Thursday, July 4, 2013

Quantitative Easing and its impact

This article was originally published in Postnoon on July 4, 2013

Vishal was waiting for me at the cafeteria when I went to get my usual cup of the morning coffee. He has been investing small amounts of money in the stock market with reasonable success. He would usually stop by to tell me about the performance of the stocks in which he has invested. Today he looked troubled.
Nicky: What is it Vishal?

Vishal: Professor Nicky, you must help me. My dad will beat me.
Nicky: Why? What happened?

Vishal: Last few weeks have been pretty bad. The SENSEX has been shedding points and the prices of the stocks I hold have also been going down. My dad has threatened to stop my pocket money and force me to withdraw all my investments from the stock market if there are any further losses.
A lot of the newspapers are talking about the withdrawal of Quantitative Easing by the US. They say that it will result in foreign institutional investors withdrawing money from the stock markets in India.

I don't understand any of it. Firstly, what is Quantitative Easing (QE)? Secondly, why should Indian markets go down if US withdraws QE?
Nicky: I am glad that you are reading the papers.

Quantitative Easing is a means to increase money supply or liquidity in the economy to stimulate growth. Countries like the US, Japan, UK and the Euro Zone, decided to infuse capital into their economy by buying corporate bonds, equities or mortgage backed securities.
Vishal: From what I know, these countries have huge debt and high fiscal deficit. Where do they get the money to infuse it into the system?

Nicky: Simple. They print it. Printing money does have the danger of making the domestic currency weaker. But the idea is to promote growth by increasing consumption, development and expansion. That is demand.
When the government supplies capital, some of the money finds its way to emerging countries like India, as the interest rates in emerging countries are much higher than in US, Japan, UK or the European Union. Some of this money also goes into the stock markets in the hope of better returns than the investors would find in their own countries.

When the Chairman of the Federal Reserve of US, Ben Bernake, announced plans to taper down the QE last month, it resulted in foreign institutional investors withdrawing money from emerging nations, including India. This resulted in the markets going downhill.
Vishal: You said that printing money has the danger of making the domestic currency weaker. But dollar is becoming stronger.

Nicky: Dollar is getting stronger as it is still seen as a safe haven. Also, the rate of dollar appreciation increased after the announcement of tapering the QE came.
Vishal: We are truly living in an integrated world. I must not just look at the Indian economy when taking decisions, but also the global economy.

Nicky: Yes indeed!
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