Often likened to financing fiscal deficits overnight, Quantitative Easing is meant to prevent unwarranted tightening during times of stress.
Several emerging economies have responded to the financial shock from the COVID-19 pandemic in a rather dramatic fashion. The pandemic and the ensuing fallout in terms of twin demand and supply shocks — and all this amid a persistent shortfall in public finances — induced Emerging Market (EM) governments to seek swift and innovative solutions.
Quantitative Easing (QE) and its variants have been popular for a while. Often likened to financing fiscal deficits overnight, QE is meant to prevent unwarranted tightening during times of stress. Normally, one would assume that only the most advanced economies like the US, EU, and Japan would implement it as a last resort for stabilising the economy in the face of recession; that is when the official interest rate has touched zero (effective lower bound) and cannot be reduced further. However, many EM countries have plunged into their self-styled versions of QE programmes with policy rates well over zero, citing the need to quell market dysfunctions and ease liquidity conditions over the short run. Against this backdrop, EM policymakers have tried to reconcile concerns of inflation and debt sustainability with claims of adequate forex reserves and manageable current account deficits.
Quantitative Easing or QE is an unconventional monetary policy that implies printing new money to purchase government debt and other financial assets when interest rates have already hit zero. As per the experience of advanced economies, the rationale behind this is to boost economic activity by creating new bank reserves. These new reserves are meant to normalise credit markets during crunches. But QE is often undertaken by emerging markets under different circumstances altogether. In such cases, central banks are called upon when the government faces temporary yet intense fiscal pressures. And this is also where the real risks come in.
Central banks cannot keep printing currency indefinitely by buying bonds to alleviate the stress from deteriorating fiscal dynamics. Printing money beyond appropriate limits may spark inflation fears and erode confidence in the local currency. The unsustainability of debt monetisation can spook international investors and the resultant outbound capital flows will worsen the exchange rate. At the extreme, their departure can bring a full-fledged currency run. Therefore, it is the perception of government solvency which makes the state robust against debt rollover risks.
In the context of QE deployment, it is also important to underscore the difference between the role of core currencies (say US dollar, the Euro) and peripheral currencies. Only the former currencies are truly global in the sense that those are demanded by both foreign and domestic market participants while the latter ones are only domestically demanded. Peripheral currencies are also often undermined by historical episodes of currency and debt crises, high inflation and limited credibility, and the fragility of financial sectors and political systems. This is what instentifies the possible risks posed by QE in EMs (compared to the more advanced economies).
Instructively, during times of panic, investors rush into the safest assets like US treasury securities. This usually happens at the expense of other less mature economies that face significant capital outflows. As a result, many EMs face rising bond yields and a higher term premium, which is the extra compensation offered for bonds with longer maturities.
As a matter of fact, several EM economies faced unprecedented capital outflows and subsequent spikes in bond yields earlier this year caused by a sudden investor panic. Simultaneously, most private asset markets, say stocks, bonds, commodities, and property, also came under stress as liquidity dried up. At least 20 EM central banks, fiscally stronger and vulnerable ones alike, have since resorted to some form of asset purchases on top of sharp interest rate cuts, to backstop the economy by stabilising financial markets. And so far for most EMs, these thick and fast measures have not been counterproductive.
Interestingly, at the time of QE introductions, only Croatia and Chile were close to zero while Poland reached there slightly later. While this first group of EM central banks chose to engage in QE only after exhausting the space for further rate cuts, a second group dived in with largely fiscal (instead of monetary) objectives. Central banks in Ghana and the Philippines cited exceptional circumstances and openly offered lifelines to their governments by purchasing sovereign debt to ward off excessive pressure. Lastly, central banks in South Africa, Thailand and India among others, which constitute the third set, merely undertook the role of a market maker to bolster confidence in private investors. Their intent was not just to raise bond prices, but to simultaneously tighten the spreads (otherwise large gaps between the bid and offer prices) and reduce its volatility.
Apparently, the good news is that the presence of central banks in asset markets brought a soothing effect on private investors. These measures have contributed to falling yields on government bonds, between 20 and 60 basis points, as per the IMF. The term premium has also normalised to a significant extent, partly offset by central banks’ swapping shorter-term securities for longer ones. Moreover, domestic monetary conditions eased in the short term as liquidity returned and credit spreads tightened. And with a few exceptions, these measures barely led to any currency depreciation in EMs. All in all, early evidence certainly appears favourable.
Notwithstanding the short term gains, it is not difficult to see why QE is often seen as high-risk advice for EMs. Public debt and deficit levels are likely to worsen further owing to lower expected revenues and growing expenditures. Output and employment parameters will take time to recover. And given the limited funding capacity of multilateral lenders and the growing reluctance of international capital markets, central banks may be required to address the financing gaps with monetary stimulus. However, this option is not suitable for all EMs as there are major risks associated with systematic forays into the bond market. In fact, intense injections of liquidity can damage the credibility of central banks greatly and cause inflationary shocks, currency runs, and exchange rate instability besides the possibility of debt distress and worsening private sector balance sheets.
At this juncture, Brazil, Colombia, and Costa Rica are among those facing challenging debt dynamics. Brazil is perceived to be the riskiest of all, because of its reluctance in adopting reforms amid a high public debt burden (86% of GDP). Costa Rica, meanwhile, has been facing a steep interest payment burden, reflected by loosening credit spreads, since its economy went into a tailspin.
Similarly, Turkey, Poland, Hungary, and India are among those facing inflationary risk. Yet the capacity to manage this risk is different in different countries. Illustratively, at one extreme, Turkey has been grappling with double-digit inflation and negative real interest rates for a while. Capital flight led by foreigners has sent the exchange rate plunging of late. On the other end, annual inflation in India has also increased in recent months owing to a spurt in food and fuel prices. But a relatively modest import dependence and the credibility of its central bank are probable factors setting India apart from other fiscally fragile EMs like Turkey.
Lastly, tapering QE measures after attaining its objectives is just as crucial. As of now, a majority of these central banks have refrained from setting limits in terms of time-frames and the size of QE packages. It is thus only natural to be concerned about whether these measures are actually temporary. Poland and Indonesia are prime suspects in this context, after having monetised debt upto levels as high as 4.6% and 6.8% from March to August respectively. Poland especially is causing worries that its central bank could be on its way to finance the entire fiscal deficit for this year, which stands at about 8% of GDP.
Finally, it is worth noting that only strong and credible central banks are able to pull off unconventional policies successfully over the longer run. EM central banks with weak and unstable currencies should understandably be more cautious when it comes to unconventional monetary policies. These are extraordinary circumstances and it may be wrong to assume that investors would continue reacting the same way as intervention becomes routine. Moreover, the ‘perfect’ QE dose may be awfully difficult to calibrate. So, if QE is too large and pumped for too long, medium-run borrowing costs (as reflected by the term premium) may rise, implying serious ramifications for the overall fiscal position.
But there are other less tantalising alternatives to QE. Moderately increasing public debt, reprioritising spending, and seeking assistance from multilateral institutions offer some options. In all fairness, QE in emerging markets has so far been encouraging. But this trailblazing effort may not prove too innocuous if carried on for long.
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