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QUANTITATIVE EASING EXPLAINED
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Q U A N T I T A T I V E E A S I N G E X P L A I N E D 1
Samson O. Odeniran2
SECTION ONE
Introduction
Quantitative easing could be broadly defined as the use of non conventional
tools of monetary policy to propel economic recovery by central banks, when
the traditional tools become ineffective. Expressed in a simple language, it is a
systematic increase in money supply in order to reduce key interest rate with the
ultimate goal of combating recession. Quantitative easing is mostly used during
periods of economic crisis when the income level faces adverse shocks across
various sectors of the economy. In essence, it is occasionally used by the
monetary authority to increase money supply to a specific level in the economy.
In achieving this, the central bank injects a specific quantity of money into the
economy by purchasing financial assets from both the banks and the non-
banking public. The process works through increase in bank reserves, which leads
to increase in the volume of credit created by the banks and ultimately level of
consumption. Outlined in chapter 5; chapter 6 presented an overview of the
Nigerian financial system with chapter 7 concluding the paper.
1This publication is not a product of vigorous empirical research. It is designed specifically
as an educational material for enlightenment on the monetary policy of the Bank.
Consequently, the Central Bank of Nigeria (CBN) does not take responsibility for the
accuracy of the contents of this publication as it does not represent the official views or
position of the Bank on the subject matter.
2Samson O. Odeniran is a Principal Manager in the Monetary Policy Department, Central
Bank of Nigeria
QUANTITATIVE EASING EXPLAINED
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SECTION TWO
Rationale for Quantitative Easing
The overall goal of macroeconomic policy regardless of whether it is fiscal or
monetary policy is to stimulate output, with the ultimate objective of reducing
unemployment, thus improving the well being of the citizen. Central banks, across
the globe, contribute to this overall economic goal by stabilizing the
macroeconomic environment through the conduct of monetary policy, so that
investments (foreign and domestic) can take place. In the conduct of monetary
policy, central banks use some tools which have been adjudged universal,
though with slight variations from one jurisdiction to the other. These conventional
instruments include Open Market Operations (OMO), Liquidity Ratios (LR), Cash
Reserve Requirements (CRR), and Rediscount rate. These instruments work
through the interest rate channel, such that when central banks want to stimulate
economic activities, the interest rate is increased, while the converse holds when
they want to moderate economic activities.
The use of this approach in managing the economy is hinged on certain basic
assumptions. Most significantly, it is expected that at lower interest rate, the
disposable income of consumers is enhanced, thereby increasing the spending
capacity. As aggregate spending increases, producers of goods and services are
able to sell their products which invariably lead to further production in goods
and services, hence increase in economic activities. Under certain conditions,
however, the above scenario may fail to hold. For example, in an environment of
acute low level of income, reduction in interest rate may not be sufficient to
stimulate aggregate spending with the implication that central banks may need
to think out of the box when confronted with such a situation. This is the premise
for the use of quantitative easing by most central banks. In essence, quantitative
easing is different from the conventional central banking monetary policies which
rely heavily on interest rate. Quantitative easing is undertaken under a number of
conditions including when interest rate has been reduced to almost zero, when
the banking system is confronted with systemic risk due to huge non-performing
loans, and when the economy is facing depression. Quantitative easing is more
or less a last resort by central banks to stimulate the economy, by directly
increasing money supply rather than reducing interest rate, which cannot be
reduced further.
QUANTITATIVE EASING EXPLAINED
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SECTION THREE
Transmission Channels of Quantitative Easing
Quantitative easing measures work through a number of channels in the process
of influencing the real economy (figure 1). When central banks purchase bonds,
the immediate effect is an increase in aggregate money supply, which would
generate a chain of reactions. The increased money supply could impact on the
economy through at least three main channels namely, policy signaling,
confidence, and liquidity to financial markets.
In terms of policy signaling, there is clarity on the perception of the general public
in respect of the direction of short to medium term monetary policy. The action of
central banks in massive asset purchases gives clear indication to market
participants that policy rates would remain low over a reasonable period of time.
Besides, in an economy confronted with risk of deflation, it also indicates a likely
rise in inflation over the medium term, thus anchoring inflation expectation. This is
very critical for such economy because inflation expectation could be used to
support spending. The whole import is that uncertainty in planning horizon is
removed.
The confidence channel is very critical for financial market in particular. Dearth of
liquidity in the financial market engenders confidence crisis, which could lead to
high counterparty risks with the attendant high and volatile interest rates. In
extreme cases, liquidity crisis in the financial markets could grind the market to a
halt, leading to complete breakdown of monetary policy transmission
mechanism. As such, quantitative easing that increases market liquidity restores
confidence and ultimately enhances the intermediary role of the financial
market.
