Series 44 early page - Central Bank of Nigeria | Home MONETAR… · Reasons for Quantitative Easing The Bank of Japan pioneered the use of Quantitative easing in March 2001 in order

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


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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.


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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


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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


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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.


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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.


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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


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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.


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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


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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.


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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.


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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


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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


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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


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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.


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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


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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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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,


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


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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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25

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


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.


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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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