Quarterly Bulletin April - June 2011 - Gauteng Provincial Treasury

treasury.gpg.gov.za

Quarterly Bulletin April - June 2011 - Gauteng Provincial Treasury

Quarterly BulletinQuantitative Easing and Gauteng Its Effects on Treasury Economic NewsletterMarkets1. Introduction2. QE Related Concepts2.1 Background to the Financial Crisis2.2 Monetary and Fiscal Policy2.3 Creation of Money3. How QE Operates3.1 Comparison of QE and Credit Easing4. QE to Date5. Effects of QE5.1 Commodity Prices5.1.1 Gold5.1.2 Brent Crude Oil5.2 Portfolio Investments5.3 Inflation6. Impact of QE on South African Economy6.1 Commodity Prices6.2 Currency Exchange Rates6.3 Inflation7. Conclusion8. ReferencesEconomic Analysis Directorate 2


Quarterly Bulletin1. IntroductionGauteng Treasury NewsletterTraditionally, when a country‟s central bank seeks to stimulate spending in its domestic economy,one of the options that could be considered is an adjustment of the repurchase (repo) rate. Byreducing the interest rate which it charges commercial banks when they borrow from it, thecentral bank encourages the banks to borrow more money from it. The commercial banks canthen reduce their own rates which they charge for loans. In this way, the central bank intends toincrease credit extension to the private sector and boost spending. This tactic is generally used inresponse to a downturn in economic activity.There are times however, such as the recent global recession, when a central bank lowers its reporate repeatedly as it tries to mitigate continuous downward pressure on its domestic economy. Ifthe repo rate nears zero, further rate cuts become a matter of smaller and smaller fractions of apercent, reducing their impact. In such times a central bank may resort to other measures.Quantitative easing (QE) is the term used to describe a central bank increasing the supply ofmoney by buying financial assets such as government or corporate bonds. This is done by thebank crediting the accounts of the commercial banks and other financial companies from which itbought the assets, thereby creating money electronically. This is done with the hope that theadditional money in the economy will promote spending, leading to an increase in economicactivity. QE is an expansion of the money supply and as such, falls under a country‟s monetarypolicy operations.QE is not without risks however, chief amongst these is the risk of inflation. This is because theamount of money in the economy is increasing but the quantity of goods for sale remains thesame. In this instance, if production does not increase rapidly and the money does not exit theeconomy, inflation will result. QE also risks simply being ineffective. It is possible that banks willnot lend out the extra funds and companies will not spend it. Also, the money could flow out ofthe economy to seek better returns in countries with higher interest rates. QE was introducedrecently as a way to curb the devastating effects of the global financial crisis that led to the globalrecession.The paper analyses the effect that QE had in countries where it was enacted and also how itaffected markets in terms of commodity prices, portfolio investments and inflation. The effect onthe South African economy is also analysed in terms of the mentioned indicators before the drawnconclusions.Economic Analysis Directorate 3


`Quarterly Bulletin2. QE Related ConceptsGauteng Treasury NewsletterThis section gives meaning to economic concepts that are related to the subject of QE,specifically, the financial crisis, monetary and fiscal policy fundamentals and the explanation ofmoney creation. The section also discusses the recent financial crisis, as QE was implemented asa response to the effects of that global financial crisis. Monetary policy is related to QE; interestrates and money creation form the core of all the mentioned processes.2.1. Background to the Financial CrisisAccording to a 2009 report by KPMG 1 the financial crisis began when the lending policies in theUnited States of America (USA) were amended to allow Americans access to mortgage loans,even if they had no income and no collateral. These loans were known as sub-prime loansbecause their interest rates were below the prime rate. Financial institutions packaged theseloans together because they believed that the risk of the total package was reduced due togrouping many seemingly unrelated loans. These packaged loans were then sold on, to otherfinancial institutions from around the globe. South African banks were unable to purchase thesepackages due to prudent financial legislation put in place by government recently, namely theNational Credit Act No. 34 of 2005.The world demand for all products went through a growth phase and prices began to rise.Inflation all over the globe rose, eating into the disposable income of households, which of courseincluded the USA households that had taken out sub-prime loans. In response to this inflation,interest rates were increased world-wide, further eroding disposable incomes and making evensub-prime loans more difficult to repay than they had been when first taken out. Thiscombination of factors led to a great many of the sub-prime borrowers, not good credit risks tobegin with, to default on their loans.The packaged loans consisted, as mentioned above, of sub-prime loans. As such, the loans werenot as unrelated as their packagers and subsequent purchasers had thought. Since the subprimeborrowers had similar financial situations, if one borrower in a package defaulted, it waslikely that the same factors which led to that default would apply to most of the other borrowersin that package and they would thus default as well. The entire loan-package would thencollapse. The financial companies which traded in these packages no longer wished to trade1 This was a KPMG publication of the Economic Insight Quarterly Review report.Economic Analysis Directorate 4


