because economic growth from November has slowed down or because the dollar has been stronger and the US has been importing deflation and probably some weakness in growth as well.
To that extent, if you look at market pricing of when the Fed is supposed to hike rates that has already moved down to October from July, which is a move and we think it is further going to go to January.
The thing to look out from a dollar strength and from a global point of view is yes this does help to the extent that our expectation about ECB policy and ECB led interest rates have now been pushed lower if have seen global yield curves all move down lower.
Ultimately what does this do to dollar probably pushes more capital into the US economy probably strengthens the dollar and possibly means a little bit more upside for economic growth over there. So, I do not think this fundamentally changes the picture and we would argue that it is ultimately the Fed that sets interest rates even though ECB and BOJ can help temper some of those increase.
Q: As a global emerging market economist what of your focus have changed because of this 1.14 trillion of your euro that will get printed?
Pradhan: It does help in two ways; number one it helps because it brings US interest rates lower because you tend to push as I said capital into the US economy. 10-year yields have already been low but they tend to get push down a little bit lower.
Second point is when you are exporting more of this deflation the US will import some more of it. So as you yourself said that will tend to push the Fed into hiking rates little bit later again turns out to be a little bit more supportive.
It does two things for emerging markets (EMs). It actually helps emerging markets to have more time on their hands to carry out their rebalancing process. Whereas, some very important processes are going in Russia, going to start in Brazil; India is on an early path of an expansion cycle. All these economies then tend to receive a little bit cheap capital. However, we do have to be mindful that this does not release economies that have a rebalancing process to do from their commitments.
What that means is as the interest rates get pushed down if US economic growth comes up stronger, then the higher interest rates and stronger US dollar will actually mean the downside could materially move up much faster so we are getting in sense a little bit more complacent as well while we accept help from the ECB and from the Fed.
Latha: When do you see this inflection point in Indian economic growth? We do not see it corporate numbers, we do not see it in the industrial output index. When do you see it coming up?
Pradhan: I am not really sure that there is going to be a massive inflection point or any of the like. I think what we likely to see is a slow move up in production: yes, it will come. We are probably closer to it than many might imagine -- probably couple of quarters and you will start seeing numbers that really do look like that we are on our path of a recovery.
What we are seeing very solidly is that there is a significant desire to invest in India. In fact when we talk to clients they are only surprised or if you do talk of a negative story which we do not have on India.
The sentiment is India has turned quite a lot this seems to be a very slow moving process it is the foreign direct investment (FDI) that will slowly start incentivising better production. However, do not forget the sentiment at home also has to change among the corporate sector for that to happen.
As of now what we see is a lot of concern that really there are no big bang reforms when our argument has been that India does not need big bang reforms. The level you are starting from: the technology embedded in the capital stock is so low that just physical capital accumulation through an efficient administration is enough to drive your trend growth up.
Frankly I would be quite worried if you have seen a strong inflection point in IIP and growth and all of those indicators and credit right now that is not what we mean if you want a sustainable boom to last many years. You want to see a slow and steady story you do not want to see a rapid expansion in economic output or consumption right now.
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Q: How will this 1.14 trillion get into financial markets?
Gheedia: In Europe, you have a QE where the gross issuance of government bonds is decreasing, plus you have a negative deposit rate. So, when central banks want to buy government bonds, they will have to buy from banks or other financial participants, who will become long cash and what they do with this cash is very important. Normally the in US and UK, when they did their QE, the banks who sold their government bonds gave the cash to the Federal Reserve. In Europe, they can't do that because there is a negative deposit rate.
So, what these financial institutions will do is to look for attractive carry trades, so the most attractive carry trade right now is the emerging market fixed income assets. So, with a bearish euro momentum more and more investors will look to invest in emerging market bond funds and benefit from a carry.
On the flipside, you have US that is getting into a rate hike cycle and from a US investor point of view they are already invested in emerging markets but they are not invested in Europe. So, US investors will move their funds out of emerging markets into Europe but European investors will move their funds out of Europe into emerging markets. Overall we see bullish emerging market fixed income and bullish to neutral emerging market equities.
Q: Which are your top equity markets now?
Gheedia: For 2015, we are quite bullish US equities in US dollar. In local currency terms, we think European equity should outperform, but with the current euro-USD bearish momentum, we think in USD terms European equity might not be able to outperform US equities.
Q: And if I were to press you for a third equity market, which will it be?
Gheedia: Potentially Japan. There is still quite a lot of room left for Abenomics to play out. There is short term bullish momentum and that can potentially lead to Nikkei outperforming.
Q: Then for BNP Paribas, where is India in the pecking order among equity markets?
Gheedia: In terms of emerging markets we are quite bearish. In emerging market we only like emerging Asia and in emerging Asia, Indian equities are one of the markets that we kind of like. But in terms of global equity market, we will be more bullish European and USA equities than any emerging market equity.
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