Wednesday, 18 March 2009

Quantitative Easing

The term "Quantitative Easing" has been mentioned quite often in news these days. I didn't know an aweful lot about it and had some time handy today, so thought to study it a bit. I am just jotting down my findings in as simple words as possible.

Wikipedia defines "Quantitative Easing" as a mechanism for central banks to pump liquidity (money supply) in the economy. In other words, central bank will print more money and put it in circulation, so for example if there was £18bn of wealth in circulation through currency notes it would be increased to £20bn of wealth.

So, how do central banks do it?
Well, the honest answers is that it's the central bank and it's standing in the world that determines the wealth for us. A £10 currency note is actually the property of the Bank of England and the idea is that if I give £10 to BoE, it would return me an equivalent amount of "wealth". Now, "wealth" used to be old solid gold in the old days (well, upto 1932). These days its a combination of T-Bills, government bonds and a host of other financial tools. These tools are bought and kept by commercial banks as deposits for the lending they do.
Through quantitative analysis, central banks buy back these bonds and provide cash against these. Since, banks are required to only keep a percentage of their deposits as reserve (say 50%), increasing liquidity in banks by say £1000 would enable them to lend out £2000. This increase the money supply to banks, who can then lend them to individuals and business.

Negative Effects:
With more money in circulation, there will be more money chasing lesser goods making everything more "expensive". There is a genuine risks of inflation shooting through the roof. It depreciates the "actual" value of assetts for investers and devalues the currency.

Who's doing it?
Bank of England announced it earlier this month. And today, the Federal Reserve in US has announced it. The scale of money pumping in by the US is mind boggling. Of course, both the economies are hit hard by the credit crunch and are undergoing negative inflation.

Winners & Loosers:
The winners would be banks and financial companies. With the value of money reducing, the actual value of their bad debts would go down and they would have more cash to lend. After Quantitative Easing, a bad debt of say £100,000 would have the same effect as a bad debt of £90,000.

The biggest loosers, I think, would be Asian and OPEC countries, who keep their reserves in dollars. All gulf countries, for example, have pegged their currencies against dollars. A devaluation of dollars would devalue their currencies and reduce their wealth. Also, countries like China and India have hoarded huge sums of dollars. They will see the actual value of their dollar based wealth dwindle.

What next?
I am quite keen to see

1) How China respond to this announcement by Federal Reserve today? Will they be selling T-Bills? Would it switch buy more Euro based assetts?

2) Will the European Central Bank adopt Quantitative Easing? This is one of the sternest test of the European Economic Commission. They have countries like Germany & France on one end, which would want it to happen and have countries like Poland, which still have strong inflationary pressure and would not want to do it.

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