The other channel is the provision of liquidity to the financial market through
increase in banks‘ excess reserves. The increased banks‘ excess reserves stimulate
the supply of banks‘ credit, which through the intervention of supply and
demand, leads to a fall in lending rate. The fall in lending rate encourages
demand for capital investment, which would eventually translate to increase in
aggregate output and employment. Again, quantum leap in the quantity of
financial assets purchased by central banks would engender a surge in demand,
which invariably increases prices of the assets. Given that financial asset prices
and yields (interest rate) are inversely related, the yield would fall. As yield falls,
cost of borrowing by firms and household and firms would reduce with implication
that the cost of financing capital investments such as new plants and
machineries would reduce. Following this, new investment in plants and
machinery would bolster economic activities, create new jobs, and reduce
QUANTITATIVE EASING EXPLAINED
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unemployment. Besides, for holders of financial assets, the increase in price
translates to higher status in terms of wealth which in turn leads to higher level of
spending. Increased aggregate expenditure would stimulate demand for goods
and services thereby encouraging producers to increase their output as well as
employment of resources used in production process including labor. Thus, the
process that starts with purchase of assets by central banks ultimately ends in
improving output and employment in the economy.
Figure1: Transmission Channels of Quantitative Easing
Central Bank Purchase of Asset
Money
Liquidity to the
Financial
Market
Policy
Signaling
Confidence
Bank Lending Asset Price
Investment
Wealth Effect
Lending Rate
Lending
Capital Investment
Income and Spending
Lending Rate
Lending
Output
Invest
ment
Employment
QUANTITATIVE EASING EXPLAINED
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SECTION FOUR
Reasons for Quantitative Easing
The Bank of Japan pioneered the use of Quantitative easing in March 2001 in
order to address the problem of deflation, but since then, it has been extensively
used by many central banks across the globe for a variant of reasons. Some of
the common reasons for employing quantitative easing are presented below.
i. To Reduce Interest Rate: Generally, central banks moderate interest rates by
reducing their policy rate so that the commercial banks could also reduce
their lending rates. There are certain times however, when central banks can
no longer reduce their policy rate, particularly when such rate is almost at
zero. For example, in the late 2000s, the Fed Fund rate was between 0 and
0.25 per cent with the implication that the Federal Reserve could not lower its
rate any further. Under such circumstance, a direct increase in the money
supply by quantitative easing could drive down interest rate through the
forces of demand and supply.
ii. To Encourage Lending: When the central banks purchase long term securities
for quantitative easing operations, the commercial banks‘ level of reserves
increases immediately. As a result of increase in their reserves, the banks
would be more willing to lend at lower rates. Such loans could provide a
boost to the economy through increased consumer spending and business
financing.
iii. To Encourage Borrowing: The level of credit in the economy is a function of
both supply and demand. With increase in money supply, the price of money
(interest rate) would fall. Following the law of demand which posits that more
quantity would be demanded at lower price, it implies that borrowers would
be encouraged to demand for higher amount of credit.
iv. To Increase Spending: In a credit based economy, a reduction in interest rate
would increase the disposable income of the consumers as well as profits of
firms. With increase in the disposable income, consumers are able to spend
more which will in turn increase company sales and profits.
v. To Increase Employment: Increase in money supply through quantitative
easing would increase spending by consumers as pointed above. Higher
spending by consumers would increase the profit of companies which in turn
would lead to higher capacity to expand production lines. With increase in
production lines, firms would be willing to hire more workers, thereby
increasing employment rate.
QUANTITATIVE EASING EXPLAINED
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vi. To Prevent Deflation: Although this is rarely the case, but it could also be a
reason for the use of quantitative easing. Persistent price hikes are undesirable
and injurious to the economy, however, a reasonable degree of price
increases is necessary to encourage the producers of goods and services.
When prices fall below the optimal level, the producers of goods and services
may find it difficult to break even, and therefore, result in production shut
down. As a result of this, when inflation is close to zero or falling below zero
(deflation), some injection of money may take place in form of quantitative
easing in order to prevent further slide in price level.
QUANTITATIVE EASING EXPLAINED
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SECTION FIVE
Challenges of Quantitative Easing
Although the use of quantitative easing is gaining increasing popularity,
particularly in the light of the reasons adduced above, it is however not without its
challenges or limitations. Some of these limitations/ challenges are presented
below.
i. It Increases Inflation: The concern about inflation seems to be the highest
risk to the use of quantitative easing in stimulating the economy. One of
the fundamental theories in economics is the Fisher‘s quantity theory of
money which postulates that the underpinning force for inflation is
excessive growth in money supply. With the use of quantitative easing,
money supply is instantaneously increased, while the supply of goods
remains fixed, at least in the short run. This creates a scenario of more
money chasing few goods with implication of driving up the price level.
ii. Distortion in International Trade: This is practically possible for countries with
convertible currency. Money printed by the central bank could be used
by both private and public economic agents to import goods and
services. This implies that those imported goods and services are obtained
almost free by the importing country. With time, the exporting country
would feel discouraged from selling their goods in exchange for what
could be purely regarded as ordinary paper. As a result, international
trade could suffer severe setback. A recent example, was the action
taking by China in stopping export of valuable minerals to the US, owing
to the monetary easing programmes of the Federal Reserve.
iii. Threat to Exchange Rate Stability: Increase in money supply through
quantitative easing, which leads to the consumption of foreign goods at
the expense of domestic goods could create current account deficit. An
increase in current account deficit could lead to unfavorable balance of
payment with implication for the external reserves. As external reserves
decline, the ability of the country to maintain a stable exchange rate is
constrained. Even in countries with convertible currency, other countries
may be discouraged from lending to such a country as was the case,
when the use of US dollar as reserve currency was threatened, during the
quantitative easing program.
