Download The dangers and drawbacks of the "unconventional monetary policy

THE DANGERS AND DRAWBACKS OF THE
“UNCONVENTIONAL MONETARY POLICY” ON THE ASSET
MANAGEMENT INDUSTRY: CAUSES AND CONSEQUENCES
WHY IS IT WRONG TO ASSUME THAT QUANTITATIVE EASING WILL BE
EFFECTIVE IN THE LONG TERM?
“I have destroyed more men than all the nation’s wars, I am relentless, unpredictable, waiting
for your last breath” D.Mustaine, M.Friedman
THE DANGERS AND DRAWBACKS OF THE “UNCONVENTIONAL MONETARY POLICY” ON THE ASSET
MANAGEMENT INDUSTRY: CAUSES AND CONSEQUENCES.
1
COLEGIO UNIVERSITARIO DE ESTUDIOS FINANCIEROS
MÁSTER EN INSTITUCIONES Y MERCADOS FINANCIEROS
PROGRAMA EJECUTIVO EN: INTERNATIONAL FINANCE
TÍTULO DEL PROYECTO: THE DANGERS AND DRAWBACKS OF THE
“UNCONVENTIONAL
MONETARY POLICY” ON
THE ASSET
MANAGEMENT INDUSTRY: CAUSES AND CONSEQUENCES.
Realizado por: (NOMBRE DEL INTEGRANTE/S DEL GRUPO DE TRABAJO)
D./Dª GONZALO DADER BORONAT
D./Dª MARTA COVADONGA DÍAZ ZORRILLA
D./Dª ÁLVARO DURÁN BARATA
D./Dª JAIME SANTAMARÍA DE PAREDES FERNÁNDEZ DURÁN
Dirigido por:
JAVIER ALONSO JIMÉNEZ.
“Only a crisis - actual or perceived - produces real change. When that crisis occurs, the actions
that are taken depend on the ideas that are lying around. That, I believe, is our basic function:
to develop alternatives to existing policies, to keep them alive and available until the politically
impossible becomes the politically inevitable.”
― Milton Friedman
THE DANGERS AND DRAWBACKS OF THE “UNCONVENTIONAL MONETARY POLICY” ON THE ASSET
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INDEX
ABSTRACT ............................................................................................................................ 5
1. REPERCUSSIONS ON SECURITIES BEHAVIOUR ...................................................... 7
1.1 INTRODUCTION ..................................................................................................... 7
1.1.1 What is Quantitative Easing? ....................................................................... 7
1.1.2 Why is it now indispensable? ........................................................................ 7
1.1.3 What are Unconventional Monetary Policies? .............................................. 7
1.2.1 Before all went wrong .................................................................................. 9
1.2.2 The fall of Lehman Brothers ....................................................................... 12
1.2.3 The US counterattack ................................................................................. 13
1.2.4 The EU counterattack ................................................................................. 14
1.2.5 We live in Quantitative Easing times........................................................... 19
1.3 QUANTITATIVE EASING AS THE ULTIMATE SOLUTION .......................... 30
1.3.1 Has Quantitative Easing livened up to expectations? .................................. 30
1.3.2 Side effects of Quantitative Easing .............................................................. 33
2. LIMITATIONS OF FISHER’S EQUATION IN RESPONSE TO DEFLATION .......... 36
2.1 INTRODUCTION ................................................................................................... 36
2.2 FISHER´S THEORY............................................................................................... 36
2.2.1. Classical approach. ................................................................................... 36
2.2.2. Current situation: the paradox of the deflation and the economic growth. .. 39
2.2.3 Critical currents ......................................................................................... 46
2.3. CONCLUSION ....................................................................................................... 52
3. GLOBALIZATION AND MONETARY POLICY .......................................................... 54
3.1 CAPITAL OUTFLOWS ......................................................................................... 54
3.2 SPILL-OVER EFFECT .......................................................................................... 57
3.2.1 Spillovers during QE episodes .................................................................... 58
3.2.2“Spillbacks” from Emerging-Market Economies to Advanced Economies .... 59
3.3 EUROPEAN QE ...................................................................................................... 60
3.4 EMERGING MARKETS QE. ................................................................................ 61
3.4.1 China. ........................................................................................................ 61
3.4.2 Japan. ........................................................................................................ 62
4. THE EFFECTS OF UNCOVENTIONAL MONETARY POLICIES ON SOCIETY:
POPULISM AND WEALTH’S DISTRIBUTION INEQUALITY. .................................... 66
4.1 INTRODUCTION ................................................................................................... 66
4.1.2 What is Populism?...................................................................................... 66
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4.2 TAKING A LOOK TO USA: STOCKS BUYBACKS. .......................................... 66
4.3
WEALTH’S
DISTRIBUTION
INEQUALITY.
ANALYZING
PIKETTY’S
ST
“CAPITALISM IN THE 21 CENTURY”. ......................................................................... 71
4.1.2 Critics and limitations. ............................................................................... 75
4.4 FINAL THOUGHTS. .............................................................................................. 76
5. CONCLUSION ................................................................................................................. 77
6. BIBLIOGRAPHY ............................................................................................................. 78
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ABSTRACT
In this paper we are going to confront the repercussions of the Non-conventional,
Expansionary Monetary Policy committed in the leading occidental economies.





We are going to analyze the consequences generated by this policy:
The behavioral aftereffects over the market, assets and over commodities.
We will assess why it has generated a deflationary situation rather than an
inflationist process in the short run as previously thought. We will also examine
Fisher`s equation, explaining monetary base concepts as well as the velocity of
money.
We will attend what consequences the Globalization has over the future growth
of the developed and emergent economies, along with the currency war
generated by the monetary policy. Alternatively we will explain its influence in
public policies and in the debt management in the main economies.
Finally we will explain the arousal of populist movements derived from Social
Policies.
Regarding the market response we will discern the influence of a low discount rate in
the valuations, whether valuating equities or bonds. Being in the former case valuating it by free
cash flow discount or dividends discount. We will not only scrutinize the known repercussions
as denominator but as numerator, being the margins increments which has enabled an exemplar
increase in corporate benefits, mainly in the United States.
Concerning social effects, we are facing the Third Industrial Revolution. Research and
development generates greater productivity, although it is capital intensive and it destroys
employment. This situation produces income and revenue inequality, stimulating lower growth
as it restrains demand. It incurs social crisis as well as the emergence of radical parties.
Consumption tendency it is normally more widely acclaimed in those whose income is lower,
and that income transference from those who gain less to those who save the most, generates
instability. It is arduous to battle this tendency. One of the main ways to combat it, it is through
education. In order to achieve it, meritocracy should reemerge, together with scholarships to
those who stand out. It is essential to aware the population about the importance of education:
learn to acquire knowledge not to obtain grades, meritocracy against networking and reflecting
into information.
