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The real reason for Quantitative Easing - Outside View by Asad Dossani

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The real reason for Quantitative Easing
Jan 24, 2011

We've heard a lot about Quantitative Easing (QE) in the last six months. The US Federal Reserve and other central banks around the developed world have embarked on a program where they print money to buy their own government bonds. The stated purpose of is to bring down the yield on long-term government debt. This has two benefits. First, it makes it easier for the government to finance their deficits. Second, these falling rates should lower long-term rates for all other borrowers, thereby encouraging greater levels of investment. That's the theory anyway. But perhaps there is something else to it, another reason for QE.

Last week, China's president Hu Jintao made a state visit to the US and held talks with US president Barack Obama. As expected, there was a large focus on trade and the currency issue. China's currency is pegged to the US dollar, and is artificially low. They also enjoy a large trade surplus with the US and most other countries.

How is China able to keep its currency weak? It directly intervenes in the foreign exchange market. According to recent estimates, it purchases approximately $1bn in the currency markets each day, by printing and then selling its own currency.

There have been high levels of rhetoric and pressure from the US government towards China to let their currency appreciate. This has been going on for some time, and continues as the Chinese president is holding talks with the US president. The Chinese have heavily resisted this pressure. They have indicated that they do intend to let their currency appreciate, but at their own pace, which likely to be a long length of time.

From the US point of view - given that they are unable to persuade China to let their currency rise, what is the next best thing? Of course, it is to weaken your own currency! This is where QE comes in. By and large, one of the main reasons for QE is to weaken the dollar. Printing more dollars has exactly this effect.

For China to maintain its exchange rate peg against the dollar, it has to print more money than the US. So the more the Fed decides to print, China must respond by printing even more. By pegging the exchange rate, they are effectively forced to adopt US monetary policy for themselves. As a result, there is concern that inflation in China could become a problem in the future.

While we are all aware of the US accusations against China, the Chinese themselves are now hitting back. They have been heavily critical of the Fed's QE policy. They accuse the US of artificially lowering their currency. So now we have two countries both accusing the other of keeping their currency too weak. At the same time, each country continues to print money to keep their currency weak (so the accusations are correct). This is like fighting fire with fire, and we know that this is unlikely to result in a happy ending.

Disclosure: I do not hold the currency/commodity that is analyzed in this column.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

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2 Responses to "The real reason for Quantitative Easing"

Ramanand

Jan 25, 2011

Its a race to the bottom for all countries! People in the US are upto their eyeballs buying foreign goods with borrowed money (also borrowed eventually from foreigners). For a change, US is buying its own debt, so what if it has to print money to do so?!? President Hu is worried on both fronts...one is the value of the existing US debt (China has nearly 3 trillion worth of it) as well as the competitiveness of its industries. Both will diminish significantly if the US dollar depreciates against the Chinese Yuan.
India is close behind China in this race. Note that RBI has increased the interest rate by just 25 bps, even though the estimates would have accepted a 50bps hike. RBI does not want the Rupee to become attractive and face the full brunt of foreign inflow. If that happens, we would be further pushed to the corner in a catch 22 situation. More dollar inflow would mean more rupee printing which would mean higher inflation...but higher interest rates to counter the higher inflation would mean more dollar inflow which wants to earn the higher interest!!!The corollary of the 2nd situation would be Indian companies themselves which hunt for foreign currency loans to take advantage of the low interest rates there!! Can you beat this!!!
RBI better start imposing capital controls before the systemic shock of hitting the bottom ruins us all.

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Amitabh

Jan 24, 2011

This article is a good adaptation of Caroline Baum's article on Bloomberg titled " China Can Just Say ‘No’ to One American Export" dated Jan 21,2011 .

The original article can be viewed in Bloomberg opinion column.

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