Quarterly Bulletinthem. As investors saw the damage being done to financial markets by the loan defaults, theybegan to disinvest,Gautengworsening the problemTreasuryand creatingNewslettera full-blown global financial crisis.2.2. Monetary and Fiscal PolicyA country‟s central bank is responsible for that country‟s monetary policy and the government‟sTreasury Department oversees issues of fiscal policy. Monetary policy measures include thesetting of the repo rate and expanding or contracting the money supply. Monetary policy is furthercharacterised by the 18 to 24 month lag between its implementation and its effects. According toFourie (2006), central banks often make small adjustments through purchases of securities ontheir country‟s financial markets; this is a day to day activity known as open-market operations.QE is very similar to open-market operations, the differences being the intent of the policy, thesize of the transactions and the fact that the intent, size and timing are all widely publicised. Tocontrast, fiscal policy refers to government revenue and expenditure and as such, its policiesinclude taxation and government spending. Monetary policy, with its measures of expanding andcontracting the money supply of a country, is related to the concept of money creation.2.3. Creation of MoneyFourie (2006) explains the primary means of creating money as credit extension and not printingbanknotes. When a bank receives a deposit it is only required to keep a portion of that deposit,known as a reserve requirement 2 and can lend out the rest. The bank again keeps the requiredreserve and lends out the remainder. This process can potentially continue until the initial deposithas been multiplied by the inverse of the reserve requirement. This is known as the moneymultiplier. Figure 1 illustrates the process of how the money multiplier operates.2 According to the June Quarterly Bulletin of the South African Reserve Bank, the reserve requirement for South Africa is2.5%.Economic Analysis Directorate 5


Rands Created1234567891011121314151617181920FinalQuarterly BulletinFigure 1: The Money Multiplier Effect500Gauteng Treasury Newsletter4003002001000Initial DepositExpansion StageInitial Deposit Accumulation Current StageSource: Modern Money Mechanics, 2011Note: Assumes a 20% reserve requirement and a R100 initial deposit.XAs explained by Gonczy (1992), when money from the central bank enters a commercial bank, itis subject to the multiplier effect. This is because the bank can lend out more money than it has,needing only to maintain a certain percentage of its deposits as cash, known as the reserverequirement. For example, if a commercial bank receives R100 and the country has a reserverequirement of 20%, the bank can lend out up to R80. The person who receives this loan spendsit and the money is then banked. The bank which receives this R80 can keep 20% (R16) and lendout R64. This process can potentially continue until the initial deposit has been multiplied by theinverse of the reserve requirement, in this example 1÷0.2=5 which, when multiplied by the initialR100 gives an amount of R500. Essentially what this means is that R500 was created out of theoriginal R100 and added to the money supply. Since a commercial bank‟s balance with its centralbank counts as cash for the purposes of reserve requirements, a central bank can start thisprocess by simply crediting the accounts that the commercial banks hold with it. In QE, this creditis granted in exchange for financial assets, most often government bonds.3. How QE OperatesFigure 2 provides a brief overview of the theory of the manner in which QE is intended to work.When the central bank of a country engages in QE, it boosts the supply of money in its economyby purchasing assets such as government and corporate bonds. In modern times printing morebanknotes is unnecessary; instead the bank can pay for these assets by simply crediting theaccounts of the entities it bought the assets from, creating money electronically. The Bank‟sEconomic Analysis Directorate 6


PriceYieldQuarterly Bulletinpurchases of these financial assets should push up their prices by creating additional demand. Asthis is new money Gauteng created by the Treasury central bank which Newsletteris paying for these assets, the quantity ofmoney in the economy increases.Furthermore, because the money takes the form of increases in the accounts that commercialbanks hold against their central bank, the commercial banks are able to increase their lending byan even greater amount as detailed in section 2.3 above. Some of this money is likely to be usedto purchase financial assets, further raising their prices. It is also theorised that the signals acentral bank sends to the market by undertaking QE may have more effect on asset prices thanthat had by its actual purchases (Bernanke, Reinhart and Sack, 2004). Figure 2 below gives anillustration of the situation.Figure 2: Supply and Demand for Bonds250201510551015202500 100 200 300 400 500 600 700Bond Quantity30DemandSupplySource: The Economics of Money, Banking and Financial Markets, 2011XHigher asset prices mean that holders of those assets are wealthier than they were before thepurchases began. The prices of financial assets are also inversely related to their yields, meaningthat higher prices make it cheaper for companies to borrow by issuing these assets because theyare able to offer lower yields. The rise in wealth and the increased ease of borrowing shouldencourage both households and businesses to increase their spending in general. This increaseddemand for goods and services should deplete the inventories which were built up in theeconomic downturn, signalling to producers that they should increase production. Raisingproduction should require business to hire more workers and then the increased demand forworkers should raise wages; both these effects should raise income levels in the economy. ThisEconomic Analysis Directorate 7


Quarterly Bulletinshould encourage further spending, reinforcing earlier gains and creating a virtuous circle.However, if production does not rise to meet increased demand then the amount of money inGauteng Treasury Newsletterthe economy will have risen but the quantity of goods and services will have remained the same.Thus, money will be relatively less scarce, reducing its value. More money than before will berequired to make purchases and inflation will result. Figure 3 below gives a graphical illustrationof the QE operation as explained in this section.Economic Analysis Directorate 8


Figure 3: Theoretical Ideal of Quantitative Easing 3Central Banks purchases assetsfrom private sector. Newmoney is created electronically.Purchases of financial assetsincrease their prices.Asset purchases by private sector.Money supply increases as moneyis pumped into the economy.Higher asset prices increasetotal wealth.Higher asset prices mean loweryields, making borrowingcheaper for business.More money in their reservesmeans banks can increase lendingto households and business.Increased wealth and easier borrowing should encourage households and business to increase their spending.Increased spending should deplete inventories, which in turn should encourage business to employ more workers andraise income levels. This further increases spending, creating a virtuous circle.3 This illustration was inspired by the Bank of England‟s pamphlet, “Quantitative Easing Explained.”Economic Analysis Directorate 1


