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Quantitative easing, a necessary Monetary Policy tool for post-coronavirus economic recovery

Nigeria will face revenue challenges in the prosecution of the 2020 Budget because of the low accretion to revenue caused by the global glut in oil as a result of the pandemic. The coronavirus pandemic has affected the economies of most countries will also require ejection of more resources to restore balance at the immediate, near and long terms. The European Union, World Bank, IMF, AfDB have all been releasing what many economist call ‘rescue response funding’ to aid faster recovery of many challenged economies globally. Most countries have also released targeted response stimuli to different sectors of their economy, some as palliatives and others to support sectors that are burdened by this pandemic.

Nigeria’s 2020 budget which was premised on oil benchmark of $57 per barrel is now oscillating under $35 per barrel on a 2.18 million barrels per daily oil production has been reduced to 1.9million barrels per day. This reduction in revenue projection from the initial approved amount of N8.41tn to N5.08tn was due to unprecedented drop in global crude oil prices elicited by a slump in demand due to economic lockdowns in several countries.  Central banks as drivers of the monetary policy tools of a country operate independently of the government. To support price stability, it needs to control inflation and create a stable economic environment. These measures could be applied through the monetary policy.

There are two types of monetary policy: restrictive (tight, contractionary) and accommodative (loose, expansionary). The first one is conducted when the amount of money in the economy is huge, so the bank increases the interest rate in order to reduce the money supply and encourage a lower level of inflation. On the other hand, the accommodative policy is used when GDP growth is slow. In that case, a central bank increases the money supply and decreases the interest rate. Low interest rates attract investors and are intended to generate more cash inflows into the economy. When the rate is decreased to practically 0% and a central bank still thinks about more supportive measures, it applies quantitative easing.

At first, a bank creates electronic money or, as you may have heard, “print money”, although no cash is created. As a second step, it buys different equities. A classic form of quantitative easing involves buying government bonds, also known as Treasuries, by a central bank. Holders of the bonds receive cash and the bank adds bonds to the balance sheet as assets. However, Treasuries are not the only form of equities a central bank can buy. For example, the European Central Bank bought private sector bonds. The Federal Reserve in the USA buys mortgage-backed loan products. It is not fashionable that central banks don’t buy bonds directly from the government. That case is known as debt monetisation (monetary financing) and it’s illegal in monetary policy. Otherwise, central banks buy bonds, or debt, from large investors, such as banks or investment funds.

When money is “injected” into the economy, it increases the number of usable funds in the financial system. Following the basic economic law, such an inflow of money generates the supply of cheap money, thus, commercial banks and other financial institutions reduce interest rates to encourage businesses and consumers to borrow more. If consumers and investors spend more, it increases the levels of employment and inflation. Therefore, it boosts the economy. When a central bank stops buying new bonds, it holds on to those in its balance sheet. If these bonds mature (most of the bonds have a maturity date, when the initial investment is repaid to the bond’s owner), they are replaced by new ones. In addition, a bank can either let bonds to mature without replacement or sell them to the market.

Quantitative Easing (QE)

Under QE a central bank can create new money through the process often referred to as “printing money.” This can be seen as a misnomer because in reality, no physical money is created. The created money is in the form of balance sheet credits referred to as “central bank reserves.  The newly created central bank reserves remain at the disposal of the central bank until a course of action is chosen by which to introduce the reserves into circulation.  The new money can be introduced into the money supply ecosystem through the purchase of large-scale assets from both the public and private sectors and the acquisition of government-issued bonds, corporate bonds, and commercial papers on behalf of the central bank. The central bank can also increase the money supply through directly issuing loans to commercial banks. Essentially, the newly created central bank reserves are transferred to the commercial banks for lending to the private sector. Again, the goal is to spur economic growth through increasing the availability of credit and capital to participants in both the real and informal sectors.

Although the mechanisms of QE are unconventional and often times complex, the stated goals remain relatively the same. First, encourage economic growth through ensuring the availability and affordability of capital to the credit market. Second, promote lending through the assurance of low interbank interest rates. The major drawbacks to QE are its preponderance to creating Net Negative inflation which can result to stag inflation. The other is the devaluation of domestic currency.