Regarding the repercussions in the asset valuation and the long term consequences of
creating a false wealth effect; the capital injection generates incentives distortions as well as
transferring resources from one side of the economy to the other. The usage of bigger financial
incentives in order to lead future activity into the present can raise short term market figures, but
they also activate the demand and thus promoting deflation. Cheap financing not only maintains
enterprises with a precarious situation but also it engenders a new capacity that in normal
circumstances it would not have been a profitability objective.
We fear that once the disappearance of the short term debt profits, the vulnerability to
unexpected events could be even greater. In spite of the good political intentions endorsing
growth, they could lead to an increase of our economies’ fragility letting them exposed to
external shocks.
The deliberated price inflation has created wealth and salaries disparities. It fosters
savers to deviate their capital towards financial speculation (not profitable for the economy)
rather than maintaining it in cash with null return. It is more probable to induce the economy to
a credit expansion or to invest on non-profitable assets when injecting capital like in the United
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Kingdom and in the United States, being less probable in Germany or France, due to cultural
matters.
The prolonged combination of excessive consumption and the excess capacity of
Emerging Markets – both financed by indebtedness- it has the potential of being more
deflationary as time passes by. The high valuation of risky assets as well as high yield credit
ought to be justified by prospects of continuous growth and profitability. However, in practice
we have seen a contrary effect: the long term growth expectations have continued falling (as the
FMI forecasted). Nonetheless, the economy recovery and the imminent escape velocity have
been predominant in the media. Short run figures are being terrifying all around the globe.
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1. REPERCUSSIONS ON SECURITIES BEHAVIOUR
1.1 INTRODUCTION
During the latest financial crisis, Central Banks in many advanced economies have been
engaged in various forms of “Unconventional” Monetary Policy actions: the short-term interest
rate, the traditional policy instruments, which was up against the zero lower bound. Such policy
actions involved changes in the size and/or composition of Central Bank’s balance sheet. The
Federal Reserve in the US, and the European Central Bank in the EU, carried out several large
scale purchases of assets in the recent years; programmes often referred collectively as
“Quantitative Easing”.
1.1.1 What is Quantitative Easing?
“Quantitative Easing is an outright purchase of assets. It would inject money into the
system. Now, QE can be private sector asset-based, or also sovereign-sector, public sector assetbased, or both. The components of today’s measures are predominantly oriented to credit
easing. However, it’s quite clear that we would buy outright ABS, the senior tranches, and the
mezzanine tranches only if there is a guarantee. In other words, very much like what the Fed did
a few years ago. So there is also this component.”-Mario Draghi.1
The main goal of Quantitative Easing is to give incentives to banks not to allocate their
funding on long-term government debt, but to do so in short-term commercial paper or credit
loans, stimulating thereby the aggregate demand. As Central Bank buys government notes
massively, they seek two potential benefits: financial institutions gaining liquidity from the
selling of those gilts, which enables them to increase the volume of lending; and the pushing up
of their price, which has the opposite effect on their yields, making them unprofitable if hold.
1.1.2 Why is it now indispensable?
The need for such a demand booster emerged, due to the financial crisis, which was a
consequence of an uncontrolled financial revolution. During the first decade of the 21 st century,
brand new financial products were born under the originate-to-distribute model, leading
financial institutions to become very dependent on monetary markets to fund their investment
activities, and more interconnected, turning the situation ungovernable.
1.1.3 What are Unconventional Monetary Policies?
Among all the process by which the monetary authority controls the supply of money to
ensure price stability and general trust of the currency, unconventional monetary policies come
into play when interest rates are already close to 0% and in spite of it there are concerns about
deflation, or it is already happening. Generally speaking, there are three forms of it.
1. Signalling is the idea that one economic agent credibly conveys some information about
itself to another party in such a way that the market respond positively, and it has its
bedrock on Agency theory. A great example of signalling regarding monetary policy
was given by Mario Draghi, President of the European Central Bank, on July the 26 th,
2012:
“(…) within our mandate, the ECB is ready to do whatever it takes to preserve the euro.
And believe me, it will be enough. (…)” 2.
1
2
https://www.ecb.europa.eu/press/pressconf/2014/html/is140904.en.html#qa
http://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html
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2. Negative reference interest rate. Central Banks maintain a 0% nominal interest rate.
That is, according to Nouriel Roubini, “the most unconventional policy tool of them
all”: negative nominal interest rates.
Figure 1: “Europe dives below zero”. European Central Bank rates
* Source: ECB and Bloomberg. Credit to BBC
3. Quantitative Easing is the ultimate unconventional monetary policy.
1.2 HOW HAVE THE US AND THE EU DEALT WITH FINANCIAL CRISIS?
“Wall Street and the Financial Crisis: Anatomy of a Financial Collapse” 3 reported in
2011 the four causative aspects of the financial crisis of 2007:

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

Lenders sold and securitized high risk home loans while practicing subpar underwriting.
Credit rating agencies granted these securities safe investment ratings.
Federal securities regulators failed to execute their duty to ensure safe and sound
lending and risk management by lenders and investment banks.
Investment banks engineered and promoted complex and poor quality financial products
composed of these high risk home loans, allowing investors to bet on the failure of these
financial products, and in cases disregarded conflicts of interest by themselves betting
against products they sold to their own clients.
These four aspects of the crisis were all interconnected due to facilitating risky practices
that led to the rise of a massive bubble of securities based on high risk home loans. When the
unqualified buyers finally defaulted on their mortgages, the entire global financial system
incurred massive losses.
Except for the regulators misbehaviour, we believe that this report failed in assessing
the real causes of financial crisis, as the three other aspects respond to an aggressive-demand
background respond by economic agents. We also consider that the truly reason behind this
global behaviour was on Central Banks’ pre-crisis policy measures.
3
http://www.hsgac.senate.gov//imo/media/doc/Financial_Crisis/FinancialCrisisReport.pdf?attempt=2
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1.2.1 Before all went wrong
Before the crisis, the implementation of Monetary Policies was fairly straightforward:
In the US, the Federal Reserve adjusted the liquidity it provided to the banking system through
daily operations. That liquidity was distributed by interbank funding markets through the US
banking system and around the world. In addition, the Federal Reserve stood ready to lend
directly to commercial banks at the "discount window.
On the other side of the Atlantic Ocean, as in other parts of the world, Monetary
Policies were implemented similarly. However, there are three many differences between US
and EU economies that created a completely different landscape for Monetary Policies
implementation.