Quarterly Bulletin3.1. Comparison of QE and Credit EasingGauteng Treasury NewsletterThe USA Federal Reserve Bank (Fed) Chairman Ben Bernanke has argued that the policy beingenacted by USA‟s Fed is distinct from quantitative easing 4 . Mr Bernanke claims that, “the Fed'scredit easing approach focuses on the mix of loans and securities that it holds and on how thiscomposition of assets affects credit conditions for households and businesses,” while pure QEfocuses on expanding the quantity of bank reserves. The policies can resemble one another in thatthey both involve an expansion of the central bank‟s balance sheet. The difference, however, isthat in quantitative easing this is the ends while in credit easing it is the means.According to Bernanke et al (2004), the effect of credit easing is very much dependant on exactlywhich securities a central bank buys and exactly what loans it extends in the course of enactingthe policy. The authors argue that in a perfect financial market, the central bank‟s ability tochange the supply of financial assets by purchasing them would not have any effect because thepricing of any such asset would depend entirely on the date and value of its maturity. However, inthe real world transactions have costs attached and financial markets are far from perfect. Assuch, a central bank‟s purchases may be capable of influencing the premiums paid on factors suchas term, risk and liquidity and thus affect overall yields. The paper also states that the prevailingview amongst financial economists is that the quantity of assets that the USA‟s Fed has purchasedin the past is insufficient to have the desired impact. The Fed has been successful in similarpolicies in the past, however, it is possible that by demonstrating its intention to achieve its goals,the Fed causes other market participants to act in such a manner that the other participants bringabout the Fed‟s intended effect. The paper cites USA President Franklin Roosevelt‟s successfuldefeat of deflation as an example.4. QE to DateThe First round of Quantitative Easing (QE1) began in December 2008 in the USA and continued toMarch 2010. The Fed purchased US$1.73 trillion worth of financial assets over that period, raisingthe value of its balance sheet to US$2.3 trillion by March 2010. Blinder (2010) argues that QE1seems to have been partially successful in reducing interest rate spreads, as spreads tumbleddramatically at the time that the Fed engaged in heavy quantitative easing. The financial crisiscaused some governments to respond drastically; for an example, the Fed responded by loweringthe target federal funds rate from around 5.25% to a range of zero to 0.25% over and above the4 This was in Mr. Bernanke‟s January 2009 speech at the London School of Economics.Economic Analysis Directorate 10


Quarterly Bulletinapplication of QEGauteng 5 . The second round of QE (QE2) started in November 2010, after economicperformance which the Fed considered Treasury less than satisfactory Newsletter and was intended to keep goingthrough to the end of the second quarter of 2011, with the purchase of $600 billion of USATreasury bonds in the open market planned. The Fed is still debating whether or not to implementa third round of QE.In the United Kingdom (UK), the British Parliament‟s Chancellor of the Exchequer gaveauthorisation to the Bank of England (BoE) to set up its Asset Purchase Facility (APF) to buyassets financed by the issue of Treasury bills and the cash management operations of the DebtManagement Office 6 (DMO), in January 2009. The intention of the APF was to improve the liquidityin and flow of credit markets. At the request of the BoE‟s Monetary Policy Committee (MPC), theChancellor also allowed the APF to be used as an additional monetary policy tool by the MPC.When the APF is used for monetary policy purposes, purchases of assets are financed by thecreation of central bank reserves and thus is an example of QE if enacted in a sufficiently largeamount. When its purview was expanded, the APF was authorised to purchase, for monetarypolicy purposes, up to £150 billion of assets, including UK government securities, of which up to£50 billion could be used to purchase private sector assets. At the request of the BoE‟s MPC, thatlimit was increased twice, to £175 billion in August 2009 and £200 billion in November 2009. As ofthe 7 th of April 2011, the BoE had purchased £200 billion of assets and the MPC voted to maintainthe APF‟s size at £200 billion and to keep the UK interest rates unchanged 7 at around 0.5%. Sinceits inception, the APF has purchased £198.3 billion in UK government securities, £8 billion incommercial paper and £1.6 billion in corporate bonds. Gross redemptions of commercial paperduring the period were £7.8 billion and the APF has sold £0.1 billion in corporate bonds.It is important to track the effect of QE on inflation, specifically for the USA and UK as thecountries mentioned for the purpose of this research. The figure below tracks the two countries‟trends in inflation in order to show the effect of QE on the indicator.5 This information was obtained from the IMF Working Paper of April 2011 by Medeiros and Rodriguez.6 “The DMO is an Executive Agency of Her Majesty's Treasury. The DMO's responsibilities include debt and cashmanagement for the UK Government, lending to local authorities and managing certain public sector funds.” –www.dmo.gov.uk7 This is according to information accessed from http://www.gaurdian.co.uk/2010Economic Analysis Directorate 11


