Friday, September 21, 2012

Too much is too bad!?


Massive injection of stimulus by world's largest central banks is the highlight of the week.  European Central Bank has pledged to buy debt from Euro zone countries to contain borrowing costs earlier this month.  This was followed by US Federal Reserve's open ended QE3 (announced last week) through which the central bank would buy $ 40 billion a month in mortgage backed securities until the economy recovers. BOJ's decision to opt for easy money policy is not only to give impetus to ailing economy but also stop yen from appreciating any further to help protect country's exporters. It's highly likely that Bank of England would soon unveil additional measures to stimulate growth.  

The ultimate goal of intervention by central banks is to be able to influence prices and return on financial assets and hope to have an impact on businesses by lowering borrowing costs and also encourage households to spend in order to boost the economy.  Inflation and asset price bubble (triggered by easing) are concerns but global economy that is on life support currently is a bigger concern. Concerted effort by major central banks increases the potency and this time around we may see demand getting spurred. Investors and financial markets across the globe have been exuberant and they expect central banks' actions to play out for considerably long period. 

What is quantitative easing? Central bank plays an active role in the economic and financial functioning of it's country through monetary tools.  Most widely used tool is setting short-term interest rates in order to influence economic trends.  As we all know low rate policy is prescribed when growth needs to be stimulated and interest rates are set higher when inflation needs to be contained.  Growth is the need of the hour; however Federal Reserve for one has set the interest rate close to zero (for some time now) leaving no room for further reduction to boost growth.  The next  available option is to pump more cash into the system.  This cash is intended to buy bonds and financial assets from banks, leaving the banks liquid so they in turn justify their existence by continuing to lend to businesses.  Business expansion is expected to result in increased employment opportunities and everyone lives happily ever after; well, at least in an ideal world.  

How is easy money elsewhere, is affecting us at home? Since last week, amid flurry of freebies from central banks, Indian equities and Rupee have been beneficiaries.  Investors are flocking to countries and assets which promise more attractive returns than rock bottom rates offered by the US, Euro zone and Japan.  Now with the promise of printing money to infinity (well, close to it), there is more cash (likely) chasing Indian and other emerging market assets.  This hot money would push our central bank to review it's monetary policy in order to (1) keep inflation at bay which is an immediate concern (2) fight against untoward rupee appreciation (as and when).  

Will the easy money push inflation up in US and Euro Zone without any positive impact on demand and output?  Once the factory activity is in full swing and unemployment is under an acceptable level, it is more likely that  (continued) monetary stimulus could prove to be inflationary.  It looks like we are quite a few quarters (if not years) away to get there.  Till then, too much money doesn't seem too bad, honey!


Thursday, September 6, 2012

What's in store for Euro zone?


European debt crisis, simply put, is inability of some of the countries (Greece, Portugal, Ireland, Italy and Spain) in the region to pay back bondholders. Slow down in global economy made it unsustainable for countries with loose fiscal discipline. Greece for instance, (which historically ran high budget deficit) was the first to go under with its growth and tax revenues falling.  With increased sovereign risk, investors' expectation of returns has been going up pushing the bond yields of some of the countries in the region.  This is a vicious cycle -  higher bond yields mean higher fiscal strain which prompts the investors to demand even higher yields and this could go on.  

EU (along with IMF and EFSF) has been bailing out Greece, Portugal and Ireland.  European Central Bank announced a plan to purchase government bonds in order to contain the spiraling bond yields of countries like Spain and Italy.  Also through it's LTRO (Long Term Refinancing Operation) made credit available to troubled European banks at very low rates.  While these help stabilize the financial markets in the short term, they have been "kicking the can down the road" and postponing a more decisive step to a later date. 

So where is  EU and Euro headed? Nouriel Roubini, the economist credited with having foreseen the credit crunch has warned that euro zone will collapse within this year;  Nassim Taleb (author of Black Swan) also opines that the end of common currency is no big deal.  Structural flaws that remain in the European Monetary Union need to be addressed; but does the measure have to be extreme?  There are a number of ways that this crisis could play itself out.  We briefly discuss here a few scenarios that could be potential resolution to this now almost three year old crisis. 

Greek (Or peripheral)  exit: Tax payers of other nations (Germany for instance) of the union may push for this.  The short term impact for Greece may be quite severe; however in the long run they may be able to rebuild credibility through tighter fiscal measures and sustainable competitive advantage.  Euro zone may not be significantly impacted by Greece exit per se, provided it works on preventing contagion effect. 

New improved European union Or a full break up: The existing union with its structural flaws seems unsustainable and may pave way to a new, core and better regulated currency union. The resultant "new" euro (or its derivative) could be a far stronger currency.  The weaker members who leave the union may have to devalue their currencies to remain competitive.  But will this be the preferred path with export heavy Germany currently benefiting from a weak euro? Or all this pressure of austerity will lead to a full break up of the union?  

Fiscal union Or monetary expansion:  Fiscal union in the real sense of the term, I mean. Will there be political will to give up sovereignty and readiness to issue what you may call, Euro bonds? Else, Significant monetary expansion or liquidity injection by ECB to protect vulnerable banks and countries could be a potential resolution.  However what will this do to inflation is anybody's guess!

The probability of Greek exit and / or use of monetary expansion as preferred tool seem high, at least in the near term.  Break up of the union? Nah, what with ECB President Mario Draghi claiming (this evening) that "Euro is irreversible" and that "Fears of Euro reversibility are unfounded"!