1. The Euro area is not a Federal Union like the US.
The Treaty on the Functioning of the EU includes provisions to correct for
disincentives to fiscal discipline: the prohibition of monetary financing by the Central
Bank, the prohibition of privileged access by public institutions to financial institutions,
the “no-bailout” clause, the fiscal provisions for avoiding excessive government deficits
and the Stability and Growth Pact. The Treaty also gives responsibility for financial
stability primarily to governments, but the resolution of banks is in their domain. It
foresees that the ECB “shall contribute” to the stability of the financial system.
2. Banks are the primary source of financing for the economy.
Financial intermediaries in the euro area –in particular banks– are the main
agents for channelling funds from savers to borrowers. As for firms, more than 70 % of
the external financing of the non-financial corporate sector–that is, the financing other
than by retained earnings–is provided by banks, and less than 30% by financial markets.
In the United States it is the other way around.
Figure 2: Banking (dark blue) and non-banking (light blue)
share of funding to Non-financial sector.
Euro area
United States
*Source: ECB, BIS, Federal Reserve, Fung Global Institute, Oliver Wyman
However, the corporate sector could to some extent substitute bank lending with
other sources: bank funding started contracting at a rate of €100 billion a year after the
collapse of Lehman Brothers, but part of this was offset by a rise in market funding.
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Figure 3: Four-quarter flows, EUR billions
*Source: Eurostat, ECB.
Such substitution is primarily possible for large corporations, and less so for
small and medium-sized firms, which constitute the bulk of employment and activity in
the euro area: banks still play a pivotal role in the transmission of policy interest rate
decisions to the euro area economy.
3. Monetary policy implementation is decentralized
While Monetary Policies decisions are centralised at the level of the ECB’s
Governing Council, their implementation is decentralised and conducted by the Euro
system, which comprises the 17 national Central Banks and the ECB. This is again
different from the US set-up, where the Federal Reserve Bank of New York implements
monetary policy on behalf of the entire system. The operations consist mainly of
outright purchases and sales of assets in the open market, in line with the essentially
market-based structure of the economy, involving a relatively small number of
counterparties.
In Euro system refinancing operations, the individual national Central Banks
grant loans at uniform conditions across the euro area, against assets pledged as
collateral for a pre-specified period. The list of eligible collateral contains a very wide
range of public and private sector marketable debt securities and also includes some
non-marketable assets.
The creation of European and Monetary Union was, before the financial crisis, an
engine of financial integration: the distinction between domestic and cross-border transactions
within the euro area disappeared. If bank transactions during the day led to a net payment
outflow, the bank would find the offsetting funding in the interbank market at uniform
conditions across the euro area. More broadly, financial integration in banking and funding
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markets eased financing constraints in EMU, thus bond yield spreads became virtually nil
among euro area sovereigns.
However, in a context where fiscal and economic policies and banking oversight
remained the responsibilities of countries individually, this contributed to weakening incentives
for the various economies to address problems of competitiveness and soundness in banks’
business models. The banking system, of a country with persistent current account deficits,
could easily fund net cross-border payment outflows with money raised in the cross-border
interbank market or by means of other forms of funding such as attracting foreign direct
investment or placing debt securities abroad.
As a result, imbalances in the current and financial accounts of the balance of payments
of certain euro area countries were left unaddressed by national policies and continued to grow,
contributing to greater vulnerabilities of euro area countries.
In addition to these differences, the US and the EU shared a dramatic issue: prices differ
among smaller areas within the US and Europe, and thus Central Bank monetary policy
authorities have little grip on their economies. The ECB and the Federal Reserve could not
succeed in controlling credit supply in these areas, whereas limitation for credit supply in core
areas was excessive.
Figure 4: ECB Key interest rate seemed correctly adjusted against Euro Area inflation rate
(above), but since inflation diverges when considering each of the Euro Area countries, ECB is
likely to lose grip on countries with above-average CPI (below).
6%
5%
ECB Key Interest Rate
Euro Area Inflation YoY Rate
4%
3%
2%
1%
0%
-1%
6%
5%
4%
ECB Key Interest Rate
Spain CPI
Germany CPI
3%
2%
1%
0%
-1%
-2%
*Source: Bloomberg
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1.2.2 The fall of Lehman Brothers
During the summer of 2006, as home prices began to decline after 5 years of increases.
Some companies started to suffer from liquidity issues, as non-performing loans were no longer
offset by uprising house prices.
Problems intensified in September the 15th, 2008, when despite all effort to sell the
company after incurring in severe moral hazard, Lehman Brothers, a highly exposed to
subprime mortgages investment bank, filed for bankruptcy protection. The American
International Group had to be bailed-out on the very next day, and the remaining large US
banks, had to be either merged or transformed into commercial bank holding companies in order
to receive direct Fed assistance.
Figure 5: USD Libor overnight from January, 2001 to January 2011.
8%
6%
4%
2%
0%
* Source: Bloomberg
Soon after Lehman and AIG crushed, USD Libor rocketed: banks stop trusting each
other. As a result, they were forced to reduce drastically their credit supply to real economy.
These conditions would eventually lead to contractive effects on corporate investing,
consumption and production decisions, impacting brutally on the labour market.
Figure 6: US unemployment rate, seasonally adjusted, from January 2005 to December
2009.
10%
8%
6%
4%
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
* Source: Bureau of Labour Statistics
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Following the bankruptcy of Lehman Brothers, uncertainties about the financial health
of major banks worldwide, led to a virtual collapse in activity in many financial market
segments. Banks built up large liquidity buffers, while shedding risks from their balance sheets
and tightening loan conditions. This situation was alarming, regarding, high risk of a credit
crunch and a high risk of the Central Bank’s inability to steer monetary conditions.
Figure 7: Euribor one week index, from May 2006 to May 2015
6%
5%
4%
3%
2%
1%
0%
May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 May-14
-1%
*Source: Bloomberg
These were the conditions, in which the ECB and the Fed, started to implement its
expansionary monetary policy.
1.2.3 The US counterattack
In the US, market participants fled to the safest and most liquid assets, and as a result,
interbank markets stopped functioning as an effective means to distribute liquidity, increasing
the importance of direct lending through the discount window. Nevertheless, at the same time
banks became extremely reluctant to borrow from the Federal Reserve for fear that their
borrowing would become known and thus markets would doubt on their financial condition.