Quarterly BulletinGauteng Treasury NewsletterFigure 4: Annual Inflation Rates, USA and UK, 2003–2011*4.543.532.52%1.510.50-0.5-12003 2004 2005 2006 2007 2008 2009 2010 2011*UKSource: World Economic Outlook, April 2011Note: * indicates a forecastUSAXFigure 4 shows that quantitative easing appears to have successfully kept the UK out of pricedeflation 8 and pushed the USA back out after briefly dipping into it in 2009. In 2010, the latestinflation rates for both countries have rebounded from large falls in 2009 and are projected tocontinue in an upward trend in 2011. For the BoE in particular, getting inflation back up to its2% target was a stated aim of QE. It can also be seen from the figure, however, that theannual inflation rate in the UK never quite fell to 2% and the International Monetary Fund(IMF) 9 expects the UK‟s inflation rate to increase further above the 2% mark in 2011, to overdouble the target at 4.2%.5. Effects of QEThe section that explained how QE operates made a conclusion that the application of QE,amongst other factors, likely results in inflation. QE can also influence prices of commoditiesbecause of the carry trade concept as explained in the section under commodities below. Thissection provides the trends in commodity prices, portfolio investments and inflation in order toanalyse the impact of QE on these variables as it was enacted after the global financial crisis.8 Deflation is the opposite of inflation and the Oxford dictionary of Economics defines it as a progressive decline in thelevel of prices.9 This information is as per the IMF‟s World Economic Outlook of April 2011.Economic Analysis Directorate 12


US$ per OunceQuarterly Bulletin5.1 Commodity PricesGauteng Treasury NewsletterSome of the money being pumped into developed economies by their central banks has foundits way into the commodity markets. Near-zero interest rates enable speculators to make profitsby borrowing money at almost no expense, though transaction fees still apply and investing it inalmost anything that shows even the slightest return. This phenomenon is known as the carrytrade. The increased demand for commodities has pushed up prices, whether this is good or badfor emerging economies depends in part on whether they export or import the affectedcommodity. Sumner (2010) argues that even the idea that QE could successfully boost worldoutput may be contributing to increasing commodity prices as investors move in, anticipatingfuture gains 10 . A rise in the price of an exported commodity most often helps the exportingcountry because it increases the returns the economy receives for the product. However, it ispossible that a sufficiently large rise in exports could reduce sales volumes enough to hurtrather than help.5.1.1 GoldGold is an example of a commodity exported by South Africa which has been increasing in pricein the last few years. Figure 4 tracks performance by this commodity to show the effect on itsprice, specifically for the period when QE was implemented.Figure 5: Gold Price, Monthly Average, January 2005–February 20111,4001,2001,000800600QE14002005 2006 2007 2008 2009 2010 2011Source: South African Reserve Bank, 2011X10 This is according to a publication in the Economist by Sumner, S, and Economics Professor at Waltham‟s BentleyUniversity.Economic Analysis Directorate 13


Quarterly BulletinThe figure shows that the gold price has risen quite steadily over the period 2005 to February 2011as per the information from the South African Reserve Bank (SARB). There are, however, someGauteng Treasury Newsletterfluctuations which coincide with global events over this period under review. As the globalrecession began, the price of gold increased as investors seeking a safe investment pushed updemand. It began to fall again in April 2008, before increasing again in December that same year,the very month that QE1 was enacted. Thus, it could be reasonably assumed that money from QEmoved into the gold market and increased the price of one of South Africa‟s major exports.5.1.2 Brent Crude OilAn increase in the price of a vital import commodity harms a country because more money is paidfor the same quantity of the product. A higher price for one product can even have a knock-oneffect, raising the prices of even locally-produced products and thereby increasing inflation. This isparticularly likely in the case of imports used in a country‟s own production processes. Oil makes asuitable example of this for South Africa and most other countries.Figure 6: Brent Crude Oil Spot Prices, Daily, January 2005-April 2011Source: U.S. Energy Information Administration, 2011XFigure 6 shows the daily Brent crude oil spot prices from the 4 th of January in 2005 to the 5 th ofApril in 2011. The oil price was increasing from 2005 and reached just below $80/barrel by themiddle of 2006, before declining to less than $60/barrel by the end of that year. In 2007, the priceexperienced a continual increase and reached a high of over $140/barrel. In early 2008, thereduced global production caused by the recession lowered demand for oil, dropping the price tomulti-year lows. Prices began to recover at the very end of 2008, around the time of QE1. Theprice has since continued on an increasing trend, although it has not reached the higher level ofover $140/barrel of 2008.Economic Analysis Directorate 14


Quarterly Bulletin5.2 Portfolio InvestmentsGauteng Treasury NewsletterAnother port of call for investors flush with QE cash and looking for a way to earn even a smallreturn, is emerging economies such as South Africa. With their rates of interest and growthboth higher than advanced economies, emerging markets are an attractive prospect and therisk associated with them seems less worrisome when investing easy QE money. Seeking profit,investors buy bonds issued by emerging economies and shares in their companies. As thismoney enters the emerging economy, spending rises, increasing economic activity at first.However, when investors spread the benefits of QE they also spread its risks, most notablyinflation.The foreign money flowing into the emerging economy also strengthens the local currency, asdoes the direct purchasing of that currency by return-seeking investors betting on the strengthbrought on by their actions and those of others investing in the country. In the short term astronger currency can make life more challenging for exporters as their goods become lesscompetitive. Furthermore, the ease with which foreign investors can withdraw the money theyput into local shares and currency can also cause instability. Should any event occur whichcauses skittish investors to decide that it is time to pull their funds back out, the suddenwithdrawal of their money could cause a huge drop in the local share prices and currency,upsetting the domestic economy.5.3 InflationInflation is one of the most serious potential risks of QE and its threat is not limited to thosecountries which introduce the policy. QE by design increases the money supply of the country inwhich it is enacted. As with all things in an economy, the value of money is dependent on itsscarcity; that is the quantity of it which is available in relation to other goods and services. Ifthe amount of money in an economy rises but the quantity of other goods and services remainsthe same, it should result in each unit of money being reduced in worth compared to before theincrease. More money would then be needed to buy products, this means that the general pricelevel would rise, which is by definition inflation.Generally, QE is a policy enacted by countries whose interest rates are already near zero and isenacted by advanced economies that have low growth rates in general. As such, those whoreceive QE money have reason to take that money out of their country and seek returnselsewhere. This tendency is exacerbated by the accompanying low interest rates which allowEconomic Analysis Directorate 15