iv. Non-Sustainability of Benefits: The important benefit from quantitative
easing is the stimulation of economic recovery. It has been observed,
however, that the recovery often gets stalled or even begins to reverse
when quantitative easing measures end. One of the underlying
QUANTITATIVE EASING EXPLAINED
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assumptions of quantitative easing is generation of a new consumer
confidence, which could drive real recovery, but it is been recognized
that this is a short term phenomenon. The practical demonstration of this
thesis is often found in the stock market, which always takes a dip when
the announcement of termination of quantitative easing is made.
v. Encourages Debt: Another major concern about quantitative easing, is
that the low interest rate that accompanies the increased money supply
could lead to undue accumulation of debt by businesses and households.
Although certain debts could help stimulate an economy, but
unnecessary loans and excessive debt could worsen a fragile financial
condition. For sovereign countries, quantitative easing could increase
government deficit as experienced by the US in 2010, when it reached its
debt ceiling.
vi. Uncertainty about Policy Outcome when used against Deflation: It is very
common for the outcome to exceed the target, when quantitative easing
is used with the intention of preventing deflation. In essence, the process
of price increases that is set in motion leads to higher price level in the
longer term due to increase in money supply. On the other hand, the
policy may fail to achieve its objective, if the banks refuse to lend out the
additional reserves.
vii. Impossible for Individual Countries in Monetary Union: Quantitative easing
is possible, if the central banks could exercise control over the currency in
use within the domestic economy. Where a country is a member of
monetary union, in which case, the conduct of monetary policy has been
transferred to the Union central bank, then such a country cannot
undertake quantitative easing. For example, each of the countries
making up the Euro zone cannot individually increase their monetary
base, and as such, cannot undertake quantitative easing except it is
done centrally by the European Central Bank (ECB).
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SECTION SIX
Case Study
Many central banks in both advanced and emerging economies, have
implemented quantitative easing at various times in their economic history, with a
view to addressing specific challenges. Some of the prominent ones are
presented below.
i. Japan: The Bank of Japan (BOJ) blazed the trail among central banks across
the globe in the use quantitative easing. The Bank employed quantitative
easing to address the problem of deflation in the early 2000s. Prior to this
period, the Bank had unsuccessful confronted the threat of deflation, by
keeping the overnight interest rate close to zero. As a result, the Bank
engaged in the purchase of government bonds above the level required to
set the interest rate to zero. In addition, it purchased asset-backed securities
and equities while extending the duration of its commercial paper purchasing
operations. Through these measures, the commercial banks‘ excess reserves
increased by a whopping ¥30 trillion (about US$260 billion) between 2001-
2005. As a result, the commercial banks were flooded with excess liquidity,
which was channeled to private sector lending.
Following the global financial crisis of 2008-9, which plunged most economies
into recession, the BOJ had to deepen the quantitative easing through a
number of measures. Firstly, the Bank put in place a Special-Funds-Supplying
Operations (SFSOs) in December 2008, which was to provide unlimited
amounts of loans to banks at an almost zero rates. The program offered short
term loans to banks without collateral at overnight rate of 0.3 per cent, which
was later reduced to 0.1 per cent. Secondly, the Bank undertook a Bond
Purchase Program involving both Japanese Government Bond and corporate
financial instruments. This program assisted in restoring vibrancy to the bond
market by reducing liquidity risk, thereby driving up prices. Thirdly, the Bank
announced an elaborate Monetary Easing Program in the third quarter of
2010, with the objective of reducing future interest rates and other risk premia.
The program consisted of the reduction of the target for the uncollateralized
overnight call rate, clarification of conditions for exiting zero interest rate
policy, and the establishment of asset Purchase Program. The Bank initially
started with ¥35 trillion, which was later increased by ¥20 trillion in 2011. Lastly,
the Bank, in 2011, expanded its Growth Support Funding Facility (GSFF) to
strengthen the foundation for economic growth. The Fund was established to
stimulate bank lending through the loan support program.
QUANTITATIVE EASING EXPLAINED
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The various monetary easing measures that were deployed by the Bank of
Japan have succeeded in stimulating growth, reducing unemployment to
reasonable levels, and supporting the banking system.
ii. United States: The Federal Reserve commenced the implementation of
quantitative easing in 2008 to address the challenge of the 2007/8 global
financial crisis. The crisis, which came into being due to the collapse of the
subprime mortgage, left series of Multinational Corporation distressed with the
economy heading towards recession. Attempts by the Federal Reserve to
restore the economy to the path of recovery by reducing the interest rate to
almost zero was met with little success, consequently the Bank had to embark
on quantitative easing. Between 2008 and 2012 the Federal Reserve had
implemented three quantitative easing programs. The first quantitative easing
started in November 2008 when the Fed started the purchase of $600 billion
mortgaged-backed securities. This operation led to a phenomenal increase in
the value of Treasury notes on the Federal Reserves‘ balance sheet by about
$1. 2 trillion between 2008 and 2010. The Fed stopped additional purchases
after observing an improvement in the economy, but resumed in August of
the same year when it was observed that the recovery process was not robust
enough.