Quantitative Easing practices in the advanced economies

The US started implementing QE in 1932 to combat the great depression. About USD 1 billion was created through quantitative easing during this period. However, this did not yield the desired results. Japan is reputed as the first country that started implementing in 2001 the current version of the QE when it expended YEN 50 trillion between 2001 and 2006. But it wasn’t until the 2008 financial crisis that central banks of developed countries used QE at such regular intervals to stimulate their economies, increase bank lending and encourage spending. For instance, some of the post 2008 global financial crisis QE programs for the U.S., Europe, U.K. and Japan amounted to about USD 1.75 trillion (U.S. QE1 2008), (EUR 489 billion in Dec 2011), GBP 200 billion in the U.K. (2009-2010), and YEN 65 trillion in Japan (2012) respectively. In Europe, the ECB has implemented three asset purchase programs since 2011. In Japan, the central bank added YEN 10 trillion to its already existing asset purchasing program, thus raising the ceiling of the program   to as much as YEN 80 trillion`

The resort to QE as a monetary tool by the US Federal Reserve during the financial crisis of 2008 was in response to a massive freeze in the credit market. It targeted the “bail out” of government-backed mortgage providers in addition to large investment banks that were hard hit by the downturn in the US housing market. In November 2008, the Fed. pledged US$100 billion to Government Sponsored Enterprises (GSE), and US$500 billion to Mortgage-Backed Securities (MBS). The capital was increased in March 2009, as another US$200 billion went to GSE and MBS received capital totaling US$1.25 trillion.  In addition to the mortgage bailout, the Federal Reserve cut interbank interest rates to near zero and pledged to purchase US$300 billion of long-term treasury securities from the US government. Quantitative easing remained a crucial part of US monetary policy with the launch of QE2, QE3 and QE4 between 2009 and 2014.

From a purely empirical standpoint, the era of QE in the United States has brought lower mortgage rates, stable inflation and an improved employment situation. Advocates of the QE programs in the United States claim that the capital created by the Fed loosened up credit markets, stymied unemployment and provided a boost to equities valuations. Opponents of QE claim that the bond-buying practices and capital creation enacted by the Fed will ultimately lead to extreme dollar devaluation and a financial burden being placed upon future generations.

The application of Quantitative Easing in developing countries

The application of QE as a monetary tool has not been without challenges in the developing countries. Primarily, the vulnerabilities of the economies of these countries have been their dependency on imports, predominance of weak currencies, debts and balance of payments dominated in hard foreign currencies. In the light of these challenges any attempt by developing countries to print money to stimulate its economy will not produce the desired results. The currency gets devalued making both debt and balance of payment obligations more expensive, leading to higher inflation, budget deficits as more local money is needed to pay for debts and imports. This produces a chain in either more quantitative easing or more foreign borrowing that results in foreign exchange risk. These reasons have placed Africa and other developing countries stick to conventional economic stimulus programs like rate hikes/cuts, reserve ratio balancing, increased government spending and the (un)conventional yet widely employed borrowing.

The Nigerian experience in the implementation of Quantitative Easing

Perhaps the most challenging of the present characteristics of the economy in Nigeria is the adoption of a quantitative easing stance by the management of the Central Bank. Monetary data shows a sharp rise in the extent of CBN financing of the government deficit. Nigeria’s Central Bank has been printing money to fund the government’s spending. Statistics showed much of the rise in the CBN’s financing of the federal government in 2017 with the purchase of government bonds. Nigeria’s government has not been able to recover in any meaningful way from the collapse in oil prices.  Specifically, since December 2016, the government’s borrowing from the CBN has risen tremendously more than its lending to the commercial banks. The CBN’s purchase of treasury bills had a 30percent rise to the tune of N454bn; a 5percent increase in the government overdraft to N2.8 trillion; and an increase in the mirror account to N1.5 trillion in April 2017 from just N3billion in December 2016.  Quantitative easing has actually been deployed by the Central Bank as evidenced in the sharp rise in its financing of the government’s fiscal deficit. By increasing the size of its balance sheet, the CBN can intervene to bring relief to the ongoing economic downturn in Nigeria caused by the corona virus pandemic.  Adopting unconventional measures of monetary easing, the CBN seek mainly to stimulate growth, bring down joblessness to reasonable levels and support the banking systems by pumping more money into the economy to boost spending.

