It turned out to be a real humdinger of a fortnight for policy decisions from the Western hemisphere. The European Central Bank (ECB) did not disappoint, putting in place a mechanism for unlimited bond purchases from the beleaguered euro-zone periphery in its monetary policy announcement on September 5. The German constitutional court decided on Wednesday, September 12, that it was okay for the Germans to participate in a permanent bailout facility for the region, the European Stability Mechanism (ESM), as long as they don’t go overboard with their contribution to the fund.
On the same day, European Commission President laid out the contours of banking union in the region that, once fleshed out and implemented, could go a long way in preventing a banking or fiscal crisis in the future. Finally, the US central Bank or the Federal Reserve Bank announced its third quantitative easing (QE3) policy on Thursday the 13th, committing to infuse $40 billion a month by buying back mortgage-backed securities from the markets until economic conditions in the US improve palpably.
The challenge in attempting to make sense of these reams of policy is to strike a balance between the nuances and the broad messages of the policies. Some attention to detail is critical. For one thing, despite the apparent similarities between the ECB’s bond purchase programme and the Fed’s QE, there are key differences. The ECB facility is a contingent facility and will kick in only if any of the fiscally-stretched economies like Spain approach the ESM for succour. The Fed’s QE is not a contingent facility and commences immediately.
The other major difference is the fact that while the ECB will “sterilise” the liquidity created through bond purchases, the Fed will not. The US monetary authority will allow the liquidity that QE3 generates to flow into the markets. This would, among other things, push the interest rates on housing loans down and, hopefully, spark a revival in the housing market. When central banks buy bonds, they use freshly minted money or liquidity to make these purchases. If they are uncomfortable about this excess liquidity sloshing around, they could choose to mop it up by either selling other bonds in the market or taking in deposits from market participants, particularly banks. This is sterilisation.
There are a couple of implications of this. First, the pop that we have seen in risky assets across the board will be driven by dollar and not euro liquidity. Prices of these assets will gain and the dollar will depreciate against these. There’s another way of looking at this. Since the ECB bond-buying will not create excess euro liquidity (because of sterilisation), while the Fed has turned on a spigot of dollars, the number of dollars per euro will increase substantially. In short, the dollar will depreciate against the euro. This, in turn, will reflect in the fact that while dollar prices of assets, currencies and commodities increase, their euro prices or exchange rates stay stable. The rupee, to take an example, could gain sharply against the dollar but not against the euro.
Some of this depreciation in the dollar-euro pair appears to have happened over the past couple of weeks in anticipation of QE. I wouldn’t be surprised if there’s more upside left in the euro’s path, especially since the policy initiatives from the region have been strong and, thus, the currency has more “fundamental” supports apart from the pure liquidity effect.
The rupee has, like other non-dollar currencies, seen a fairly significant rally both in the build-up to QE3 and in the wake of the announcement itself. The fact that the QE3 news came on a day when our own government decided to announce fairly hefty increases in fuel prices just added to the currency’s momentum. If the Reserve Bank of India (RBI) decides to reciprocate this fiscal initiative with a cut in the repo rate, more appreciation could be on the cards as investor sentiment gets another boost. But how high can the rupee go? To answer that, we need to remind ourselves that the same surge in liquidity that is pushing Indian asset prices up (including the currency) will also push up global commodity prices. For a net commodity importer like India, that means a growing current account gap that will act as a natural brake on the currency.
Second, RBI desperately needs to replenish its stock of foreign currency reserves to be prepared for another round of pressures on the currency. (Since September 2011, it has lost a staggering $30 billion from its reserve chest in its bid to stave off periodic “runs” on the currency) In short, RBI is likely to buy dollars as the supply of dollars goes up. This could also prevent any major appreciation in the rupee.
The funny thing is that very few analysts expect QE3 to really help in getting the US economy back on the rails. Thus, after “reflating” the prices of assets and commodities for a period, it might lose its sizzle. Markets will go back to fretting about more basic issues regarding the world and the US economy. Monetary expansion will have only a limited impact. The US will have to find a way to curb its massive budget deficit without hurting growth too hard before the markets are really convinced that the worst behind us.
The author is with HDFC Bank. These views are personal