The crisis also involved major disruptions of important funding markets for other
institutions.
a) Commercial paper markets no longer channelled funds to lenders or to nonfinancial
businesses.
b) Investment banks encountered difficulties borrowing even on a short-term and secured
basis.
c) Lenders began to have doubts about some of the underlying collateral.
d) Banks overseas could not rely on the foreign currency swap market to fund their dollar
assets beyond the very shortest terms.
e) Investors pulled out from money market mutual funds
f) Most securitization markets shut down.
These disruptions posed the same threats to the availability of credit to households and
businesses that run on banks. As a result, intermediaries unable to fund themselves were forced
to sell assets, driving down prices and exacerbating the crisis; moreover, they were unwilling to
assume the risks necessary to support household and business borrowing.
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The Federal Reserve had to adapt its liquidity facilities. To make credit more available
to banks, it reduced the spread of the discount rate over the target federal funds rate, lengthened
the maximum maturity of loans to banks and provided discount window credit through regular
auctions in an effort to overcome banks' reluctance to borrow at the window due to concerns
about the "stigma" of borrowing from the Federal Reserve. It also lent dollars to other Central
Banks so that they could provide dollar liquidity to banks in their jurisdictions.
As the crisis intensified, the Federal Reserve recognized that lending to banks alone
would not be sufficient. The reason is that financial markets have evolved by more than the
Federal Reserve had recognized prior to the crisis.
Although the Federal Reserve's lending actions during the crisis were innovative and to
some degree unprecedented, they were based on sound legal and economic foundations: Lend
early and freely to solvent institutions at a penalty rate and against good, illiquid collateral.
To restart these markets, the Federal Reserve and the Treasury established the Term
Asset-Backed Securities Loan Facility (TALF): The Federal Reserve supplied the liquid
funding, while the Treasury assumed the credit risk.
Figure 8: Evolution of Overnight Index Swap and USD Libor overnight
from December 2001 to May 2015.
8%
6%
Libor overnight
OIS
4%
2%
0%
Dec-01
Dec-03
Dec-05
Dec-07
Dec-09
Dec-11
Dec-13
*Source: Bloomberg
These developments followed the establishment of the Term Auction Facility (which
auctioned discount window credit to depository institutions) and also of liquidity swaps between
the Federal Reserve and other Central Banks. This helped to stem the runs on money market
funds and other nonbank providers of short-term credit.
Of note, usage of these emergency liquidity facilities declined markedly as conditions as
financial markets improved, indicating that they were indeed priced at a penalty to more normal
market conditions, and they were successfully closed. The funding markets evidently remain
somehow vulnerable.
1.2.4 The EU counterattack
From October 2008 onwards, the ECB adopted a number of non-standard measures to
support financing conditions and credit flows to the euro area, the so-called ‘enhanced credit
support’. Non-standard measures were tailored to the specific, bank-based financial structure of
the euro area, aiming at supporting bank liquidity and funding. They comprised five key
elements:


Fixed-rate full allotment
Extension of the maturity of liquidity provision
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


Extension of collateral eligibility
Currency swaps agreements
Covered bonds purchase programs
1.2.4.1 The sovereign debt crisis
In 2010, the euro area sovereign debt crisis began with acute market expectations about
a possible Greek sovereign default, with a risk of impact in Ireland, Portugal, and even in Spain
and Italy. In May 2010, some secondary markets for government bonds began to dry up
completely; large-scale sale offers faced virtually a stop in buy orders and yields reached levels
that would have quickly become unsustainable for any sovereign. Given the crucial role of
government bonds as benchmarks, for private-sector lending rates and their importance for bank
balance sheets and liquidity operations, this development was considered to impair the
transmission of policy interest rate decisions to the real economy.
To calm the market down and support a better functioning of the Monetary Policy
transmission mechanism, the ECB established a Securities Markets Programme (SMP) to ensure
depth and liquidity in those market segments that were dysfunctional, and re-introducing of the
non-standard measures that were withdrawn.
The analytical and empirical basis for the SMP had to be established from scratch, given
that earlier analysis always assumed functioning bond markets. Three main channels of
potential disruptions induced by malfunctioning government bond markets were identified:
price channel, liquidity channel and balance sheet channel.
a) The price channel arises from the link between government bond prices and the prices
of assets and costs of borrowing in the economy. As banks compete with governments
in their own efforts to raise funds in the capital market, correlation between sovereign
bond yields and yields on bonds issued by banks in the respective countries is very
high. This implies increased funding costs for banks which are then passed on with
some lag to bank lending rates.
Figure 9: EUR Banks and Sovereign Bonds Bloomberg Indexes performance
170
160
150
140
130
120
110
100
90
EUR Bonds Banks
Bloomberg Index
EUR Bonds Sovereign
Bloomberg Index
Correlation
Coefficient:
93,76%
*Source: Bloomberg
b) The liquidity channel arises from the role of government bonds in repo transactions.
Given their normally high liquidity, government bonds are the prime collateral used in
European repo markets, and can provide a benchmark for determining the haircut for
other assets used in such transactions.
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Figure 10: Share of EU sovereign bonds in the collateral pool of the European repo market.
*Source: European repo survey 2015.
Disruptions in the government bond market can thus paralyse other market
segments, making increasingly difficult for market-financing-dependent banks to obtain
liquidity and affecting their ability to issue bonds or use government bonds as collateral.
A rating downgrade of sovereign bonds can lead to a review of its eligibility as
collateral and margin calls, and thus effectively increasing the haircut, making banks to
sell assets under already stressed market conditions.
c) The balance sheet channel arises from the fact that price-implied changes in the nominal
value of government bonds, can lead to direct changes in the balance sheet size of
financial institutions and an erosion of their capital base. The resulting higher leverage
may force banks to shrink their balance sheets with adverse effects on their capacity to
extend loans to the private sector. Valuation effects are also relevant for insurance
corporations and pension funds, which may need to sell off assets in case of a
downgrade in the rating of sovereign bonds they hold.
The SMP was at the outset in alleviating disruptions related to those three channels, and
led to some stabilization in markets as well as to an immediate and substantial decline of
government bond yields. It also provided time for governments to find a durable solution to the
crisis and restore the sustainability of public finances: fiscal and macroeconomic adjustments
and financial stabilization.
As it turned out, governments did not use the time effectively. In the Greek programme,
significant implementation shortfalls emerged, new debt was discovered, and the fundamental
issues of substantially improving tax collection and strengthening competitiveness were not
addressed sufficiently resolutely. At the same time, the German government argued strongly
that a debt restructuring through ‘private-sector involvement’ was necessary.
On the positive side, the SMP helped to avoid for some time an uncontrolled increase in
sovereign bond yields and thereby in general financing costs for the economy with adverse
implications for price stability. In addition, it helped to reduce contagion across countries and
thereby shielded monetary policy transmission in large parts of the euro area.