However, the CBN has been criticised for providing ‘piggy bank’ services to the federal government and starving commercial banks of liquidity, raising the amount of reserves they must park with it. To keep a lid on inflation, the CBN has to balance out the increased government lending with a tightening of the amount of cash banks could lend. It does this by raising the cash reserve ratio (CRR) of banks, effectively taking money out of circulation. Thus, the private sector is “crowded out” for the sake of the government. The effect of increased government lending is making it practically impossible for the private sector to pay it the taxes it desperately needs. Completing the vicious cycle, the government must then borrow more to fund its spending.

Defending its role in creating quantitative easing, the CBN noted that it was lending against the federal government’s deposits in its Treasury Single Account (TSA) which currently stand at N5.2 trillion. The TSA is a mechanism whereby all cash resources of government ministries, departments and agencies (MDAs) are consolidated in a single account with the CBN. The policy had been half-heartedly implemented for several years but president Buhari finally expanded it to cover the entire government in 2015.

Unlike Quantitative Easing by Federal Reserve and Bank of England that came with built-in mechanisms for their eventual unwinding, there is no clear-cut mechanism by which the CBN can roll back the expansion of its balance sheet.  While central banks in developed economies have deployed monetary easing to ameliorate the impact of the recession, the collective magnitude of monetary easing may have unintended consequences in developing countries. The reason is simple. As economies are more integrated, the implementation of QE in developed countries can cause excess flow of liquidity in emerging countries and inadvertently disrupt their currencies, exports, inflation levels.

One major feature of the world economy is the globalisation of the financial markets. Increasingly, emerging economies including those in Africa are integrated with most developed ones mainly through trade ties and capital flows. When an important central bank adopts a QE program, it expands its monetary base and provides liquidity to the markets thus creating excess liquidity which in part will flow to the developing world for diverse reasons. This excess liquidity is chiefly attracted by the higher risk-adjusted investment returns offered by the emerging markets compared with the developed world. Over the long term and on a risk-adjusted basis, investments in financial emerging markets yield more than in the developed world. The attraction for instance in the Nigerian market, offers foreign investors high return on investment despite the dearth in infrastructure. Furthermore, emerging markets offer global investors the possibility of portfolio diversification. Lower level of leverage and better ability to take on debts by emerging countries compared with major economies indicate a strong capacity of the developing economies to absorb greater foreign flows to feed their growth without jeopardising their financial viability. But this in recent times, has not only remained inadequate to competing demands but has also left developing economies with high indebtedness to bilateral, multilateral and international financing creditors. In the same vein, liquidity expansion seems to positively affect credit conditions in developing markets. In fact, while credit availability in advanced economies has not translated into higher borrowing by their banking sector, the credit and lending to private borrowers in emerging countries significantly increased the borrowing capacities by the banking sectors.

Conclusion
Considering the foregoing and other challenging factors, developing economies are functioning in very rigid conditions that call for critical structural shifts and re-positioning to enhance their economic growth. The main purpose of quantitative easing is to ease monetary condition in banks to raise their capacity to lend. Also, quantitative easing typically increases the monetary base as banks hold increased reserves. When banks loan these reserves, they effectively increase the money supply, and if the money supply grows at a rapid rate, the increase in economic activity engendered by this could cause higher inflation and inflation expectations. This downside is one strong point of quantitative easing critics.

There are many pros and cons for the quantitative easing program. From the one side, it definitely supports a stagnating economy. From the other side, there are risks for the currency devaluation, inflation and the creation of bubbles. Some analysts criticize it for its ineffectiveness, suggesting fiscal policy (government spending and tax cuts) as the best solution to revive the economy. But reliance on monetary policy alone cannot provide the needed response tools to restart the economies that have taken a hard-hit by this ravaging pandemic. In the end, many experts suggest quantitative easing is just a way for governments and commercial banks to hide their problems and rely on the central bank to solve them.  Nevertheless, the effect of the quantitative easing can give a boost to economic activity during the time of uncertainties.

 

Larry Chukwuemeka Iwuala

Dr. Iwuala, Operations at Nigeria Incentive-Based Risk Sharing System for Agricultural Lending (NIRSAL) PLC, writes from Abuja.  iwualaemeka@yahoo.com

 

 

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