Queasy about QE

In a market economy, price mechanism plays a key role in allocating resources efficiently. When it comes to capital allocation, monetary policy assumes a decisive role; the interest rate is one of the important tools to ensure efficient allocation of capital.

The traditional way of conducting monetary policy was misshaped by zero interest rate policy. Unconventional policies such as quantitative easing (QE), designed to prevent the collapse of the global financial system following the fall of Lehman Brothers, drove capital towards riskier bonds and compressed yields on such assets.

Artificially depressed interest rates, through easy monetary policies, enabled even struggling enterprises to get access to cheap finance, increasing the risk of series of corporate defaults in the future. With the QE enabling central banks to become a dominant player in the government bond market (the BoJ, for instance, owns around 25 per cent of outstanding Japanese bonds), private liquidity has dwindled, creating an environment where even small transactions will lead to exaggerated moves.

When central banks in advanced economies, particularly the US Fed, begin the policy normalisation process, the obvious response of investors would be to offload riskier holdings. What if everyone were to sell an illiquid, high-yielding bond at the same time? Would that not lead to a freeze in that market?

Given the scale of investment in high-yielding bond markets, a freeze in that market could have major ramifications for advanced economies.A return to a normalised interest rate environment could address the problem of capital being allocated to less productive use. For financial markets, having been awash with abundant liquidity for long, a return to normalcy is going to be a bumpy ride. Even a 25 bps hike by the Fed has the potential to spook financial markets with strong repercussions for the global economy.

Perhaps, increasing liquidity in the high-yield debt market can limit the potential impact of policy normalisation. But stringent capital regulations dissuade banks holding big bond inventories for trading with customers, meaning the problem of illiquidity is unlikely to be addressed anytime soon.

Market participants have lost confidence in central banks’ ability to stabilise inflation, as evidenced by subdued inflation expectations; imagine what would happen if they were to lose faith in central banks’ ability to rescue economies and protect financial stability. No matter how much the size of the next QE would be, global investors would not be convinced and would continue to dump riskier assets. That would in turn trigger an abrupt rise in market risk premiums and a sudden drying up of liquidity in high-yielding bonds, including emerging market bonds, thereby setting a stage for the next financial crisis.

Given its close integration into the global economy, India is not immune to external shocks.

While prevailing macro-prudential measures believed to have limited excessive overseas borrowing, we have to keep a watch on emerging global developments and how they transmit into domestic corporate balance sheets. Indian firms on their part should increase their hedging ratio to cover much of their foreign exchange exposure.

The writer is an economist

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