Since the 2008 global financial crisis, the developed world has entered a deflationary environment due to overwhelming government debt. For many years, these governments have run deficits and increased debt load, and now deflation is magnifying the debt load.
To solve this deflationary problem, governments around the world have elected to venture into Quantitative Easing (QE) in the hope to cause inflation which would shrink their debt load. QE is essentially solving a debt problem by issuing more debt. However, high levels of inflation may destroy the currency.
In January 2015, ECB announced a huge asset-purchase programme, worth around €1.1 trillion, in a bid to resuscitate the struggling European economy. It would involve the ECB and the individual national central banks buying sovereign debt from the Euro Zone. This unconventional policy began years ago when the US Federal Reserve, the Bank of England and the Bank of Japan embarked on monetary stimulus in an effort to kick-start their failing economies by boosting inflation.
The QE programme, together with existing schemes, will release €60 billion a month into the economy. The aim of QE is to create inflation by boosting economy growth and ward off deflation by lowering borrowing costs and depreciating the currency to encourage exports and tourism.
The Euro has been sliding for six months and after the implementation of QE, on January 30, the Euro plunged to 1.1291 against the greenback, hitting fresh 11-year lows.
One important thing to note in this programme is the risk-sharing ratio, being 20% going to the ECB and 80% falling on to the shoulders of the national central banks. Should a euro zone government happen to default on its debt, then the bulk of any potential losses would go to the national central banks. This would prove to be counterproductive for those countries with already existing sky-high debts.
One of the unintended consequences of QE is that after it was announced, the Swiss Central Bank’s (SCB) balance sheet blew up. This caused SCB to unpeg the Swiss Franc as they had decided that they wanted no part of it.
On the flipside, the benefits of QE are still being debated. The US recovery has been attributed to QE. Although, economists argue that much of the GDP and employment gains were due to US shale oil fracking in Texas and other mid-west states. In over 20 years of multiple QE, Japan has seen no appreciable recovery. In their case, the unintended consquences are clear. After their implementation of QE, deflation set in. So instead of weakening their currency, it strengthened it. By performing monetary experiments on a grand scale, they have effectively destroyed their capital markets. You don’t know anymore how much their bonds are really worth. Price discovery has been thrown out in favour of ‘easy money’. ‘Easy money’ brings about a higher likelihood of misallocation of funds. With these questions in play, who is to say what is going to happen in Europe.
Looking at success stories of debt repudiation by indebted countries such as Iceland and Argentina, the implications are pretty obvious. The solution to unpayable debt is not taking on more debt. It is debt modification or repudiation.A clean slate.
Impact on Singapore and the Financial Industry
In theory, QE sounds like a brilliant idea. Like a simple solution. The Central Banks would simply print more money and use that money to buy up government bonds. That way, the sellers (governments) would have more cash to pump into the economy, increasing asset prices and generating a wealth effect. But in reality, the economy is much more complex.
We should not ignore secondary effects. The Singapore Economy is linked to the Euro Zone in multiple ways. After China, the European Union (EU) is our second largest trading partner. Thus, with QE set to boost euro zone growth, it could benefit its trading partners, like Singapore.
With a falling euro, Singapore’s imports would increase. On the other hand, the dwindling Euro damages Singapore’s export competitiveness. This might compel Singapore to also devalue its currency. In fact, Singapore has already started to devalue the Singapore dollar by loosening the slope of their policy band.
Banks, would not be greatly affected as they have a low dependence on the Euro Zone. However, on the subject of trade credit, some Eurozone banks have cut down on their lending to Asian SMEs and corporations in an effort to conserve capital and liquidity due to the heightened risk aversion. Singaporean banks with strong liquidity positions have stepped in to fill this void.
In the financial services sector, sentiment-driven activities such as stock broking and foreign exchange trading have seen large increases in volatility. Consequently, risk and margin requirements have risen.
With all its varied implications, it is nearly impossible to forecast either positive or negative outcomes to QE. However, chances of unintended consequences would rise dramatically with the size and duration of the QE. Singapore has to look at the horizon and look out for black swans.