Quarterly Bulletininvestors to obtain loans so cheaply that a profit can be made by investing the funds in nearlyanything that shows even a slight return. In the current times much of this money has flowed intoGauteng Treasury Newslettercommodities and emerging economies; with their higher rates of interest and growth.The increased demand for commodities naturally puts upward pressure on their prices and thecurrency flowing into emerging economies increases their money supply and creates inflation inthe same manner. As the money first pours into an emerging economy it almost uniformly beginswith positive effects. As the foreign investors buy up financial assets, they put money into thepockets of those local persons from whom they buy the assets. The increased demand pushes upthe prices of those assets which increases the wealth of domestic holders of financial assets whoretain them. Higher financial asset prices also make it cheaper for businesses to borrow money byissuing bonds and similar instruments. Increased supplies of cash, increased wealth and easierborrowing should all result in higher spending, resulting in higher economic activity in the shortterm. The longer term effects are less unambiguously positive. Increased spending means ageneral rise in demand for all products in the economy, if producers cannot increase supplyrapidly enough to keep up, then demand growing faster than supply would translate into priceinflation.Stimulating inflation, however, can be the intention behind QE for central banks whose economiesare facing deflation. The BoE 11 illustrates quantitative easing as a method for the institution toraise inflation to the bank‟s target of 2%. Deflation is a serious concern for an economy as fallingprices can cause consumers to defer spending, slowing economic activity. Central banks need tobe careful with this policy, though, because the full effects of monetary policy are generally notfelt for an average of 18 months. It is possible that policy enacted today to keep inflation fromfalling too low could push future inflation too high.It is worth noting at this point that the first recorded instance of QE, that of Japan in 2001, did notresult in rampant inflation, rather Japan‟s inflation has in fact remained close to zero. Shirakawa(2002) describes the QE enacted by his country as largely ineffectual, though he states that thepolicy could support a rise in demand originating from another source. Japan‟s early experience ofQE, however, is not necessarily what is going to be played out now in the rest of the world asdiffering circumstances should create different outcomes to some extent.Figure 7 tracks inflation trends in the advanced and emerging economies during a period thatincludes QE enactment to see how these countries were affected.11 This information was obtained from a document “Quantitative Easing Explained” published by the BoE.Economic Analysis Directorate 16


%Quarterly BulletinFigure 7: Inflation in Advanced and Emerging Economies, 2006-2010108Gauteng Treasury Newsletter64202006 2007 2008 2009 2010Advanced EconomiesSource: WEO database, April 2011Emerging EconomiesXInflation for emerging economies is relatively higher when compared to that for advancedeconomies. However, the two regions seem to be following the same trends, increasing anddeclining during the same periods. Inflation for advanced economies was at 2.3% in 2006 andincreased to 3.4% by 2008, the percentages were 5.3 and 9.3 respectively for the emergingeconomies. After the increases of 2008, both inflation rates declined to 0.1% and 5.2% in2009. This period of decline was immediately after the year that QE1 was enacted. However,inflation started on an increase after 2009, to reach 1.6% and 6.2% for the advanced andemerging economies respectively. This shows that if QE had any effectiveness at all inincreasing inflation, it was subject to significant lag.6. Impact of QE on South African EconomyDespite the fact that the SARB has not implemented QE-style policies in the domesticeconomy, the country is still affected by QE. As mentioned earlier, this could occur throughrising commodity prices and currency exchange rates. Notable commodities for South Africainclude gold, which is a major export and platinum; oil is the country‟s major import. Toparticipate in international trade, every country has to pay in foreign currency and receivepayment in its own currency. These kinds of financial transactions create a necessity for thecurrency exchange rate market in order to facilitate payments and receipt of income.This section discusses the effects of QE on the South African markets by analysing the trendswithin commodities and the currency exchange rates markets during the period that QE wasenacted. The section ends by looking at the trends in inflation in light of the effect of the inflowof QE funds in the country, in the form of the carry trade.Economic Analysis Directorate 17


Quarterly Bulletin6.1 Commodity Gauteng Prices Treasury NewsletterThe South African economy partakes in the trade of many commodities, including gold andplatinum. The country imports oil as transport forms the life blood of the economy and fuel isan integral part thereof. Figure 6 has shown that the price of oil started falling at the beginningof 2008; which was the time when the global financial crisis struck. This makes economic senseas business activity had started to slow down. The oil price had reached a peak of about $140per barrel by the end of 2007. The declining price reached a level of about $40 per barrel bythe end of 2008, before a gradual recovery that ended at $120 per barrel by February 2011.The declining oil price during the period that QE was enacted augured well for the country asthis means that the petrol price would stay stable and inflation would be kept within theSARB‟s target band.Gold is regarded as a safe haven by investors and as financial uncertainties strike markets,most investors would hedge their bets by turning towards investment therein. Figure 4 hasshown that the general trend in the gold price was increasing since 2005 before declining in2008. By the end of 2008 when QE was enacted, then the price of the commodity experienceda gradual increase. For South Africa, this would be a benefit as the country is one of the mainthree producers of gold, globally.Platinum has gained prominence as a precious metal in the past few years and South Africa isalso one of the largest producers and exporter of this commodity. The figure below tracks themonthly average price of platinum over the period 2005 to 2010 in order to analyse the effectof QE.Economic Analysis Directorate 18


