Quantitative Easing in South Africa

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The Quantitative Easing in South Africa:

A need or a fashion?

Nowadays it is well acknowledged that the excessive amount of money in the economy generally causes inflation. Inflation could be good when it is controlled and maintained at a level that is socially acceptable level. By lowering the interest rate, inflation can be used to boost the economic activities through the aggregate demand. Both the long and short run interest rates are key factors of expenditure decisions (Kiley, 2014).

In this last 20 years, the world countries’ economies have experienced major unexpected financial crises. For example in the Japan, the bubble economy emerged and expanded from 1987 to 1990. That was a coexistence of a striking rise in asset prices, an increase in money supply and credit and a quick expansion of economic activities (Okina et a, 2001). This is according to Shiratsuka (2003) the Heisei boom which in 1992 leads officially to the collapse of asset prices that persisted for a decade. The USA have experienced the great recession between 2007 and 2009. The collapse of the housing bubble caused by the subprime crisis has been followed by a falling in housing asset that provoked a global financial crisis. This led to a decrease in oil and food prices and failure of many US’ biggest financial institutions. Another example is that of the United Kingdom. This country has been touched by a recession between 2008 and 2009. This has decreased the manufacturing output, bended activities of several sectors comprising investment firms and banks and raised the unemployment rate.

Generally these financial crises, with adverse consequences for the economies of countries, are expressed by regression in economic growth or sudden spikes in interest rates at which commercial banks or financial institutions lend money to businesses and consumers (Ali, 2002). For example, a higher interest rate can in short-term cause an increase of the cost of transactions raising the cost of goods; and in long-term raises the cost of mortgages; and therefore reduce consumption.

The interest rate is one of the usual gauges of the upcoming financial crises. Cited by Gonpu (2014), Kaminsky and Reinhart have concluded that both low growth rate and high interest rates remained the preeminent signal of forthcoming financial crises. The interest rate depends on the prevalent official interest rates and other tools determined by the central banks (CBs) that could at will control it given the conditions prevailing on the market.

Nonetheless, the last financial crises are such that they are not reacting to conventional monetary policy making the solution impossible. Thus new unconventional monetary policy tools such the “zero” fed funds rate, the forward guidance (FG) and the Quantitative Easing (QE) have been developed to deal with these new kinds of financial crises (Vahey and Oppenheimer, 2014). Among these tools the QE is more effective and it is the most extensively used. At Jackson Hole Economic symposium (2010), Charlie Bean, the Deputy Governor for Monetary Policy at the Bank of England advocated that the QE is found to more powerful than forward guidance.

That is in this context we will review how the QE has been successfully used by the USA as a means to prevent deflation and an extended economic recession after the 2008 economic crisis. We will also see how the European Central Bank (CB) has recently undertaken the implementation of a QE to counter a forthcoming deflation in the Euro zone given a lackluster recovery from the 2008 financial crisis. Then we'll examine the attitude that the South African monetary policy will adopt towards QE reality before concluding.

The QE: What is it?

Generally the QE is wrongly defined as “money printing”. However the bank of England defines it as:

“An unconventional form of monetary policy where a Central Bank creates new money electronically to buy financial assets, like government bonds”.

Standing for an unconventional monetary policy tools, the QE is usually applied in circumstances where the classic monetary tools do not work. These circumstances are the cases of long lasting situations like post-war periods, economic stagnations or financial collapses. Generally, the features of these periods are such a ruthless decline in business activities, a low aggregate demand, a decline in tax income, a rise of unemployment rate etc.

In this section we will provide a brief historical overview of the QE, following by its objectives and its transmission mechanisms.

  • Historical overview of the QE

Various authors contended that a sort of QE has been implemented by the US Federal reserve during the 1930s and the 1940s as a mean to fight the Great Depression and the recession that followed given this period has been characterised by a continuous low interest rates (Bordo, 2014). Nonetheless, the Bank of Japan (BOJ) was the first institution to use the QE as a monetary policy. That was in 2001 when the QE has been implemented to fight domestic deflation. During four years a series of QE schemes have been used (Ali, 222222222). The resulting outcomes of the QE showed that the QE was not effective. Thus the BOJ suggested that the QE should not be used for monetary rule.

After the dawn of the recent world financial crisis, CBs began to apply QE given conventional monetary tools were not working. Ali (2000) argues that recently it has been seen a very aggressive usages of QE in the Eurozone and in countries such the United Kingdom and the United States. Japan as well has announced a new QE for 2013.