The second quantitative easing by the Fed worth US$600 billion Treasury
securities was between the third quarter of 2010 and the second quarter of
2011. The third quantity easing commenced in September 2012, with a
monthly purchase of $40 billion bond and was increased to $85 billion in
December 2012. It was mainly to propel economic growth, reduce
unemployment rate, and improve the health of the banking system, through
the direct injection of fund with a view to bolstering spending. The third
quantitative easing has some unique features, including maintaining the
federal funds rate at almost zero, at least through fiscal 2015, as well as being
open ended. However, in the latter part of 2013, the Federal Reserve
commenced a gradual reduction of the amount of the bonds purchased
under the third quantitative easing, following an improvement in the
economy.
In all, the quantitative easing succeeded in reducing unemployment to the
long run trend in the US, with significant expansion of economic activities.
iii. European Central Bank (ECB): The ECB conventional monetary policy
strategy, is by refinancing operations in which the Bank lends a specified
quantum of funds to commercial banks at rates determined by bidding
process. The lending is done with the aid of prescribed collateral of two
QUANTITATIVE EASING EXPLAINED
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maturities namely, the main refinancing operations (MROs) with a two week
period, and longer-term refinancing operations with a three month period.
This monetary operation implies that the Bank determines the quantity of
fund, while the markets determine the price (interest rate). However, by
October 2008 when the Global Financial Crisis hit the Euro zone with the
resultant deterioration in financial conditions as a result of illiquidity, the ECB
had to reverse to non-conventional measure. The Bank undertook its first
quantitative easing measure with the objective of injecting funds to the
financial markets, by lending to banks as much funds as required by them,
and at a fixed rate. The rate at which ECB lent to banks was reduced from
4.25 per cent to 1 per cent between October 2008 and May 2009. In addition,
the eligible instruments for collateral were expanded to accommodate lower
grade items.
The approach succeeded in restoring liquidity to the financial markets but
could not completely obviate most of the challenges confronting the market.
High counterparty risk was prevalent in European interbank markets, such that
by the first quarter of 2009, interbank lending had been completely grounded
due to absence of confidence. In response, the ECB put in place its second
measure of quantitative easing in May 2009, by introducing a longer term
refinancing operations (LTROs) of one-year maturity. The longer term
refinancing operations were to cater for the commercial banks need for loans
of longer maturities, while the CBPP helped banks to eliminate the usual
challenge of maturity mismatch between the long-tenor assets and short term
obligations.
Following the disruption of the European Financial markets in 2010 by the rising
sovereign debt crisis, the ECB commenced the third quantitative easing
known as Securities Market Program (SMP). The ECB, through the program,
used secondary markets to purchase government debt, thereby achieving
the dual objectives of improving the depth and liquidity in the market, as well
as restoring the transmission mechanism of monetary policy
Although the outcome of the quantitative easing was mixed, it succeeded in
addressing some of the problems confronting the market. The CBPP was able
to stimulate the bond market, with the €60 billion initial bond purchases
generating €150 billion in issuance. The SMP purchases succeeded in
reducing yields on euro debt, particularly on Spanish and Italian debt.
iv. Bank of England (BOE): In 2009, after the Monetary Policy Committee had
reduced the Bank Rate to 0.5 per cent, which was considered as the lowest
level possible, the Bank decided to undertake series of asset purchase
program with a view to providing further monetary stimulus to the economy.
QUANTITATIVE EASING EXPLAINED
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From March 2009 to July 2012, financial assets worth £375 billion were
purchased by the Bank of England, with the immediate objective of directly
injecting liquidity, while the ultimate goal was to boost nominal demand.
Unlike in some other jurisdictions, the objective of the monetary easing in the
UK still aligned with the overall objective of monetary policy, which is to
maintain price stability. Before the commencement of the quantitative
easing, the MPC had anticipated that the annual inflation target of 2 per
cent would be undershot in the medium term, requiring therefore, the need
for the extra spending. In its design, the Bank electronically created new
money, and invested it in risk free private instruments like pension funds. These
investors normally use this money for further purchase of other assets, such as
corporate bonds and shares, with the effect of lowering future interest rates,
and thereby promote new capital. This process invariably stimulates spending
and pushes inflation toward the government target.
QUANTITATIVE EASING EXPLAINED
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SECTION SEVEN
Roles of Quantitative Easing in Restoring Stability during the 2007/8
Global Financial Crisis
Unlike most major global economic crises, the 2007- 08 Global Financial Crisis
(GFC) could not be traced to a single cause, but a combination of both macro
and micro economic variables. The macroeconomic factors include lingering
global imbalances, prolonged expansionary monetary policy in key advanced
economies, and the non-recognition of asset prices in policy formulation and
implementation. The microeconomic causes include rapid surge in credit,
reduction in credit standard, intensification of financial innovation, weak
corporate governance, poor incentive structure in the financial sector, as well as
ineffective regulatory measures (Mohanty, 2011).