US$ per UnitQuarterly BulletinFigure 8: Platinum Price Performance, 2005-20102,5002,000Gauteng Treasury Newsletter1,5001,000500QE102005 2006 2007 2008 2009 2010Source: London Fix Historical Platinum Results, 2011XThe figure shows that the average monthly price of platinum has been on the increase since2005 before declining towards the end of 2007. During this period, the price fell below theprevious level of under $1,000 per unit (2005) by the beginning of 2008. By the third month of2008, the price of platinum experienced a free fall but by the end of that year, it was increasing.It is evident from the figure that the price increased during the period that QE1 was enacted.Although the platinum price has not returned to the high levels of around $2,000 per unit of2007, it has been boosted by the enactment of QE. The price increase is beneficial for thecountry because as the price increases, the country earns more for its exports of the commodity.The assumption made in this paper is that the enactment of QE did affect the prices ofcommodities and caused them to increase. The global financial crisis led to the oil pricesdeclining, although gold was affected to a smaller extent. However, as QE was enacted by theend of 2008, prices started rising again. The effect to the country is twofold; as the increase inthe price of gold and platinum brings more revenue to the country in the form of exports, theincrease in the Brent crude oil price means fuel becomes more expensive and could lead toinflationary pressures.6.2 Currency Exchange RatesThe currency exchange rate is the price of one unit of currency in the terms of another currency.According to a 2010 report by the Organisation for Economic Co-operation and Development(OECD) the links between QE and exchange rate intervention are intricate and provide differentEconomic Analysis Directorate 19


Quarterly Bulletinoutcomes across countries and conditions. The effect of QE depends on the levels of publicdebt and interest rates. The experience at the end of 2008 and early 2009 has shown that eachGauteng Treasury Newsletterofficial announcement of future large-scale asset purchases by the Federal Reserve has beenfollowed by a fall in the value of the dollar. The effective external value of the dollar fell by anaverage 1.3% two days after the statement. Since central banks prefer to buy governmentdebt, due to its low risk, when enacting QE, economies whose governments have issued largeramounts of debt are more easily affected by QE and thus their currencies are more easilyaffected as well 12 . It is also possible, however, that central banks of economies which havelittle government debt as to eliminate the purchasing of that debt as a viable QE channel mayattempt to enact the policy through the currency market itself.Charles Purdy (2010) a Director at Smart Currency Exchange 13 has argued that as soon asinvestors sense that quantitative easing is on the cards, then the currency of that country willlose value. This is explained by figure 2 of the supply and demand for bonds. Internationalinvestors want to protect their returns and when a government enters into a programme of QE,the end result is that this will reduce yields on the government bonds. When government infact buys it own bonds, it increases the demand for those bonds thus increasing the price andreducing the yield. Therefore an international investor looking to buy those bonds whichcurrently are at a higher price and lower yield, would want their own currency to appreciateand the currency of the country practising QE to depreciate in order to make the same return.Charles Purdy (2010) gave an example that “if the investor was expecting a yield of say, 3%and the QE resulted in the bond price increasing by 10%, the yield would fall to 2.7%. Theinvestor would then want their currency to appreciate by 10% so that the effective yield theyreceived was back at 3%.”South Africa plays an important role in international trade and is therefore affected by currencyexchange rates. Pearls, precious stones and metals formed the country‟s largest exportcategory 14 in 2008. Amongst the country‟s largest export markets were Japan, USA and the UKin the same year. The largest import categories were machinery & mechanical appliances,mineral products and vehicles & transport equipment. These imports were sourced fromGermany, China and the USA. Figure 9 shows the country‟s trading partners in terms ofimports and exports for the year 2009.12 A country such as Switzerland that has very low debt will find difficulty undertaking QE in a government bond marketand will have to look towards the private sector bond market.13 Charles Purdy is one of the co-founders of Smart Currency Exchange, a company that helps clients to effectively andefficiently send and receive payments internationally.14 This information is according to the 2010 Provincial Economic Review and Outlook of Gauteng Department of Finance.Economic Analysis Directorate 20


Quarterly BulletinFigure 9: Major International Trading Partners, 2009.Gauteng Imports Treasury NewsletterExportsJapan,4.9UK, 4China,13.1UK, 4.96China,9.6Japan,6.7USA, 7.6Germany,6.4Germany, 11.6USA, 8.1Source Quantec Research, 2011XFigure 9 shows South Africa‟s major trading partners in 2009, with only the countries withsignificant contributions included 15 . According to the figure, China (13.1%) was the country‟smajor trading partner in terms of imports in 2009, followed by Germany (11.6%) and the USA(7.6%). China was also the country‟s top export partner at 9.6% in the same year, followed bythe USA (8.1%) and then Japan (6.7%). It is important to track the performance of thecurrencies of these trading partners as shocks in their currency values would also haveconsequences for the South African Rand. The assumption by this paper is that QE affects theexchange rates, strengthening currencies of emerging markets countries because of carrytrade. This section analyses the trend of South Africa‟s major trading partners in order todetermine whether this was in fact the case. Figure 10 below tracks the currencies of thesemajor trading partners for the reasons mentioned. The currencies tracked are the JapaneseYen, Chinese Yuan, British Pound, European Euro and USA Dollar. A higher figure in theexchange rate of any of the currencies translates into a weaker Rand value, since it thenrequires more Rands to purchase one unit of the other currencies.15 The contributions are calculated in percentages but because only a few countries have been selected, the percentagesdo not add up to a 100%.Economic Analysis Directorate 21