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When the sovereign debt crisis stroked Italy and Spain in the summer of 2011 and their
government bond markets risked becoming dysfunctional, the ECB decided to re-implement its
SMP. But in autumn 2011, however, the euro area banking system came increasingly under
strain as the adverse interaction between the sovereigns and the national banking systems,
including via portfolio exposure to foreign sovereigns, took hold. Depressed sovereign bond
prices weakened bank balance sheets, markets questioned the viability of a number of banks
across a range of euro area countries, and the strained sovereigns were seen as increasingly
unable to provide credible backstops.
The spiral led to falling sovereign bond prices also well beyond the countries under
strain including France, Belgium, and Austria. Bank equity prices fell by up to 70% during the
year, bank credit default swaps spreads exceeded the Lehman peak, and the interbank market
became dysfunctional. In large parts of the euro area bank funding dried up, the bank issuance
of covered bonds was severely constrained, and uncovered issuance virtually closed. Banks
lacked funding and their liquidity beyond the immediate horizon was also brought into question.
In this context the situation of banks across the euro area countries became increasingly
differentiated, with some banking systems facing acceleration in net payment outflows. Indeed,
their interbank borrowing and debt securities stopped being rolled over and this was sometimes
exacerbated by a reduction in client deposits, notably from non-residents. Other banking
systems were net recipients of those inflows and faced excess liquidity.
At that time, the EBA agreed on an additional capital buffer and raised the so-called
Core Tier 1 capital ratio to 9%, a measure meant to be a stabilizing initiative, but created a
capital need in the European banking sector of over €100 billion to be raised within less than a
year. Banks, then, were expected to reduce risk-weighted assets to improve capital ratios.
Figure 11: Risk-weighted assets over total assets for banks listed in Euro Stoxx 50
index.
70%
60%
DEUTSCHE BANK
50%
BNP PARIBAS
SANTANDER
40%
SOCIETE GENERALE
30%
BBVA
20%
ING
10%
0%
-10%
INTESA SANPAOLO
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
UNICREDIT
*Source: Bloomberg
In addition, they started to raise capital by issuing subordinated debt, which is reflected
in the fact that, despite capital core ratio grew during 2010 – 2014, capital core tier 1 remained
stable, as it is disclosed in Figure in the next page.
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Figure 12: Tier 1 Capital Ratio (above) and Core Tier 1 Ratio (below)
for banks listed in Euro Stoxx 50 index
*Source: Bloomberg
Available indicators and survey information pointed to a severe credit crunch coming
up for the Euro area as a whole, well beyond countries under strain. In this context, a response
was needed that provided banks not only with a short-term liquidity support but also with a
sufficient perspective so that they would maintain credit lines in this very special environment.
Among other measures, the policy response consisted of two LTROs with a maturity of
3 years each, which would provide banks with a guarantee of having enough liquidity over the
medium term.
The measures were providing enhanced credit support. However, in the summer of 2012
there were signs of increasing fragmentation in the funding conditions for households and firms
across the euro area countries: bank funding costs were pushed up by continued tensions in
sovereign debt markets, which for some countries led government bond yields to incorporate
tail risk of an abandon of the euro for a new currency. In such conditions, the signal of the
policy interest rates was not transmitted appropriately throughout the euro area.
Against this background, the ECB decided on September the 6th, 2012 on a scheme to
intervene the secondary sovereign bond markets subject to strict and effective conditionality, the
so-called Outright Monetary Transactions (OMT), a programme of the European Central Bank
under which ECB made purchases of bonds issued by Euro zone member-states.
By signalling its readiness to intervene in government bond markets (“Ready to do
whatever it takes” speech by Draghi), the ECB could help to reduce the likelihood of adverse
self-fulfilling equilibrium. The OMT could contribute to aligning financing conditions for
households and firms better, with policy interest rates throughout the euro area.
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“In order to restore confidence, policy-makers in the euro area need to push ahead
with great determination with fiscal consolidation, structural reforms to enhance
competitiveness and European institution-building. At the same time, governments must stand
ready to activate the EFSF/ESM [The rescue funds] in the bond market when exceptional
financial market circumstances and risks to financial stability exist – with strict and effective
conditionality in line with the established guidelines. The adherence of governments to their
commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions for our
outright transactions to be conducted and to be effective.”4
The ECB was effectively signalling the Euro area governments; it would wait for them
collectively to be ready to put their money first before deciding whether to use ECB’s money in
the sovereign bond markets. The ECB explicitly commits itself to suspending the OMT in case
of failure on the side of the government to comply with conditionality– or in case of success
where the OMT objectives are achieved, thereby setting two cases for exit from the OMT.
There were two more differences with the latest SMP programme. First, OMT is a way
to enhance the incentives for governments to address public debt sustainability, as transactions
are focused on the shorter maturities; and second, the OMT provides ECB with the same
creditor treatment as private, mitigating the risk that private investors would not invest in the
bonds of sovereigns under strain if the ECB would have been a preferred creditor. With those
differences, the ECB aimed at addressing a number of concerns relating to the SMP, which was
terminated at the same time as the OMT was announced.
There are three conceptual elements that stand out in the ECB’s approach to date:
1. ECB has determined its non-standard actions in line with its monetary policy strategy.
2. Non-standard measures are primarily as a complement to its interest rate
instrument.
3. Non-standard measures aim at supporting the effective transmission of the
policy interest rate signal to the euro area economy when transmission is
hampered by the exceptional economic and financial situation.
1.2.5 We live in Quantitative Easing times
Neither the Federal Reserve nor the European Central Banks succeeded in maintaining
price stability by means of conventional monetary policies. The mess they caused by keeping
low reference interest rates in feral economies cannot be solved by orthodox policy measures.
Hence, the US rapidly started to promote and finally implement quantitative easing
programmes. However, the EU failed at doing it so fast, and we assess this might be caused by
four reasons:
First, before the intensification of the euro area sovereign debt crisis, the epicentre of
the crisis was in the US and the UK, and in line with this and with the choice of the policy
response, the balance sheet of the Federal Reserve and the Bank of England increased by about
a 150%, whereas that of the Euro system only rose about 50% during the period.
4
http://www.ecb.europa.eu/press/pressconf/2012/html/is120906.en.html
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Figure 13: Value of total assets with reference to January 2007
*Source: ECB
As the epicentre of the crisis progressively moved to the euro area, the Euro system
balance sheet has been significantly widening, similar to the cases of the other two Central
Banks.
Second, with the exception of the purchase programs, the ECB has focused on lending
against collateral rather than on purchasing assets. With such lending operations the ECB has
not sought to boost market prices, but has taken for the collateral market prices as a given and,
applied a haircut that can be considerable for some asset classes.
