QE proposal could yield untold financial instability for SA’s economy
If global inflows from global QE are combined with domestic QE, the combined domestic liquidity can cause an asset price bubble to burst
Prof Christopher Malikane concluded a recent opinion piece by saying “ ... a QE programme ... would significantly ease the fiscal constraint on government and support liquidity provision to the banking sector, thereby ensuring financial stability”. In my opinion, when all things are considered this proposal is dangerous and might yield untold and unprecedented financial instability for the SA economy if implemented as suggested.
Quantitative Easing (QE) is the financial policy of purchases of government debt-raising paper (bonds) in the hands of the private sector holders, and could be narrowed to the banking sector for this discussion. Let us assume that one agrees with the proposal “ ... to set the repo rate at the level that is consistent with the stability of the exchange rate, and then embark on QE”, as the author postulates.
My point of entry in this debate is first on the challenging task posed by this proposal, that is to model and present a repo rate that is consistent with the exchange rate, if you can model it with any success. This by itself would build the volatility of the exchange rate into the repo rate, and by implication to the prime lending rate. Unless you abandon the free-floating exchange rate policy, which has served us well so far, for a more restricted exchange rate policy path.
The manner in which Malikane frames his argument suggests a floating exchange rate, a floating repo rate and market determined inflation, which would then leave the Bank to only determine the quantum of QE. We need further clarity on his operational modalities for setting the repo rate at a level consistent with the stability of the exchange rate. Otherwise, there would be truly little success with a floating trinity.
Between Malikane and Reserve Bank governor Lesetja Kganyago, a hypothetical R500bn is used as a quantum for contextualising the QE example, and on that basis their respective calculations yield a profit of about R32bn by the former and a loss of about R19bn by the latter. On a nice sunny day we may express these numbers in ratios of some relevant macroeconomic indicators, to give context to the benefits of this exercise, but I would not bother sweating such small arithmetic at the macro scale.
Just for the background, the governor is tasked with the maintenance of financial stability in the republic, in the interest of balanced and sustainable growth. Sustenance in financial markets requires nurturing, in a balanced manner, the supply and demand for loanable funds in the financial system.
The SA financial system has evolved well over the years to earn its global stature of depth and breath. There is a healthy interplay between the liquid money and capital markets, all offering savers and borrowers reasonably efficient services at low costs of transacting with decent liquidity to facilitate entry and exit.
The government debt market is healthy, where the government supplies the paper and financial institutions buy such paper, using funds from the broad spectrum of savers. Before the economic downturn fiscal policy sought to be non-dominant in a countercyclical conduct and debt funded predominantly in the well-developed domestic debt market. Our banks interplay in both the money and debt markets with funding mostly sourced in the domestic market.
So, in the QE context, the governor must wear all his hats, that of price stability and financial stability and the interplay between the two policies. The governor is legitimately worried about inflationary effects of QE and so should all the sectors of the economy, but one must be mindful of his broader mandate, which is financial stability.
If the entire QE is sterilised, the concern for inflation falls away but raises concerns over the cost of sterilisation, as indicated by the governor’s back-of-the-envelope calculation of R19bn per annum. If the governor fully sterilises the QE, Malikane’s need for QE is negated as the money flows back to the Bank without causing real economic effects.
Sterilisation is taking the full amount used to purchase the bonds back as deposits with the Reserve Bank and remunerated at a fee, rendering the net effect of the whole exercise a simple swap of the source of borrower for banks. That is, where the initial borrower was the government to then become the Reserve Bank as a substituted borrower, as per the mechanics of QE.
If we go by the unsterilised QE, where the Bank engages in a simple purchase without taking an equivalent deposit from banks, the transmission of the Reserve Bank money now in banks may take many forms when entering the economy. If we have unsterilised QE we may rely on the difficult speculation that has perennially ended in tears, that is of trusting that banks and their shareholders will exercise sufficient prudential restraint from embarking on “reckless lending”, as also expected by the financial regulators. The last global financial crisis is one such result.
Reckless lending destroys the borrower, the lender, the bank and the fiscus. Reckless lending is often rife when banks have excess liquidity in relation to bankable projects. Liquidity in the banks’ hands mean they are obliged to remunerate those they have sourced the liquidity from. It is noteworthy that QE happens in a zero-bound interest rate environment and this has stressful implications for banks, which are compelled to seek a return for funds that require remuneration at the end of the period.