Quarterly BulletinFigure 10: Major Trading Partners’ Currency Exchange Rates, 2006-201018161.50Gauteng Treasury Newsletter1.25141210861.000.750.500.250.002006 2007 2008 2009 2010Source: SARB, 2011Pound Euro Dollar Yen YuanXThe left y-axis of Figure 10 shows the Rand exchange rates of the Pound, the Euro and theDollar with the y-axis on the right showing the rates for the Yen and Yuan 16 . The figure showsthat the USA Dollar exchange rate has been the most consistent currency over the period 2006to 2010, trading between R6/$ and R8/$. The exception was during the period when QE wasenacted, late in 2008 to the beginning of 2009, when the Rand depreciated to about R10/$.During this period, investors frightened by the global recession began quickly selling Rands,pushing the currency from R8.05/$ in September 2008 to R9.67/$ in October. After theweakness of the fourth quarter of 2008 to early 2009, the Rand began to strengthen again asforeign money started to flow into the country from the USA which had been flooded with cashin December 2008 in that country‟s first round of QE.According to the figure, the Euro was following more or less the same trend as the Dollaralthough its exchange rate has been higher throughout the review period. The Rand haddepreciated higher against the Euro during the financial crisis and gained strength around theperiod of QE1‟s enactment. The Pound also followed the same trend of the Dollar and the Euro,a clear indication that QE helped strengthen the local currency after the global financial crisis.The Rand exchange rate against the Yen and Yuan is much stronger, at averages of less than25 cents and less than R1.50 respectively over the review period. The Yen had a ratherconsistent exchange rate against the Rand but the Yuan had a more fluctuating one. The Yuanstrengthened against the Rand towards the end of 2006 and into 2007; again in the period ofglobal financial crisis. The strengthening of the yuan in 2007 was as a result of the new policyreform that China had applied to its exchange rate. The new policy reform entitled the Yuan toEconomic Analysis Directorate 2216The Yen and Yuan have been separated to the secondary axis because of their comparative small values.


%Quarterly Bulletinbe adjusted based on market supply and demand forces. The currency was allowed to fluctuate by0.3% daily; an Gauteng undervaluation. Treasury According to Wayne Newsletter(2008) other countries regarded thisundervaluation as being unfair since during that period, exports from China had become muchcheaper and their imports very expensive. China however explained the reason behind modifyingtheir currency as fostering economic stability and not to favour exports over imports 17 . In general,the results for the currency exchange rate shows that the QE helped strengthen the Rand after itwas negatively affected by the global financial crisis. The strength of the Rand is advantageous forthe import industry as the country pays less for goods bought abroad and all domestic concernsare helped by the reduced price of oil in Rands. However, this comes at a cost to exporters as thecountry‟s goods become more expensive in international markets.6.3 InflationIt was pointed earlier in this paper that the carry trade that results from QE cash injections intoemerging economies as portfolio investments could lead to such economies experiencinginflationary pressures. It is important to look at the trend of the inflation rate in the country, toascertain whether the arguments have played out in practice.Figure 11: CPI Inflation, 2006-201016QE128402006 2007 2008 2009 2010Source: Stats SA, 2011South Africa Advanced Economies Emerging EconomiesXFigure 11 tracks the inflation trend in the country over the period 2006 to 2010. Inflation waswithin the SARB target range of 3-6% from the beginning of 2006 to the second month of 2007.After this period, the Consumer Price Index (CPI) increased to levels outside the target range andEconomic Analysis Directorate 2317 This information was sourced from CRS Report RL32165 on China‟s currency.


Quarterly Bulletinreached a peak of 13.7% in August 2008. Stats SA attributed the higher CPI mainly to theincrease in electricity tariffs and food inflation during that time. The CPI experienced a free fallGauteng Treasury Newsletterthereafter, reaching 8.1% in January 2009. The CPI continued on a gradual decline from 2008and by February 2009, it had returned within the SARB‟s target range. The assumption that QEwould lead to inflationary pressures increasing in the emerging countries where the investorswould flood their extra cash, did not hold true for South Africa. Statistics displayed by figure 11shows that inflation continued to decline during and after the enactment of QE1.7. ConclusionThe global financial crisis and its resultant recession exhausted the traditional tools used byadvanced economies‟ central banks to help their countries‟ economies through difficult times.Central bankers in many developed countries turned to QE and began to enlarge theirrespective money supplies by buying financial assets in exchange for central bank reservedeposits. This practice allowed their commercial banks to lend on many times more money thanthey had received. The advanced economies response to the global recession, of increasingtheir money via QE, seems to have been successful for them so far, in that they have avoidedfalling below the inflation minimums they set for themselves. The enactment of QE helped theUK avoid price deflation and the USA rebound from a small dip into deflation. Commodity priceswere held at high prices and investors flooded emerging economies with cash. It remains to beseen, however, what the future impact will be, for the rest of the world.Much of the money using QE in the world‟s advanced economies has left those countries forcommodity and emerging economies. Zero interest rates make it possible for speculators toturn a profit by borrowing money for next to nothing and investing it just about anywhere thatshows any return at all. This carry trade has already had noticeable effects on emergingeconomies. The effect of QE for South Africa has shown that the enactment made the prices ofcommodities to increase. The country benefitted from the prices of precious metals increasingand the Rand exchange strengthening against the basket of currencies. The detriment was theincrease in the price of Brent Crude oil. A rise in the general price level of not only commoditiesis another potential consequence of QE. However, this theory did not hold true for South Africa,as the country‟s inflation rate was declining following the period when QE was enacted. It ispossible that the effects are still to be felt, as monetary policy is subject to significant lag. It isalso possible that markets have successfully adapted to quantitative easing and avoided thepolicy‟s pitfalls.Economic Analysis Directorate 24