Third, at least until late 2011 the ECB made clear that non-standard measures were not
the new regime but exceptional means that were temporarily required and should be measured
in dimensions and phased out as soon as possible. One of the reasons for this more measured
approach was the need, in the EMU context, to avoid moral hazard on the side of the various
governments: they should not rely on monetary policy to stand in for their own responsibilities.
And fourth, from our perspective, the ECB had to deal not only with the financial shock
that spread globally from the US since 2007, but also with the economic debate that sprout out
of it within the EU. Some countries represented by Germany, championed austerity policies as a
way to overcome, in 2007, the newly born financial crisis. Austerity policies aimed at reducing
government budget deficits— including spending cuts and tax increases— to demonstrate the
government’s fiscal discipline to their creditors and credit rating agencies by bringing revenues
closer to expenditures. In most macroeconomic models, austerity policies generally increase
unemployment in the short term, but aim at reducing a high debt to GDP ratio.
Germany imposed its economic vision and, as a result, unemployment grew as
predicted. However, debt over GDP remained high, despite reductions in budget deficits relative
to GDP, because future expectations about taxes and government changed negatively, resulting
in overall economic recession through a deflationary process.
We may wonder why Germany has been, since then, opposing to any expansionary
policy, and we may guess it is because its government fears that it will let countries in the
periphery off the hook of sorting out their ill-functioning economies, but also due to historical
reasons. As we saw in Figure 5, real interest rates for Germany were really high, in comparison
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to other European countries, and thus a collectively reliance on their own saving rather than
credit demand landed on Germans’ financial behaviour.
These and the loss of nominal exchange rate flexibility in the Euro zone against
Germany given by the Euro currency led Germany running persistent current account surpluses,
while the periphery until the crisis had run large deficits, and Germany’s unit labour costs until
2008 growing considerably slower than the Euro zone average, while those of the periphery
grew much faster 5.
Figure 14: European, German and Spanish unitary labour cost
1,2
Europe
1,1
Germany
1,0
Spain
0,9
0,8
0,7
0,5
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
0,6
*Source: Bloomberg
The OMT had, a great opposition from Germany, and not only formal. Jens Weidmann,
German Bundesbank President, countered explicitly any expansionary action taken by ECB 6.
Moreover, the German Constitutional Court referred several questions about the OMT to the
European Court of Justice. Verdict in January 14, 2015 found the ECB’s OTM programme to be
compatible, in principle, with the TFEU.7
“In order to carry out its task, the ECB has at its disposal technical expertise and valuable
information, which, together with its reputation and communications strategy, enable it to
manage expectations in such a way that its monetary policy “impulses” actually reach the
economy. Therefore, the ECB must have a broad discretion when framing and implementing the
EU’s monetary policy, and the courts must exercise a considerable degree of caution when
reviewing the ECB’s activity, since they lack the expertise and experience which the ECB has in
this area.”
As the Euro area officially slipped into deflation, consistent with Draghi’s warning
about deflationary risk having increased8 in the past year, European Court of Justice paved way
for a Euro area Quantitative Easing.
5
http://www.policyreview.eu/the-german-economic-model-and-the-eurozone-crisis/
See, for example, an interview with WSJ on April 17, 2013: http://blogs.wsj.com/eurocrisis/2013/04/17/jens-weidmann-qa/
7
Court of Justice of the European Union, Press Release No 2/15.
8
https://www.ecb.europa.eu/press/inter/date/2015/html/sp150115.en.html
6
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1.2.5.1 American Quantitative Easing: “There’s many a slip ‘twixt the cup and the lip”
The several QE programmes implemented by Federal Reserve were, in some cases,
painful evidence that theory and real life don’t converge usually.
QE1 (2008 — 2010)
American first QE programme was announced by Federal Reserve on November the
25th, 2008, by means of a purchase programme of direct obligations of housing-related
government-sponsored enterprises and MBS backed by Fannie Mae, Freddie Mac, and Ginnie
Mae. This action was taken to reduce the cost and increase the availability of credit for the
purchase of houses, which in turn should support housing markets and foster improved
conditions in financial markets more generally.
The Federal Reserve purchased $1.25 trillion of agency MBS. The purchase activity
began on January 5, 2009 and continued through March 31, 2010, using agency MBS dollar
rolls as a supplemental tool to address temporary imbalances in market supply and demand, and
coupon swaps when agency MBS were not readily available for settlement and there are
different agencies more readily available.
Although purchases were completed at the end of March 2010, the Federal Reserve
continues to use both dollar roll and coupon swap transactions, to facilitate an orderly settlement
of the agency MBS program’s remaining forward purchase commitments.
Figure 15: US Home Mortgage index along QE1 lifetime
6,0%
5,5%
5,0%
4,5%
Nov-08
Feb-09 May-09 Aug-09
Nov-09
Feb-10 May-10
*Source: Bloomberg
The following months, the FED, cut its reference interest rates to zero, and began
paying interest to banks, for their reserve requirements. As a result, all of the Fed's most
important expansionary monetary policy tools had now reached their limits.
QE1 concluded in the first quarter of 2010 and, contrary to analysts' expectations,
mortgage rates tumbled after the program ended, to as low as 5%, about a year after QE1
started.
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QE2 (2010 — 2011)
Macro data in the third quarter of 2010 were suggesting that the pace of recovery in
output and employment continued to be slow. According to the Federal Reserve, banks still
weren't lending as much as the Fed had hoped. Instead, they were hoarding the cash, using it to
write down the rest of the subprime mortgage debt they still had on their books. Others were
increasing their capital ratios, just in case. Many complained that there just weren't enough
credit-worthy individuals and companies to lend to. Perhaps that was because they'd also raised
their lending standards. For whatever reason, the QE1 programme looked a lot like pushing a
string.
To promote a stronger pace of economic recovery and to help ensure price stability, the
Committee decided on November the 3 rd, 2010 to expand its holdings of securities by a second
Quantitative Easing programme. The Federal Reserve intended to purchase a further $600
billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of
about $75 billion per month.
Taken together, this would result in an average purchase pace of roughly $110 billion
per month, representing $75 billion per month associated with additional purchases and $35
billion per month associated with reinvestment purchases.
The Fed planned to distribute these purchases across the following eight maturity
sectors based on the approximate weights below9.