The crisis snowballed into an economic recession beginning from the Euro zone
sovereign debt crisis, disrupted the monetary policy transmission mechanism and
overwhelmed conventional monetary policy. In addition, it dried up liquidity in
inter-bank markets, contracted credit conditions, caused extreme risk aversion,
heightened deleveraging and liquidation of banks and other financial institutions,
triggered reduction of equity prices, reduced the trust in the pillars of the financial
system, and escalated the risk of illiquidity, insolvency, and international
transmission of liquidity shocks (see Mohanty, 2011; Ande et al, 2014; Chitiga et al,
2009).
The crisis revealed the shortcomings of conventional monetary policies, which
necessitated the adoption of unconventional Monetary Policy (UMP) measures to
address the challenging economic and financial conditions (see Stiglitz, 2013).
The unconventional monetary policy was used to achieve two broad goals,
namely the restoration of a functioning financial markets and continuation of
expansionary monetary policy stance at a very low interest rate. Each of the
goals depends on various instruments: provision of liquidity to specific areas and
purchase of private assets, while the second one is to guide economic agents on
future investment. There were two types of UMP, those designed to restore a
functioning financial sector and those aimed at promoting real sector activity,
which covers a reduction in long-term interest rate, expansionary monetary policy
and the purchase of government bonds. These were complemented by
assurance of the long duration of the measures to manage market expectations
and keep the yield curve relatively flat (Shinohara, 2014)
With the large scale economic downturn that accompanied the financial crisis
and the fears over economic slowdown, monetary easing occupied the front
burner in the policy of most central banks. Central banks in major economies
QUANTITATIVE EASING EXPLAINED
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resorted to unprecedented monetary easing through the reduction in their policy
rates in the first instance which was followed by unconventional adjustment in
their balance sheet to augment liquidity(Mohanty, 2011).
Central banks in the advanced countries especially US, Euro Area, England,
Japan, etc, expanded the pool of securities, increased the number of counter-
parties eligible for their central banking operations, and extended the maturity of
those liquidity providing operations. Faced with zero lower bound domestic
interest rates, perceived threat of price deflation and projected weak economic
growth, the US Fed (in late-2008) and the Bank of England (in mid-2009
commenced the purchase of securities of long (relative to the sizes of their
economies and to the stocks of outstanding government debt), in order to push
down bond yields and provide additional monetary policy stimulus to the
economy. Similarly, the Bank of England, which had lowered its policy interest
rate—the Bank Rate—to its effective zero lower bound, projected weak U.K.
economic growth and a medium-term inflation rate that was below its official 2
percent target.
Specifically, the US Fed implemented three quantitative easing (, and it was
finally terminated in October 2014, following a gradual QE), namely QE1 in 2008,
QE2 in 2010 and QE3 in 2012. The QE3 was a monthly injection of $85-billion
through the purchase of mortgage-backed securities, and long-tenor Treasury
securities scale down that commenced in October 2013. The US Fed were buying
government or other bonds, and then making these funds accessible to banks
thereby increasing aggregate money supply as well as reducing future interest
rates. In the UK, the Bank of England gradually raised the limit of its QE asset
purchase program to £375 billion, comprised of mainly UK Government Securities.
In the Euro area, the ECB has undertaken different form of quantitative easing
since 2008: two tranches of covered bond purchase programs in 2009 and 2011;
an unlimited securities market program in 2010; and open-ended outright
monetary transactions in 2012. The Bank of Japan, on the aggregate, increased
the size of its monetary easing by about 44 per cent of GDP by end-2013. In April
2014, the BOJ announced plans to increase the monetary base by 100 per cent
in two years through the purchase of various instruments, including government
bonds, exchange-traded funds, as well as real estate investment trusts (see
Ncube, 2014).
These QE policies have succeeded in addressing the slowdown in economic
activities, and more importantly in curtailing the greatest financial turmoil. Market
malfunctioning influenced by risk appetite of private sector investors were
significantly corrected, while a considerable deceleration in tail risks was
achieved. The policies also reduced the risk on long-term bond in some yields,
and in some cases credit spreads. The charts 1a-c below show that the behavior
QUANTITATIVE EASING EXPLAINED
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of the US 10-year Bond, UK 10-year Bond, Japan 10 – year Bond and European
Financial Stability Facility Bond Yield clearly exhibit this downward trend since
2008, which is attributed to the QE.
Chart 1a: United States 10-Year Government Bond
Chart 1b: Japan 10-Year Bond
Chart 1c: United Kingdom 10-Year Bond
In addition to restoring stability in the financial markets, the QEs have equally
succeeded in ameliorating some other challenges in the macroeconomic
environment. Specifically, QEs have been successfully used to avert recession in
QUANTITATIVE EASING EXPLAINED
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many countries. Prior to the commencement of quantitative easing by the Bank
of England, the UK economy was almost heading towards recession with GDP
growth of 0.3 per cent in 2012. The implementation of quantitative easing from
2010-2014, led to the upturn in the economy with the country outpacing most of
the advanced countries in terms of economic growth in 2014. Output growth in
2014 estimated at 3.2 per cent was not only above the long run average, but
significantly higher than 1.8 per cent for the advanced economies.
Furthermore, the third quantitative easing implemented by the US Federal
Reserve was intended, among others, to address the rising unemployment level.
