What is QE TAPERING?
“Tapering” is a term that entered (and entered with explosion) into the financial wordlist on May 22, when U.S. Federal Reserve Chairman Ben Bernanke stated that Fed may taper the bond-buying program known as quantitative easing (QE) in the coming months. To understand the effect of “QE TAPERING” on emerging market, one must understand the effect of QE in India and other emerging markets. QE had created surplus liquidity in global financial markets, which was directed towards emerging markets in search of higher yields. This enabled emerging markets to have record low interest rates and an environment generally conducive to higher growth than in advanced economies.
Quantitative easing fundamentally is an unusual money supply experiment used by central banks to alleviate the economy. During economic slowdown, central banks lower its interest rates, which would stimulate lending and economic movement in the economy as lower interest rates boosts people to spend rather than to save. However, in case of US Federal Reserve, when interest rates could not drop further, the central bank started buying bonds to inject money into the fragile economy that was at risk of seeing financial market impurity. Theoretically, the institutions selling these bonds have, thus, improved ‘fund positions’, which increased money supply providing momentum to the lending activities, thus, the economy is set in motion. In late 2008, when the financial crisis hit, FED started buying up Mortgage Backed Securities and later on even T-bills to alleviate financial markets and to provide liquidity to the market that had entered into a financial impurity. US Fed initially reduced the interest rates to the historical low level of 0.25%. When this step also did not prove adequate, quantitative easing was used to increase liquidity, spur borrowing and kick start the economic activity in high gear. The current monetary policy termed as QE3 is the 3rd edition of this ‘bond shopping’ which the Federal Reserve has started with USD 85 billion worth of bonds being bought every month. This includes USD 40 Billion in Mortgage Backed Securities and USD 45 Billion in long term US Government securities (To know about QE in detail please read my article on “Quantitative easing”
http://raytirtha.wordpress.com/2013/08/06/quantitative-easing/)
How does it affects the Indian and other Emerging Markets
Let us discuss the area of concerns one by one.
High foreign debt – The end of incentive is going to badly affect the International high yield bond market. In near future, if not immediately, normalization of interest rates in US is predictable. This would put all the companies who had raised low cost floating rate debt from the global markets to use the benefit of low interest rates prevalent in the global markets in jeopardy as they should see a significant rise in their interest cost. This would mainly include companies which have, in last 2-3 years, gone for major overseas acquisition via the debt route. Indian companies raised USD 11.16 billion worth of funds overseas in FY 12-13. These low rates do not seem to be eye-catching any more with the bond yields on rise amid news of ending of money easing policy by US. Indian companies’ overseas bond sales have slowed down substantially in a tightening global money market as just one Indian company managed to sell dollar bonds since May 22, the day when the Federal Reserve hinted at tapering of the quantitative easing programme. Since the chairman Ben Bernanke’s statement, only one Indian firm, Indian Oil, has raised $500 million by issuing a 10-year dollar-denominated bond with a coupon of 5.75%. Two public sector banks- Syndicate and Canara Bank- have deferred their plans to raise funds through overseas bond issuances. Canara Bank was planning to raise $1 billion, while Syndicate $500 million. Yields have risen more than 150 basis points and, for Indian companies, the cost of funding in US dollars will be more than the cost of funds in rupee terms, if adjusted for hedging costs because of the currency fall. For some of the companies, it could rise as high as 11%. Slowing economic activity where economists are forecasting growth slipping below even the 5% achieved last year, could hurt fund-raising plans.
Emerging Market (EM) currency depreciation – With the yields in US T-Bills, especially TIPS (Treasury Inflation protected strips) rising above 0%; for many FII’s who had been investing in emerging markets would now move back to investing in US bond markets. While in near term, this would make USD stronger and EM currencies weaker. However once the structural adjustments have been made, EM currencies would stabilize at a new higher level, and EM with strong macroeconomics, is likely to see large FII inflow back in to their Debt market.
This short term volatility in currencies would put pressure on the balance sheets of the companies with high USD denominated debts with no natural hedge. So, for example, because Reliance has large amount of USD denominated debt, it will not get hurt as its revenues and earnings are also in dollar terms. While Indian infrastructure companies like L&T can see their debt servicing cost increased because of higher cost in Rupee terms.
FII holdings and their debt investments – As treasury yields rise, the gap between US treasuries and Indian G-Secs have narrowed, thus, making the debt investments in India not much an attractive option for FII’s . Indian stock markets received huge amount of FII inflows in 2012, which are likely to suffer a setback in the short term, on account of falling Rupee and Fed’s policy. This means that the companies that have high FII investor interests are expected to suffer. The depreciating Rupee along with announcement of slowing down of the bond-buying by Fed may trigger FIIs to withdraw from investing in Indian markets. Over last month as Nifty fell by nearly 8%, an FII investor would have seen a total loss of about 13% (8% from fall in Nifty and another 5% from fall in Rupee against USD).
Banks to face the heat - Indian bonds may also experience rise in the yields as FII’s exit from Indian G-Secs (Since the start of August 13, the FII’s have sold net Rs. 21,000 Cr. in Debt Markets). As a result, the bond prices will go down. The banks investments in G-Secs that are accounted on the basis of Mark to Market accounting methods i.e. Available-For-Sale and Held-For-Trading Securities may see losses if Indian yields rise as a result of liquidity crunch and if RBI is forced to reverse its interest rate policy stance because of continued Rupee slide.
Current account deficit- Despite deteriorating fundamentals, net capital inflows totalled USD88bn in 2012, largely due to global quantitative easing. Indian economy relied on a flood of cheap QE-sponsored foreign capital over the last two years to offset bloating current account deficits. When these inflows dry up, even for a brief period, the currency comes under pressure and an underlying trade deficit can quickly run down foreign exchange reserves. The threat can be managed if countries respond with reforms to cut their deficits. Unfortunately, India’s policy makers seem less inclined to recognise the full extent of the problem and in the absence of sustained foreign investment flows its economy will be unable to avert an eventual Balance of Payment crisis. But the Government refuses to demonstrate the political will to enact necessary measures. In fact, its insistence on passing the Food Security Bill, for what would seem to be self-serving reasons, will only aggravate the problem.
Some words of caution- The Asian financial crisis of 1997/98 was, in part, triggered by an earlier version of QE pursued by Japan in the aftermath of the bursting of its property and asset bubble in the early 1990s. Then, too, the large inflow of low-cost yen loans led to the asset price bubbles, inflationary pressures and currency instability in the Asian economies. They paid a heavy price in the bargain. A larger, more pervasive crisis may await the emerging and developing economies unless there is a much more coordinated and careful handling of the risks that are already building up. The G20 should have this issue at the top of its agenda.
If you have any query please contact me at tirtha.ray@gmail.com
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