In a globally interlinked financial system lending institutions must often cross borders in search of yields, because failure to do so at zero-bound interest rates may lead to liquidation. Cross-border lending is expensive and very risky for banks because they must assume external business and sovereign risks. It is also an export of skills.
Since the last global financial crisis, our banks have shown a significant affinity to fund projects on the African continent and overseas, and unsterilised QE could easily force them to resume that route in earnest and bypass the domestic economy, which would have assumed zero-bound interest rates under QE conditions.
The Reserve Bank publishes an indicator of the phases of the business cycle, and this shows that the SA economy has been in a downward phase since December 2013, making this the longest downturn since 1945. The Covid-19 pandemic has made a bad situation worse. There would be truly little hope that QE would find fertile “animal spirits” to take up the liquidity offered by banks domestically; instead large leakages would be forced upon them.
A rhetorical passing question would be, do domestic banks and borrowers see interest rates at current settings still as a barrier to the supply and demand for credit in the domestic economy? In an unsterilised QE situation one can overload an assumption, where you would add a burdensome case for the Reserve Bank, working with the Treasury to come up with what one might term selective conditional quantitative easing (SCQE). This would be burdensome because it would set the two institutions in a domain they are not legally geared for, nor resourced for.
The SCQE would be a condition that requires the two institutions to identify banks that are significant holders of government bonds as targets for bond purchases (QE) with an upfront agreement that those banks commit to infrastructure expenditure with their QE receipts. The Reserve Bank and Treasury would then have to appoint a reputable project manager to monitor adherence to project timelines and quality delivered, bearing in mind that this would be burdensome and outside their mandates, resources and competencies.
In trying to accommodate the calls for QE by Malikane et al, all of the above should still be tested against what other monetary policy jurisdictions are doing, bearing in mind that in the end we are a price-taking economy in the global economic policy space, by far. If you aggregate the policy easing efforts by the systemically important and policy-determining central banks around the globe, you will quickly conclude that their current QE easing intentions far outweigh their previous levels, effected after the global financial crisis.
The previous round of global QE was prominently problematic for emerging economies. Emerging-market economies had better growth and higher yields compared to the countries that embarked on QE, and in the current situation the policy settings are lower, but yield differentials still favour broadly emerging-market economies in attracting funds.
As the current phase of QE gathers momentum, the trends seen in the previous round of QE will be replicated and multiplied as the new QE quantums are larger. Zero-bound yields in the large economies will trigger larger QE responses than seen before and the search for yields in smaller policy-taking economies with “interest rates set for exchange rate stability”, as per Malikane’s model, will invariably start experiencing large portfolio capital inflows.
As in the previous episode, there were no instruments to stop such currency inflating inflows and those that tried failed. This time QE packages are bigger and therefore will cause larger flows to emerging economies. The currency appreciations for emerging market currencies will be larger and the trade balances will be more distorted.
Strong currencies of emerging markets will make exports into developed economies uncompetitive and will increase their ability to import from them, the trade balances will deteriorate, export-led growth will become impossible, import substitution efforts will get undermined, growth will recede, with increasing unemployment. The capital inflows will push domestic financial assets far higher than their book values, with a potential to cause dangerous asset price bubbles.
Such conditions can cause conditions to be extremely dangerous for financial stability. At such already exceptionally low economic growth and historically low inflation, the domestic economy can easily be pushed into a very deflation and depression. If global inflows from global QE are combined with domestic QE, the combined domestic liquidity can cause an asset price bubble to burst, causing unprecedented financial instability.
Domestic QE can be managed by sterilisation, but in that case the real sector effects would be counteracted. If QE is unsterilised it is not certain that the domestic real economy can absorb the full stimulus, given the exceptionally low levels of confidence and capacity to present bankable projects. The latter would heighten the external search for yield into finance-hungry and likely better-growing economies in Africa and overseas.
The attractiveness of the JSE to significantly large QE jurisdictions can bring large distorting capital inflows, as seen before, and such liquidity can combine with domestic QE liquidity to inflate financial asset prices, pushing price-to-earnings ratios of our JSE to financial instability proportions. Such conditions can push the SA economy close to, if not deeper into, deflation and depression.
So, the quantum of the profit or loss of the technical implementation of QE in SA are too small compared to the potential problems of combined liquidity bombarding the local financial system emanating from QE, of local and international source. Such liquidity would inflate asset prices and cause a meltdown and unprecedented financial instability. I would certainly advise against domestic QE along with globally systemic QE programmes.
• Mamba is a former SA Reserve Bank economist, now retired.
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