Prior to the commencement of the measure in 2012, unemployment rate was
almost hitting 9 per cent, due to slack in capacity, particularly in the
manufacturing sector. The implementation of the asset purchase program has
not only succeeded in diminishing slack in the manufacturing sector, but it has
generated a positive impact on unemployment, by reducing it to the long run
target of 5.5 per cent by the third quarter of 2014.
QUANTITATIVE EASING EXPLAINED
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SECTION EIGHT
Impact of Quantitative Easing Adopted by the G-4 Countries on
Emerging and Developing Economies.
Although almost all central banks across the globe implemented one variant or
the other of quantitative easing at the wake of the global financial crisis, t four
central banks were very prominent. these central banks were the US Federal
Reserve, Bank of England (BoE), European Central Bank (ECB), and Bank of Japan
(BoJ) otherwise known as group of 4 (G-4). The effects of the quantitative easing
implemented by these countries cut across the global economy, but were very
strong in emerging and developing economies in particular. Some of the effects
on the emerging and developing economies are presented below.
i. Surge in Portfolio Flows: Low interest rates, crashing stock markets and fiscal
crises in advanced economies during the period, prompted huge portfolio
investment outflows to emerging markets in search of higher yields. The surge
led to currency appreciation, increased financial system liquidity, expanded
credit creation, and stock market recovery.
ii. Increased in Commodities Prices: Most emerging economies rely on primary
commodities such as crude oil, gold, diamond, and a number of agricultural
produce as the mainstay of their economies. The prices of these products, to
a larger extent, are subject to global liquidity. The implementation of
quantitative easing by the G-4 countries led to a surge in global liquidity,
while investors in the process of seeking higher yield found outlets in
commodities markets, in addition to the financial markets. As a result the price
of many primary products experienced significant increase during period. For
instance, the price of crude oil, after the initial sudden drop to about
US$47/barrel in the wake of the global financial crisis in 2009, commenced an
upward trend, reaching an all time high of about US$113/barrel in the early
part of 2013. This could be attributed in part, to efforts by these major central
banks to improve global liquidity through the different kinds of quantitative
easing measure put in place. The increase in prices of these commodities has
in turn helped the management of economies in developing and emerging
countries by boosting government revenue.
iii. Moderation of Inflation: Nearly all emerging and developing economies are
import dependent with respect to both inputs and finished goods. Thus,
exchange rate pass through to domestic price is strong and rapid in these
countries. The quantitative easing embarked upon by the G-4 countries
provided considerable support to currencies of emerging market economies
QUANTITATIVE EASING EXPLAINED
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though portfolio flows thereby enhancing the capacity of central banks to
stabilize the exchange rate while a modest appreciation was recorded in
some cases. With stability of exchange rate, the central banks were able to
curtail pressure emanating from imported goods on the domestic economy.
For example, in Nigeria the monetary authority was able to achieve a single
digit inflation rate in 2013, after a persistent double digit rate, mostly due to
ease of pressure in the foreign exchange market.
iv. Growth: The stability obtained in the macro environment as a result of capital
flow aided consumption and investments in major emerging economies. As a
result, emerging market economies provided strong impetus to global growth
during the post global financial crisis by posting strong growth performance.
For example, China, one of the leading emerging economies was on growth
trajectory of about 7 per cent per annum from 2009-2013. The average for the
whole emerging economies during the period was about 5.0 per cent,
compared with the developed economies of below 2.0 per cent.
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21
SECTION NINE
Tapering of Quantitative Easing
Generally, exiting quantitative easing is not always sudden, but follows a long
and carefully drawn out process that encompasses a number of phases. Such
series of stages are referred to as tapering. The purpose of allowing the
termination of quantitative easing to proceed in stages is to minimize the adverse
impact on the global financial and macroeconomic conditions. According to the
IMF, safe exit from quantitative easing should be gradual, clearly communicated,
and dependent on the pace of the recovery (Shinohara, 2014). The overall aim is
to return to conventional monetary policy, where central banks determine only
short term interest rates and withdraw from the use of balance sheet instruments.
In line with this view, the US Federal Reserve in December 2013, after taking into
consideration the fiscal retrenchment since the inception of quantitative easing
program and improvement in economic activity particularly labor market
condition, decided to reduce the US$ 85 billion monthly asset purchase program
by US$10 billion. This was followed by series of gradual reduction in January,
March, April, and June 2014 while the final termination took place in October
2014. The exit strategy is normally in four phases: slowdown of the speed of asset
purchases; complete termination of quantitative easing; changing of the long-
term low interest rate policy; and shrinking of the balance sheet.
9.1 Impacts of Tapering of Quantitative Easing on Emerging and
Frontier Economies
The impact of the tapering of quantitative easing by the Federal Reserve on
emerging and developing economies manifested in such macro variables as
growth, interest rates, foreign exchange reserves, capital flows, stock markets and
macro-prudential policies. The impact however, is not uniform across all emerging
markets, as the behavior of these fundamentals in the wake of the tapering
exercise exhibited considerable degree of variations. For instance, Mishra et al
(2014) notes that market pressures as a result of the tapering were fairly under
control in countries with robust macro indicators, resilient financial markets, high
growth prospects, and restrictive monetary policy stance, among others. The
effects of tapering of the quantitative easing on these variables are presented
below.
i. Capital Outflows: As indicated above, the commencement of quantitative
easing led to a surge in inflows of portfolio investments in a number of
emerging economies as a result of higher yields relative to the advanced
economies. At wake of the announcement of the Tapering on May 22,
QUANTITATIVE EASING EXPLAINED
22
2013, there was broad -based sell of emerging market assets in expectation
of likely uptick in US interest rates, as a result of the announced scale down
of bond purchases to the tune of $85 billion dollars every month by the Fed.