Quarterly Bulletin8. ReferencesGauteng Treasury NewsletterBank of England. Quantitative Easing Explained. Accessed at:http://www.bankofengland.co.uk/monetarypolicy/pdf/qe-pamphlet.pdf.Bank of England Asset Purchase Facility Fund Limited. Annual Report 2009/10.Bernanke, B, Reinhart, V and Sack, B. 2004. Monetary Policy Alternatives at the Zero Bound:An Empirical Assessment. Finance and Economics Discussion Series Divisions of Research &Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C.Bernanke, B. 2009. Credit Easing versus Quantitative Easing. Stamp Lecture. London School ofEconomics. England.Black, J. 2003. Oxford Dictionary of Economics. Oxford University Press. New York. USA.Blinder, A. 2010. CEPS Working Paper No. 204: Quantitative Easing: Entrance and ExitStrategies. Princeton University.Borio, C and Disyatat, P. November 2009. BIS Working Papers No 292: UnconventionalMonetary Policies: An Appraisal.Fourie, F. 2006. How to Think and Reason in Macroeconomics, Second Edition. Juta Education(Pty) Ltd. South Africa.Gonczy, A. 1992. Modern Money Mechanics. Chicago Federal Reserve Board. USA.Joyce, M, Lasaosa, A, Stevens, I and Tong, M. August 2010. Bank of England. Working PaperNo. 393: The Financial Market Impact of Quantitative Easing.Kitco Metals Inc. 2011. London Fix Historical Platinum Results; accessed fromhttp://www.kitco.com/scripts/hist_charts/yearly_graphs.plx.Kollewe, J. 2010. World Stock Markets Rally on Fed Move. Guardian.co.uk. 4 th November 2010.KPMG. 2009. Economic Insight Quarterly Review, Issue 8. Johannesburg.Medeiros, C and Rodriguez, Economic M. Analysis 2011. The Directorate Dynamics of the Term 25 Structure of Interest Rates inthe United States in Light of the Financial Crisis of 2007-10. IMF Working Paper. Monetary and


Quarterly BulletinMedeiros, C and Rodriguez, M. 2011. The Dynamics of the Term Structure of Interest Rates in theUnited States in Gauteng Light of the Financial Treasury Crisis of 2007-10. NewsletterIMF Working Paper. Monetary and CapitalMarkets Department. Washington, DC. USA.Mishkin, F. 2004. The Economics of Money, Banking and Financial Markets. Seventh Edition.Addison-Wesley. United States of America. Pearson International Edition.Organisation for Economic Co-operation and Development.developments”, OECD Economics Department Briefing, October 2010.2010, “Briefing on exchange rateProvincial Economic Review and Outlook. 2010. Gauteng Department of Finance: TreasuryDivision.Quantec Research. 2011. Information on major trade partners for South Africa. Pretoria.Purdy, C. 2010. Quantitative Easing and how it affects Exchange Rates. Currency Exchange.November 23, www.internationaltrade.co.ukShirakawa, M. April 2002. IMES Discussion Paper Series 2002-E-3: One Year Under „QuantitativeEasing‟. Bank of Japan. Tokyo.South African Reserve Bank Governor, Gill Marcus. November 2010. Statement of the MonetaryPolicy Committee. Pretoria.South African Reserve Bank. 2011. Selected Historical Exchange Rates and other Interest Rates.PretoriaSouth African Reserve Bank. 2011. Online Statistical Queries for the gold prices.Statistics South Africa. Consumer Price Index, December 2005. Accessed fromwww.statssa.gov.za. Pretoria. South Africa.Statistics South Africa. Consumer Price Index, August 2008. Accessed from www.statssa.gov.za.Pretoria. South Africa.Economic Analysis Directorate 26


Quarterly BulletinStatistics South Africa. Consumer Price Index, December 2010. Accessed fromGauteng Treasury Newsletterwww.statssa.gov.za. Pretoria. South Africa.Sumner, S. 2010. Monetary easing has raised expected aggregate demand. The Economist.Accessed at http://www.economist.com/economics/by-invitation/guestcontributions/monetary_easing_has_raised_expected_aggregate_demand.US Energy Administration Information. 2011. Accessed fromhttp://tonto.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=RBRTE&f=D.Wayne M. 2008. China‟s Currency: Economic Issues and Options for U.S trade Policy. CRSReport RL32165.World Economic Outlook. April 2011. International Monetary Fund. Washington D.C.World Economic Outlook. April 2011 database. International Monetary Fund. Washington D.C.For a full set of research documents producedby the Economic Analysis Unit, visit thedepartmental website and the Intranet and clickon documents and publications. For furtherinformation contact Gauteng Department ofFinance: Treasury Division, 14 th Floor StandardBank Building, 78 Fox Street. Tel: 011 227 9000Fax: 011 227 9055 or emailGDFCommunications@gauteng.gov.zaEconomic Analysis Directorate 27

More magazines by this user
Similar magazines