Figure 16: Purchases distribution of QE2
2%
4%
3%
5%
1,5 -2,5 years
2,5 - 4 years
20%
23%
20%
23%
4 - 5,5 years
5,5 - 7 years
7 - 10 years
10 - 17 years
17 - 30 years
TIPS: 1,5 - 30 years
*Source: Federal Reserve Bank of New York
When the programme ended, the 30-year fixed-rate mortgage was about 30 basis points
higher than it was when QE2 started. That was a consequence of the programme ending, which
raised some fears of interest rate spiking.
9
http://www.newyorkfed.org/markets/opolicy/operating_policy_101103.html
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Figure 17: US Home Mortgage index along QE2 lifetime
5,5%
5,0%
4,5%
4,0%
Nov-10 Dec-10
Jan-11
Feb-11 Mar-11 Apr-11 May-11 Jun-11
*Source: Bloomberg
Operation twist (2011 — 2012)
Operation Twist is a programme of Quantitative Easing utilised by the Federal Reserve,
where it uses the proceeds of its sales from short-term Treasury bills to buy long-term Treasury
notes. This program put downward pressure on longer-term interest rates and helped make
broader financial conditions more accommodative.
Figure 18: US Home Mortgage index along Operation twist lifetime
4,5%
4,0%
3,5%
Sep-11
Dec-11
Mar-12
Jun-12
Sep-12
*Source: Bloomberg
QE3 (Sep 2012 — Dec 2012)
In August 2012 macro data continued suggesting that economic activity continued to
expand at a moderate pace. Coherent with its recent monetary policy history, the Federal
Reserve agreed on September the 13th, 2012 to increase policy accommodation by purchasing
additional agency mortgage-backed securities at a pace of $40 billion per month.
In this case, the Fed did three things which it had never done before:
1. It announced it would keep the Fed funds rate at zero until 2015.
2. It said it would keep purchasing securities until jobs improved "substantially."
3. The Fed acted to boost the economy, not to avoid a contraction.
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QE3 was expected to hold rates down or reduce them on mortgages and other financial
instruments. It was hoped that with new cash injections, banks would lend out the money and
give the economy a boost. The 30-year fixed-rate mortgages initially fell but have since
bounced up and down.
Figure 19: US Home Mortgage index along QE3 lifetime
3,625%
3,500%
3,375%
3,250%
Sep-12
Oct-12
Nov-12
*Source: Bloomberg
QE4 (2012 — 2014): To the infinity and beyond
Just 3 months after QE3 implementation, Federal Reserve was well aware that
economic activity wasn’t expanding at a sufficient rate, and unemployment remained high.
Fiscal policy application was restraining economic growth, and inflation projections still were
lower than desirable.
From Federal Reserve’s perspective, QE3 was not enough. Thus, it decided to expand
its purchase programme by buying a total of $85 billion in long-term Treasuries and MBS. It
ended Operation Twist, instead of just rolling over the short-term bills.
This fourth round signalled a substantial change in Federal Reserve policy. First, Fed
Chairman Ben Bernanke announced that it would continue until either one of two things
occurred:


Unemployment dropped below 6.5%.
The core inflation rate rose above 2.5%.
This was the first time the nation's central bank targeted the unemployment rate. It
meant the Fed was just as concerned with stimulating economic growth as it was with
preventing inflation. Some people refer to QE4 as "QE Infinity" because it didn't have a definite
end date.
Later improvement in economic activity and labour market conditions were seen as
consistent with growing underlying strength in the broader economy. In light of the cumulative
progress toward maximum employment and the improvement in the outlook for labour market
conditions, the Federal Reserve finally decided to modestly reduce the pace of its asset
purchases. This monetary policy measures should maintain downward pressure on longer-term
interest rates, support mortgage markets, and help to make broader financial conditions more
accommodative, which in turn should promote a stronger economic recovery and help to ensure
that inflation is at the rate most consistent with its dual mandate.
1.2.5.2 Euro Area Quantitative Easing: License to kill debt
Only one week after the European Court of Justice’s press release on the OMT being
compatible with the Treaty, the ECB announced in January the 25th, 2015 an expanded asset
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purchase programme. This programme would add the purchase of sovereign bonds to its
existing private sector asset purchase programmes in order to address the risks of a too
prolonged period of low inflation, in a situation in which most indicators of actual and expected
inflation in the Euro area had drifted towards their historical lows.
Figure 20: Annual inflation (%) in December 2014, ascending order
*Source: ECB Annual inflation report, 16/01/2015
Combined monthly purchases will amount to €60 billion, intended to be carried out
until at least September 2016 and in any case until the ECB sees a sustained adjustment in the
path of inflation that is consistent with its aim of achieving inflation rates close to, 2% over the
medium term.
Purchases of additional euro-denominated securities must meet these eligibility criteria:
1. They fulfil the collateral eligibility criteria for marketable assets.
2. They are issued by an entity established in the euro area that is a central government or
certain agencies, international or supranational institutions located in euro area.
3. They have a first-best credit assessment from an external credit assessment institution of
at least a rating of BBB-/Baa3/BBB.
4. Securities that do not achieve the minimum rating will be eligible, as long as the Euro
system’s minimum credit quality threshold is not applied for the purpose of their
collateral eligibility.
Figure 21: Quantitative easing in the Euro area, forecast based on EB buying €60bn of
assets a month.
*Source: The Economist, Bruegel, ECB.
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The ECB’s foray into QE involved a big concession to Germany. Draghi may have got
his way on QE, but Weidmann won the argument on keeping the risk from buying bonds of less
creditworthy countries with their own central banks. When the ECB conducts monetary policy
by lending to banks, any risk of losses is, as a rule, shared between the 19 national central banks
that actually execute the policy, according to “capital keys”, which reflect their countries’
economic and demographic weight in the euro area.
Figure 22: National Contribution to the ECB’s capital
through their respective Central Banks (ECB’s capital key), descending order.
Germany
Italy
Netherlands
Greece
Portugal
Ireland
Lithuania
France
Spain
Belgium
Austria
Finland
Slovakia
Slovenia
*Source: ECB
QE will be conducted in a quite different way. The capital keys will still determine the
amount of sovereign debt that is bought in each country. But each of the 19 national central
banks, which together with the ECB constitute the Euro system, will buy the bonds of its own
government and bear any risk of losses on it. Risk-sharing through the capital keys on national
sovereign debt will be limited to the 8% share that the ECB will buy itself, and risk-sharing on
the purchase of bonds issued by European institutions will amount to 12% of the overall
purchases of public debt: all told, no more than 20% of risk will be shared.
The announce was held just days before the Greek election, which eventually brought a
Syriza-led government to power that overplays its hand in demanding concessions from its
European creditors, to such an extent that Greece has to leave the monetary union.