This impacted capital flows into emerging markets from US and Euro Area.
This, invariably, resulted in loss of value in most financial assets. For instance,
the stock markets in key emerging economies started showing signs of
depreciation with the announcement of tapering in the latter part of 2013.
The value of the Nigerian Stock Market declined by about 15 per cent
between end-December 2013 and mid-November 2014, while similar trend
was observed in a number of countries like Russia and Colombia. It was
observed, however, that emerging and developing market economies that
imposed capital controls and those with lesser international financial
integration, were less impacted upon by the capital outflows during the
tapering announcement by the Fed. However, uncertainties in the Euro
Area where interest rates are still low and reduced expectations of a likely
huge spread between the Euro Area and emerging market interest rates
moderated the level of such capital reversal. In addition, the
announcement by Japan to engage in open ended purchases of financial
assets, also gave indication that interest bond yields in advanced markets
may remain low in the near future. Recent data show that there has been
considerable reversal of capital flows to emerging markets, shortly after the
initial uncertainty and shock, occasioned by the US tapering programme.
ii. Growth: At the onset of tapering announcement, markets started
reassessing the growth potentials in emerging markets. Huge capital inflows
into the emerging market prior to the announcement of tapering,
contributed to loosening monetary conditions in these markets and such
inflows increased the growth prospects to levels higher than it would have
naturally been. On the announcement, such growth numbers were
reassessed downwards, and emerging markets with greater growth
prospects were less impacted by the tapering. For instance, in China, the
Purchasing Manager Index (PMI) for the manufacturing sector dropped to
a contraction zone in 2014 for the first time since September 2012, making
economic agents to envisage adverse effects on China. In other emerging
economies of Brazil, India, and Russia, the indicator fluctuated around the
long term mean, reflecting contraction and expansion. This development,
coupled with improved outlook in the advanced economies, reduced
investors‘ sentiments for emerging economies.
iii. Interest Rates: The quantitative easing aided low and falling interest rates in
most emerging and developing economies as a result of inflows of foreign
capital. The announcement of the tapering in May 2013 triggered a
QUANTITATIVE EASING EXPLAINED
23
massive sell off by foreign investors in emerging economies. To counter the
move, the monetary authorities in several emerging economies like India,
South Africa, Kenya, among others, had to tighten monetary policy stance
by raising their policy rates. As pressure in the foreign exchange market
increased, strong policy response led to a much higher hike in policy rate,
which invariably permeated the spectrum of rates in these economies.
Under the circumstances therefore, the retail end of the credit market was
the worst hit, with severe implication for small and medium scale industries,
which depend on that segment of the market for funding. This invariably,
contributed to the slowdown in output in the emerging economies. In
addition, the high interest rates created risks such as capital losses on fixed-
rate securities held by commercial banks and other financial institutions in
emerging market economies. Though, such losses were offset by increasing
net interest margins by some of the banks, it worsened the high interest
regime associated with the impact of Tapering in emerging markets. Belke
(2013) further notes that banks with weak capital base faced greater
interest rate risks, especially if they were over exposed to foreign credit lines.
Commercial banks exposed to such interest rate risks may be further
burdened by weak loan performance, as their customers are likely to
default as interest rates overshoot.
iv. Exchange Rate: Foreign exchange market response to the Tapering is
sensitive to the performance of portfolio inflows and current account
positions during the Quantitative Easing period. Emerging market
economies that allowed their exchange rates respond to the huge inflow of
portfolio investments are currently suffering from the withdrawal syndrome
of such inflows, and it is impacting negatively on their exchange rates. On
the other hand, emerging market economies that allowed their current
account deficits to widen when it was easily funded by inflows are currently
faced with current account imbalances as inflow reversal hit such
economies. Indeed, emerging market economies that were wise enough
to prevent significant appreciation in their exchange rate and moderate
the current account deficits during the boom era, did not suffer
appreciable capital outflow
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SECTION TEN
Nigeria’s Experience
The 2007/9 global financial crisis had severe adverse impact on the Nigerian
financial system and by extension, the whole economy. The negative impacts on
the financial system included liquidity shortage due to reversal of capital flows,
erosion of the capital base of the banking system due to unprecedented
increase in the non-performing assets, breakdown in monetary policy transmission
mechanism due to high volatility in short term interest rate, and near collapse of
the interbank-market due to high counterparty risk. As a result, the Central bank
of Nigeria (CBN), like many other central banks, adopted an expansionary
monetary policy stance using the conventional instruments of monetary policy.
