QE is not a Helicopter-Drop!

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QE is not a Helicopter-Drop!
2010年11月18日
According to the Institute for International Finance, net external private capital inflows into Emerging Markets in 2010 will reach$825 bn, far ahead of the$581 bn in 2009. With the US Fed adopting QE2, these flows have obviously intensified in recent weeks, and may yet increase further in the months ahead. What should the recipient economies, particularly Hong Kong, do in the face of these massive inflows to ward off asset bubbles and avoid the painful consequences of a bursting bubble later on?
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John Greenwood

To understand the overall situation we need to be clear about what is happening in both developed and emerging economies because current business cycle conditions in each are very different.
First the developed economies. During the credit and housing bubble of 2003-08, households and financial institutions in the US, the UK, Spain, Ireland and elsewhere became seriously over-leveraged, and now require an extended period of balance sheet repair. While this balance sheet repair is on-going, bank lending has been shrinking and is likely to remain very slow, credit growth is very weak, and money growth is very low. Already broad money(M2, M3 i.e. the currency plus bank deposit liabilities corresponding to bank credit) in the US, the eurozone and the UK are at their lowest post-World War II growth rates, and outside the banking systems there is credit shrinkage. This means that in 2011-12 there is much more risk of deflation in developed economies than inflation.
But what about QE and QE2? Surely that will generate inflation?

No, not necessarily!! Most people have a huge misconception about QE. They think that money is created by a kind of helicopter-drop of banknotes, but this is false. In a modern economy, money is created principally by commercial banks making new loans, and as we have just seen, because households and others are repaying debt, there is virtually zero growth of bank lending in the developed economies.
QE means the central bank expands its balance sheet by purchasing Treasury bonds(or other securities), but so far the main counterpart to that has been a huge increase of excess reserves of banks at the central bank, and a contraction of the money multiplier. For example, out of the Fed's current balance sheet of$2.125 trillion, no less than$1 trillion is bank reserves. Similarly at the Bank of England, out of a total balance sheet of? 50 bn, no less than? 50 bn is bank reserves. In other words, commercial banks are risk averse; they are building up capital and liquid assets; they are not lending to customers.

Consequently there is currently no threat of inflation in developed economies. However, because deposit interest rates there are virtually zero, there is a huge arbitrage or carry-trade between the developed markets and the emerging markets of Asia and Latin America where interest rates are higher and growth is strong. In fact interest rates are likely to stay low in the developed markets for an extended period, just as they did in Japan under QE. That resulted in a huge, multi-year yen-based carry-trade, but no inflation in Japan.
Second the emerging markets of Asia and Latin America. Most of these economies had serious banking, currency and debt crises in the 1990s. Mexico triggered the Tequila crisis in 1994-95, Brazil undertook a currency reform in 1995-96 to end hyperinflation, and Asia had its financial crisis in 1997-98. Since then these economies have undertaken balance sheet repair, and by and large they did not participate in the credit and housing bubble of 2003-08. Consequently in the major sectors- household, corporate, financial and government sectors-- they mostly have balance sheets in good shape. As a result, when the global financial crisis occurred in 2008-09, they were able to cut interest rates and see monetary and fiscal policy gain traction quickly(in contrast to what has happened in the developed economies where monetary and fiscal policy have not gained traction).

Policy-makers in the developed economies are likely to struggle to get monetary and fiscal policy to be effective over the next few years. The reason is that when balance sheet repair is on-going, bank credit and money growth remain stagnant, and interest rates will remain low. This means the carry-trade and inflows to emerging economies will escalate.
Policy makers in the emerging markets have three choices:(1) they must either allow their currencies to appreciate to avoid a monetary explosion, or(2) they must keep their currencies stable against the dollar but sterilise the net inflows to prevent inflation(as China does), or(3) they can impose some form of capital controls(as Thailand and Brazil have done).
Hong Kong's case is a little different because the currency cannot appreciate, yet Hong Kong will be reluctant to sterilise, and Hong Kong will definitely not impose capital controls. The key lesson of the recent bubbles is to avoid leverage. In my view the crucial task, therefore, is to use macro-prudential measures to prevent leverage from building up-- either in the household sector or in the financial sector. If necessary, tighten the loan-to-value(LTV) ratios for home mortgages to ensure households don't over-borrow, and ensure that banks have ample capital, while monitoring their derivative positions, their inter-bank borrowing and other wholesale market activities.

There is not much Hong Kong can do about low interest rates in the developed economies. But if a bubble does develop, then provided Hong Kong banks and households are not leveraged, the damage on the downside will be limited.