As the US Federal Reserve Chairman, Ben Bernanke, hinted in June at an end to the policy of quantitative easing (QE) in the world’s largest economy, global markets suffered an attack of the jitters and emerging economies – among them South Africa and the other BRICS nations – were particularly hard hit.
As is so often the case, when America sniffs the rest of the world fears catching a cold and, in smaller and more vulnerable markets like ours, this quickly turns to concerns of a full-scale bout of the ‘flu. So, like it or not, South Africa needs to pay attention to QE and Bernanke’s pronouncements on its future.
But before going into detail on the current situation, it’s prudent to take a step back in order to understand QE and the reasons for its introduction in the United States.
BACKGROUND TOQUANTITATIVE EASING
In 2008, as the US battled the effects of what has now become known as the Great Recession, it became obvious that drastic measures were required to stabilise the tottering economy. Bernanke and his colleagues at the Federal Reserve (the equivalent of the South African Reserve Bank) decided on an unconventional, emergency, monetary policy consisting of two key elements: a reduction in the interest rate to its lowest level ever (which now sits at between 0% and 0.25%) and the introduction of quantitative easing.
In simple terms, QE is a way of increasing the amount of money in the economic system by buying government or other securities from the market. This has the effect of improving liquidity and also stimulating lending. But, while the amount of money in the economic system is increased, it is not backed by gold or any economic activity.
QE is not something the US has done before and is not recommended in economic theory because of the potential repercussions – Zimbabwe being a case in point a few years ago. The government simply printed money and the result was hyperinflation and the eventual collapse of the local currency.
The Federal Reserve’s approach to QE has been more sophisticated in that it has not physically printed more money but has created electronic balances. However, the impact effect is the same: you are creating more money in the system.
Bernanke’s strategy was implemented in three phases; QE1 came into effect at the height of the recession in 2008, QE2 followed and we are now in the QE3 phase. Since inception, this has added a massive $2.7-trillion to the US economy and, at the moment, is adding $85-billion of additional money every month.
WHAT QE HAS BEEN ACHIEVING
This enormous influx of funds has been used in two ways by the Federal Reserve. The first was to buy government bonds – in other words, US government debt. The second was to purchase ‘mortgage-backed securities’, an asset-backed security that is secured by a collection of mortgages.
These instruments were, and continue to be, bought from the private banking system using the money created by QE which, because it was artificially created for this purpose and is not backed by anything, has the effect of putting more and more money into the economy.
The main reason for doing this has been to reduce the cost of mortgages and resuscitate the housing market, which started to collapse in 2007 in what was known as the subprime mortgage crisis and triggered the 2008/2009 recession. It’s important to note that in the US the cost of a mortgage is not dependent on the interest rate (as is the case in South Africa), but on the government bond market – hence the need for the Federal Reserve to buy government bonds.
As a result, housing has become more affordable and buyers have come back into the market. A US property recovery is unfolding, house prices are up 12% year-on-year and new homes are being built.
Because the problems in the banking and housing sectors are being addressed, businesses and consumers are feeling more confident and the recovery has broadened into almost every aspect of the US economy. While employment is still not back at the pre-recession level, 6.7-million of the 8.7-million jobs lost during the recession have been regained. The stock market has reached an all time high, company profits are up and vehicle sales have almost fully recovered.
QUANTITATIVE EASING TO TAPER
Given this positive outlook, Bernanke hinted at a press conference in Washington DC in June that central bankers might, by the end of the year, slow the pace of the programme with a view to stopping sometime in mid-2014. What is unknown at this stage is how the phasing-out will work. Will it be reduced by a set figure each month, for example?
It was inevitable that, at some point after five years of QE, the strategy would need to be slowed and eventually stopped so as to avoid possible longer-term distortions to the economy and unintended consequences – like the hyperinflation we saw in Zimbabwe, or erosion in the value of the currency caused by an oversupply.
So far there has been no sign of a problem and it’s important to emphasise that Bernanke’s intention seems to be to get the market used to the idea and then implement the reduction in a planned manner; tip-toeing out of QE rather than expecting the US economy to go cold turkey.
The difficulty for the markets – financial, equity, bond, property and others – is that they have become used to quantitative easing and now it feels like a necessity. Think of it as someone who is learning to ice skate with another person holding their hand. At some point the hand-holding needs to end and she must skate across the ice by herself…but as that moment approaches she’s nervous and fears she may fall.
That’s where the markets are right now: worried about what might happen once the Federal Reserve’s handholding ends. Can the US continue to recover without the benefit of QE? Will the housing market collapse again? What does it mean for global markets?
The bond market, which has been the main beneficiary of QE, has reacted with particular nervousness and has been selling off. This includes South Africa, where our bond market – in common with others across the world – slavishly takes its cue from the US bond markets. Given that the markets are entirely different, it’s a bizarre situation, but nevertheless a reality.
Our view is that Bernanke is correct in his assumption that now is the time to let go of the US economy’s hand. It is broad, stable and robust enough to withstand the withdrawal of QE – but that doesn’t mean there isn’t nervousness.
SOUTH AFRICA AND EMERGING MARKETS
For South Africa and other emerging markets, it’s unfortunate that the Federal Reserve’s withdrawal of QE comes at the same time that economists and investors are revising their once-bullish views of emerging market economies in general. For years these markets have been seen as a kind of golden boy; some of the BRICS economies were forecast to achieve growth rates of 6% and it seemed to many that an unstoppable success story was unfolding. But in the last 3-6 months this vision has been questioned as emerging markets have slowed and performance has not been as robust as anticipated. We saw the Rand drop to more than R10 to the dollar, but were not alone; currencies in Indonesia, Turkey, Brazil, Russia and India all dipped in similar fashion.
South Africa is now experiencing a significant bout of currency weakness, which creates risk because our inflation rate could potentially rise. It also means that, as a nation, we need to re-look our economic parameters and the strategies we require to grow this economy.
However, the root cause has been uncertainty as to the fate of QE in the United States. Once Bernanke provides clarity and a firm timetable for reducing or stopping QE, we can expect further global market uncertainty. However, as the US economy proves itself to be a skater who can stay upright on the ice and grow without QE’s hand-holding, we think there will be a return to confidence at the end of 2014.
At that stage we are hoping Europe will be doing better, Japan will have improved and the world economy as a whole have picked up and started to lift South Africa’s growth rate from the present very mediocre 2%.