By Shyam Saran
NEW DELHI - The global economy is awash with successive waves of liquidity generated over the past few years by the four most advanced economies - the United States, the European Union, (EU), Japan and the United Kingdom, known as the G4. This liquidity has taken the form of "quantitative easing" (QE).
When zero rates of interest have failed to stimulate their economies, these countries have resorted to large-scale asset purchases by their central banks, such as corporate bonds or mortgage backed securities, to pump more money into the banking system.
The aim is to extend credit to business and industry and encourage consumption.
In the immediate aftermath of the global financial and economic crisis in 2008, when there was a danger of financial collapse, both advanced and emerging economies adopted stimulus packages, to revive demand, maintain trade flows and avoid large-scale unemployment. During the crisis phase of 2008/09, QE played an important role in crisis management, helping advanced and emerging economies alike.
However, while emerging economies have weathered the crisis and seen a revival of growth, the G4 continue to experience economic stagnation, depressed markets and large-scale unemployment.
Their response has been to persist with even larger doses of QE as a means of propping up demand, encouraging banks to expand and boosting stock valuations.
Before the crisis, the US held US$700 to $800 billion of Treasury notes. The current level is $2.05 trillion. In the latest round, QE-3, the US Federal Reserve is committed to the purchase of $40 billion of mortgage-backed securities per month as long as unemployment remains above 6.5%.
The European Central Bank (ECB) has pumped 489 billion euros (US$640 billion) of liquidity into the eurozone since the crisis, while in the United Kingdom QE has reached the level of 375 billion pounds (US$577 billion).
Most recently, the Bank of Japan has decided to pump $1.4 trillion in the next two years into its economy, aiming at a 2% inflation rate by doubling the money supply.
The assets of the G4 central banks have expanded from a figure of 11-12% of their gross domestic product (GDP) to the current unprecedented level of 23%. These assets were $3.5 trillion in 2007 before the crisis. They are now $9 trillion and rising. This is the scale of liquidity expansion we are dealing with.
Since interest rates in the G4 remain at zero and their economies remain stagnant, it is inevitable that there will be significant capital outflows to emerging and other developing economies, in quest of higher risk-adjusted returns.
According to one estimate, about 40% of the increase in the US monetary base in the QE-1 phase leaked out in the form of increased gross capital outflows, while in the QE-2 phase it may have been about one-third.
This massive and continuing surge of capital outflows to emerging and other developing economies is having a major impact. Corporations which have a sound credit rating are taking on more debt and increasing their foreign exchange exposure, attracted by low borrowing costs.
Their vulnerability to future interest rate changes in the developed world and exchange rate volatility will increase. Such inflows put upward pressure on exchange rates, stimulate credit expansion, and cause inflationary pressures, which pose a major challenge to policy-makers in the developing world.
Most of the capital inflows are in the nature of portfolio investments, which are prone to sudden and volatile movement and puts emerging economies at greater risk. The volatility one has witnessed in the Indian stock market is a case in point. In general, we may conclude that the overall impact of these capital flows is expansionary and distortionary.
There has been considerable criticism of the G4’s unconventional monetary policies from the emerging economies, including the BRICS (Brazil, Russia, India, China and South Africa).
The magnitude of QE has had unintended consequences beyond the borders of the G4, especially because their currencies are not only fully convertible but, together, constitute the pillars of the global financial system.
The US dollar is the world’s leading reserve currency, and the euro, the British pound and the Japanese yen together constitute the basket of currencies the International Monetary Fund uses to value its Special Drawing Rights. Thus, the nature of the G4 currencies and their significant role in the global financial market ensures that QE undertaken by them has a global impact on economies across our globalized and interconnected world.
It is necessary, therefore, for the G4 to act with great responsibility and to work together with the emerging economies, to minimize the adverse effects of their QE policies. It would be particularly important to forge a consensus on how to handle the potential financial turmoil and disruption that may afflict developing economies once the QE is sought to be retired and interest rates once again become positive in the G4. The sudden and large-scale reversal of capital flows is a likely scenario that would need to be anticipated and managed.
The Asian financial crisis of 1997/98 was, in part, triggered by an earlier version of QE pursued by Japan in the aftermath of the bursting of its property and asset bubble in the early 1990s. Then, too, the large inflow of low-cost yen loans led to the asset price bubbles, inflationary pressures and currency instability in the Asian economies. They paid a heavy price in the bargain.
A larger, more pervasive crisis may await the emerging and developing economies unless there is a much more coordinated and careful handling of the risks that are already building up. The G20 should have this issue at the top of its agenda.
Former Indian foreign secretary Shyam Saran is current chairman of the Research and Information Systems for Developing Countries and senior fellow at the Centre for Policy Research in New Delhi. |