The various conventional monetary policy instruments-Monetary Policy Rate
(MPR), Cash Reserve Requirement (CRR), Liquidity Ratio (LR) - were reduced to an
all time low. The reduction of rates on the conventional instruments were further
complemented with some administrative measures such as expanded discount
window operations to improve the liquidity status of the banking system,
reduction in the Net Open Position (NOP) of the banks to manage the risk of
distress due to capital outflow, minimum duration of portfolio flows to ensure
orderly exit of portfolio capital, interbank market guarantee to de-risk interbank
market transaction and restore confidence, restructuring of margin loans to
address the huge non-performing loans due to exposure to capital markets, and
guarantee on foreign credit lines to ensure confidence and maintain important
correspondent relationships. Despite these measures, rebound in output was still
sluggish as critical sectors of the economy were denied access to credit owing to
myriad of factors including the weak balance sheets of the DMBs as well as non
suitable financing products. In a bid to catalyze financing of the real sector, the
Monetary Policy Committee in 2010 adopted a quantitative easing measure by
approving the sum of N500 billion to support direct credit to three critical sectors
namely manufacturing, power, and aviation. The scheme was implemented
through subscription to the debenture of Bank of Industry (BOI) for the sum of
N500 billion to enable the BOI offered on-lending to the sectors indicated. The
scheme was structured in such a way that N300 billion was allocated to power
and airline projects, while N200 billion was to refinance and restructure the
Deposit Money banks‘ existing loan portfolio in the manufacturing sector, in order
to achieve double-digit growth. The specific objectives of the scheme include:
fast-tracking the development of electric power projects, especially in the
identified industrial clusters of the economy; fast-tracking the development of the
aviation sector of the Nigerian economy by improving the terms of credit to
airlines; providing credit enhancement tool for improving the financial position of
the Deposit Money Banks (DMBs); improving power supply with a view to
QUANTITATIVE EASING EXPLAINED
26
generating employment; and providing platform for additional private sector
investments in the power and aviation sectors.
A significant contribution of the scheme was the bold steps taken to address the
infrastructural deficit in the country, particularly on power projects. The power
and aviation intervention fund was designed as a quantitative easing monetary
policy measure to address the major constraints of real sector development,
including the unavailability of appropriately priced long-term credit facilities, and
the acute shortage of power supply in the country. The components of the fund
include refinancing of existing loans, refinancing of existing leases, and working
capital for both power and aviation sectors.
In its implementation, the Fund is disbursed to power projects with a tenor of 10-15
years at concessionary maximum interest rate of 7.0 per cent by the Deposit
Money Banks. This has tremendously aided the rebound of the Nigerian economy
from the crisis in a number of ways. First, it has boosted the power generation in
the economy. To underscore this point, eighteen (18) power projects have been
financed under the Fund with nine (9) of them having potential generating
capacity of 582 mega watt, out of which 349.2 mega watt was additional
megawatts generated. The contribution is better appreciated if cognizance is
taken of the prevailing total electricity generation of about 4000 mega watts,
indicating that the Fund has succeeded in increasing the national supply by
about 9 per cent within its short duration. Second, the design of the fund is such
that beneficiaries must provide 30 per cent equity finance, thus the N85.74 billion
approved under the project as at February 2012 suggests that an additional
amount of about N26 billion had been invested by private sector into the
Nigerian power sector by that date. Third, the Fund has aided the developments
of long-term bank credits suitable for financing infrastructure projects, which had
allowed DMBs to compete for Direct Foreign Investments (DFIs). The Fund has also
resulted in savings on interest expense for investors in the power sector of the
economy. The average commercial lending rate in the economy is 19 per cent
unlike, 7 per cent under the fund. Available statistics showed that interest
expense of about N6.00 billion was saved by beneficiaries as at February, 2012.
Finally, the concessionary interest rate of the Fund at 7 per cent, coupled with its
long tenor of 10-15 years, has created a stabilizing effect on the capital structure
of power projects.
QUANTITATIVE EASING EXPLAINED
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SECTION ELEVEN
Conclusion
Quantitative easing is a monetary policy tool normally employed, when the
conventional monetary policy tools become inadequate to address the
challenges confronting the macro-economy. As a result, it is normally regarded
as an unconventional monetary policy tool reserved for periods of
macroeconomic crisis. The conventional monetary policy tools are essentially
market based instruments, which presumes an effective and efficient functioning
financial markets for their efficacy. In light of this, any hitch in the operations of
the financial market invariably constrains the smooth use of the conventional
monetary policy instruments. Apart from failure of the financial markets, other
factors such as adverse global shock, political tension or crisis, wars, natural
disasters, could render the conventional monetary policy tools ineffective.
Quantitative easing is normally used under this regime with the overall objective
of increasing money supply through direct target intervention in critical sectors of
the economy. The Bank of Japan introduced quantitative easing in the early
nineties to address deflation concern, while its use gained increasing prominence
during the 2007/9 global financial crisis as central banks across the globe widely
deployed it. The Central Bank of Nigeria equally used quantitative easing during
the period to accelerate the rebound of the economy through direct
intervention in manufacturing, power and aviation sectors. The tool has been
highly successful in moving economies out of depression to the path of recovery,
although its use has equally attracted a number of criticisms including the
aftermath surge in inflation. The critique notwithstanding, a great deal of global
intellectual effort is ongoing about the possibility of using quantitative easing as a
monetary policy tool during normal times.
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