Having provided a brief historical overview, it appears important to review how the money eased through the QE is flowed in the economy. H before the mechanism xxxx

  • Objective of the QE

The QE mechanism intends to precisely raise the private sector outlay in the economy and restore inflation to its target (Bank of England). This is to smooth lending conditions and to maintain long-run interest rates lower. Thus the QE will put pressure on long-run interest rates to keep it down by modifying banks, firms or individual portfolios.

Bear in mind the fundamental principle of bond investments that is prices of bonds are inversely related bonds’ yields, the QE mechanic works when CBs put emphasis on the “portfolio-balance effect”. For example when CBs use money printed to purchase bonds from investors, they proceed in such way to rebalance their portfolio by purchasing assets of dissimilar maturity and risk. Acting this way CBs push up asset prices and reduce interest rates. Low interest rate meaning low cost of borrowing or investment, companies and ménages will tend to invest or to consume more.

The portfolio balance channel has been described by Ben Bernanke, the Former Federal Reserve Chairman, at Jackson Hole Economic Symposium (2010) as follow:

“Once short-term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets.”

  • Transmission mechanism

Much of what central banks have said

The prominence of the aggregate demand or total consumption, as a component of the Gross Domestic Product, is well established. It is also the key factor of the economic growth. Evidence has shown the increase in money supply boost demand. Thus the QE outcomes are expected ultimately to affect positively the aggregate demand, ie, allow a rising of total consumption through the interest rate channel. Then a diffusion of the spillovers in the entire economy

By setting lower interest rate, the Central Bank reduces the cost of money. The predicted consequences of a QE scheme are such low interest rates allows decline in the government borrowing charge and then a decrease in expected taxation. Moreover, consumer will increase their consumption or invest more. The firms will also raise their investment to satisfy the increasing needs of consumer and to develop their activities beyond the country boundaries. The international trade will then allow a creation of new wealth.

Moreover the QE provide the advantage of shaping the expected inflation. For example, when CBs announce a higher target of inflation, the projected increase of money supply implies a increase in prices. By anticipation, consumer will have incentive to spend on goods bearing in mind a future loss of wealth due to the forthcoming increase in money supply.

The QE: Empirical from the USA

The review of literature brings to the conclusion that the CB and Government of the USA have anticipated to protect their economy against an eventually entering in a depression. Classical tools were not working meaning there was no effective way to stimulate the economy. In an attempt to save the economy from the present matters, the Government borrowed from its future by printing more money. That has been done through the three QEs’ rounds till the economy is capable to support itself.

This section reviews all the three rounds of the QE implemented in the USA up to date. For each QE the objective and the outcome are provided.

QE round one (QE-1)

Right after the recession and prior to the QE-1, the balance sheet of the US Federal Reserve was made up of Treasury notes valued around US$750 billion.

QE-1 was implemented in November 2008 in order to revitalize the banking system. Money has been injected into the system by buying $500 billion of toxic mortgage-backed securities from some financial institutions.

QE-1 ended on April 2010. The U.S. Federal Reserve spent around $1.7 trillion in buying those bad securities. QE-1 implementation led in some key achievement: decrease in interest rate (from 6.3% to 5.2%); growth stimulation; and bailout of many borrowing institutions by allowing them to convert their bad securities into cash. But from a main street’s outlook, QE-1 had failed. The unemployment rate did not shrink and financial institutions were busy to clean their books by eliminating bad securities instead of lending money to the economy.

QE round one (QE-2)

The U.S. Federal Reserve has instigated QE-2 in November 2010. QE-2 had two goals: pushing financial institutions to lend money to stimulate the economy and decreasing unemployment. Long-term U.S. Treasury bonds have been purchased for $600 billion. A reinvestment of extra $250 - $300 billion in short-run treasuries has been done with the revenue from its previous savings. Operation twist has been launch in order to perform some changes of the U.S. Federal Reserve balance sheet. Consolidation U.S. economic recovery and sinking the chance for deflation, those were the outcome of the QE-2 achieved by keeping interest rates at lower level in order to boost household spending and corporate innovation. At the end of the QE-2, the unemployment rate has slightly fallen (from 9.90% to 7.90%).

QE round one (QE-3)

The round three of the QE has been realise to consolidate the economic recovery and more to lessen the unemployment rate. This has been done January 2013 and November 2013 where

QE2’s procuring policies of Treasury bond and bad securities was carried out. From a main street’s outlook, QE-3 had decreased the unemployment rate to 7%.

Sub-conclusion on evidence

Globally the QEs’ outcomes in the USA are satisfying even though there has been some in the level of outcome.

