The initial euphoria following the United States Federal Reserve’s announcement that it would buy bonds worth $40 billion every month – what is generally being called the third round of the Fed’s quantitative easing, or QE3 – has largely dissipated. European stock markets are back to worrying about the euro, and all benchmark indices in the United States responded negatively to bad data about the state of US manufacturing. Indeed, it appears that at least some of the expected gains from QE3 had already been priced into the market. But the question remains: what are the lessons of the previous rounds of QE for Indian investors and policy makers? And will the effects be the same this time around?
There are two simple ways to think of QE. The first is to recognise that, as an increase in the balance sheet of the Federal Reserve, it decreases the value of the US dollar compared to that of all other paper. In other words, the rupee should get a bit of support. Then there is the point made by Ruchir Sharma in a widely quoted recent article for the Financial Times, that it essentially attempts to create a “wealth effect” by increasing the nominal value of assets in order to support asset markets and stimulate spending. Mr Sharma said that this effect – that people might sense that their shares, their retirement accounts and their houses are now more valuable, leading to consumer spending – will be more than counteracted by the “income effect” of higher commodity prices. Quantitative easing will, thus, have a broadly negative effect on the real economy, and increase the already existing inequality between those with financial assets and those without.
The effects on India will be similarly double-edged. The inflation of the value of financial assets, and the fact that the United States will not be a suitable destination for investment any time soon, means that QE will increase risk appetite in the world’s markets, and increase flows to emerging markets. That will support both the rupee and the Indian stock markets. Among the BRIC countries, Russia’s stocks have benefited the most, and China’s and Brazil’s the least. India’s stock market continues to outperform analyst reports, recently hitting a 14-month high, and the QE effect will likely keep that going for some time.
On the flip side, however, there is no doubt that oil is headed back up, taking many other commodities with it. At the height of previous episodes of quantitative easing, the price of oil easily crossed $120 a barrel for lengthy periods. High fuel prices will not only further stress the fiscal deficit, but the current account deficit as well — especially since QE3’s impact on the real economy globally, and thus on India’s export demand, might well be limited. The Rs 5 increase in diesel prices will be wiped out soon enough, by this analysis, turning fiscal correction into an elusive target. Certainly, the availability of increased liquidity worldwide and the inflationary pressures of higher commodity prices will not help convince the Reserve Bank of India to cut interest rates. Indian manufacturing’s recovery, too, is likely to be delayed by higher input prices. The government must not be seduced by the stock market’s gains; the costs of the Fed’s money-printing must be watched out for, as well.