The QE in the Euro zone

The QE in SA: Is it a need?

South African economic context

In SA, global economic growth was 3.3 in 2014 and projected to be 3.5 in 2015. That is the economic growth is expected to be slower during the forthcoming period (Budget speech 2015). The current situation on the commodity market is such that SA is benefiting from the decrease of oil price but suffering from the global slowdown of the mineral to be exported.

SA is facing some structural and competitiveness challenges that are restraining output and investment. The utmost prominent is the security and trustworthiness of energy supply. The principal economic sectors in SA are more energy-intensive sectors. For example mining and manufacturing. The electricity shortages have negative impact on their productions, ie inhibit investment in housing and increase the cost for industries and ménages.

Mostly for this reason, SA projected economic growth for 2015 has been set just at 2 per cent, down from 2.5 per cent specified in October 2014. Growth is expect to rise to 3 per cent by 2017. Consumer price inflation peaked at 6.6 per cent in June last year. It has subsequently declined to just 4.4 per cent last month, and is expected to average 4.3 per cent in 2015, laying a foundation for economic growth (Budget speech 2015).

About economic outlook, the Minister of finance argue, in 2015 budget speech, that in long run higher growth could be possible if SA realize progress in founding solution to the electricity problems or improve its performance in export. In short-run a faster projected growth lies in less energy-intensive sectors such as tourism, agriculture, light manufacturing and housing construction. Yet It is noteworthy to notice that given the SA economic sectors of production are more electricity intensive, the export depends also on the response to the electricity problem. Thus the electricity that is the most used source of energy is the central of the SA economic problem currently.

Having roughly described the SA economic context, next section will show if it is important for SA to apply the unconventional tools of MP.

Does South Africa's situation need a QE implementation?

According to the economic state and perspective provided in the newly budget speech, a high caution is required for a potential QE implementation to avoid a fashion implementation instead of a really needed implementation.

Around the world the QE has been implemented according to the countries context and the objective. For example, while the US Federal reserve was acting to buy US Treasuries, agency debt and bad securities, the European Central Bank was focus on purchasing only covered bonds which is a kind of corporate debt. By implementing its QE SA should, according to its context, what types of securities to purchase. Moreover, a decision should be taken whether the SARB would be buying directly the securities or some brokers should be used.

Currently the production factors in SA, especially capital and machines, are under used because of the electricity shortage. In these conditions, any QE should not be undertaken since the goal of the QE is to boost the economic activities. Boosting the economy in this context of a structural constrain would lead to a failure of the QE. Activities cannot be push beyond the limits constrained by the structure of the economy. That is if given the supply of the energy the economy can produce for example 100 kg of output, how can we boost the output without solving the energy constraint?

Reasonably, no actions (de politic monetaire) could be undertaken in SA in order to boost the economy without solving the energy problem. Thus any QE implementation in SA should be back by a solution to the energy problem. The accounting of the energy problem should be such that the impacts of the actions should first affect the energy sectors because only these sectors could permit the expansion of the production activities of other sectors. For example ……..

One could be attempted to argue that QE could be establish but with impact oriented to less energy-intensive sectors. It is acknowledge that conventional monetary policies are based on theoretical grounds as well as on significant evidence on how endorsed interest rates could impact the economy. Still, there is no a perfect established framework on the way unconventional monetary policies influences the economy because maybe its design was not a result of an knowledgeable developments but was due to a practical reply to circumstances (Joyce and al., 2012). There is no evidential foundation for unconventional monetary policies that setting a quantum of interest rates is necessary to produce a specific response. That has been observe in the USA where QE-3 has been implemented with almost the same objective as QE-2 because the decrease in unemployment was not satisfactory. The QE-3 would not be necessary if the exact amount of securities purchase was known such that the yielding level of interest rate will lead to the desired unemployment rate.

SA should learn from the experience of countries that have applied the QE by focussis on the critic side because that constitutes the risk to be undertaken. That is: If Its works there is no problem and what happens if it does not work? Thus by adopting the QE, SA bears the risk resulting from these criticisms.

It is essential for SA to be inspired on key criticisms of the QE has implemented in the USA which is the biggest experience of the QE application. There are three rounds of QEs encompassing multiple and diverse information resulting in controversies on the QE subject even though the global results of the QEs are satisfying.

The review of materials suggests that the QE criticism is centered on the following points. That is, the QE is decreasing the currency value, it does not fuel credit, it creates inflation, it has potential deflationary effects, it creates hazard and it stoking inequality and rewarding financial institutions.

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