The council’s decision on QE reflects a compromise. The trade-off is an important
breach in the ECB’s usual risk-sharing arrangements, which creates within the very heart of the
monetary union the fragmentation it has been seeking to fight. That is a worrying augury for a
programme on which so many economic hopes now rest, apart from the fact that the ECB has
committed itself to buy far more debt that is available in the market.
1.2.5.2.1 The ECB is buying a lot of debt
The €720 billion per year QE programme— accounting for 7.2% of the Euro Area
GDP— while the Euro Area is expected to run an aggregate deficit of about €205bn, means that
the ECB is not only purchasing all the net supply of Euro Area sovereign paper, but is also
buying part of the existing stock. The ECB will actually reduce the stock of debt available for
investors by about 5% of Euro Area GDP, or €515billion.
This simply means that investors will have to disinvest from Euro Area sovereign debt
and will be forced to invest in other assets.
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Figure 23: The stock of public debt available for investors will decline
*Source: UBS, Haver
Figure 24: Reduction of public debt due to QE (% GDP)
*Source: UBS, Haver
It is interesting to note in passing, that national fixed income markets will not be
impacted similarly: countries with low deficits (or surpluses as we expect in Germany) will see
their stock of debt decline much faster than countries with persistent deficits, as shown in Figure
above. In this context, the pressure on prices will be considerable. We believe that initially,
Bunds could sell-off due to investor positioning, as many investors went into QE overweight
European sovereign debt and so, initially, this will provide a ready pool of sovereign bonds for
the ECB. However, any large sell-off in German Bunds is difficult to envisage in this context in
which the available stock of Bunds will decline by almost 1/10 this year.
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1.2.5.2.2 Can other fixed income products absorb the excess?
We doubt it. According to UBS10, the size of the market is too small to be able to absorb
all the ECB purchases or all the crowding out of investors.
Figure 25: UBS estimate on size and issuance on the credit market
*Source: UBS European Credit Team
Figure 26: Left, the scale of the ECB's QE purchases compared to the size of European
markets.
Right, ECB's QE is larger than the total issuance of sovereign and corporate paper this year.
*Source: UBS, Haver, Bloomberg
The QE total amount is larger than the net issuance of sovereign and private paper.
De facto, the market will have no choice but to move out of fixed income products into
other assets. This is why we think European equity returns are very likely to be boosted by QE
this year. However, insurance companies, which are one of the main holders of sovereign paper
in Europe, are unlikely to move to equity as Solvency II makes it very difficult.
Impact #1: Peripheral sovereign spreads are too tight, but with given the large scale of
ECB purchases it is difficult to expect normalization any time soon.
Impact #2: Sizeable support for the credit market and we believe spreads will remain
well supported.
Impact #3: Equity market has to benefit from the move. This is the only asset class,
large enough and liquid enough, in the EU to absorb the liquidity provided by QE (see Figure
left above). Note however that the €414bn decline in fixed income domestic paper available for
investors is equivalent to about 6% of Euro market cap which should be supportive of a strong
rally.
10
Macro Keys: The ultimate argument for European equity. UBS Global Macro Team, 11 March 2015.
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1.3 QUANTITATIVE EASING AS THE ULTIMATE SOLUTION
Quantitative Easing has become, as we have just seen, the ultimate solution held by
Central Banks to overcome, once and all for all, the deflationary climax that came after the
global financial crisis. But we must ask ourselves now, has QE fulfilled its promises? And if so,
at what cost to global economy?
1.3.1 Has Quantitative Easing livened up to expectations?
As Quantitative Easing programs aim at restart a depressed economy, we must analyse
if credit supply rose as a consequence of this programs.
Figure 28: Changes in Sovereign Bonds, Equities and Exchange rates
IMF Global Financial Stability Report, April 2015
*Source:
As we see in the left chart, in most cases, Quantitative Easing programs fulfilled their
main goal of dropping sovereign bond yields. Moreover, on the right chart we see that equities
have spiked as the Quantitative Easing programs have been implemented, and suggests that
stock markets benefit from these unconventional monetary policies.
Figure 27: Behaviour of sovereign bond yields in Euro area
in the aftermath of the Quantitative Easing
*Source: IMF Global Financial Stability Report, April 2015
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By April 2015, up to the first seven years of Germany’s term structure of interest rate
was below 0%, and so was the first four in Finland, Netherlands, Austria, Belgium and France
(left chart), what we call “core” Euro area. But lately, we witnessed in countries of the
“periphery”, such as Spain, that its TSIR started to drop below zero on its initial portion.
However, the intensity of this public sector purchase program has moderated lately, as the
difference between two-year bond yield and the deposit rate fixed by Central Banks become
closer (right chart).
Institutional investors are the key to the transmission of QE to the private sector in the
euro area. However, European life insurers, which hold about 20 % of EU government bonds,
may have limited incentive to sell bond portfolios to the ECB, partly because of regulatory
considerations, but also as a result of their weak balance sheets. Given significant duration
mismatches, the cash from a bond sale would need to be reinvested into similar-duration bonds.
Since re-risking by taking on lower-quality credit will further eat into their fragile capital
buffers, rebalancing will likely take place primarily in investment grade sovereign and corporate
bonds, particularly in U.S. bonds, given the combination of attractive yields, long duration, and
low foreign currency hedging costs.
Figure 28: Bank credit growth to the Non-Financial Private sector (Percent)
*Source: IMF Global Financial Stability Report, April 2015
In spite of financial markets benefited from non-conventional monetary policies, bank
lending growth has lagged in the past QE episodes. Financial institutions may be reluctant to
use current buffers to increase their lending, particularly given the challenges that historically
low profitability are posing for business models. Banks may face limits on the degree to which
they can reallocate sovereign bond portfolios toward riskier assets, because the Risk Weighted
Assets over Total Assets ratio would rise, eroding bank buffers. Even if banks have the capacity
to expand their loan portfolios, there is a risk that they may reallocate their portfolios toward
more profitable strategies.
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Figure 29: Plausible alternative investment choices as a reaction to Quantitative Easing
programmes.
*Source: IMF Global Financial Stability Report, April 2015
According to these estimates, banks may have incentives to invest in higher-yielding
bonds, such as U.S. and emerging market sovereign bonds. In the euro area, improving asset
quality at some banks could further bolster bank credit, and successive Asset Quality Review
tests implemented by Euro area banking authorities are likely to drive banks in this direction.
Figure 30: Nonperforming loan stock and its distribution through EU countries
*Source: National Central Banks and IMF calculations on the GFSR, April 2015
In Cyprus, Greece, Ireland, Italy, Portugal, and Slovenia, a majority of the banks
involved in the ECB’s AQR were found to have nonperforming assets of 10 % or more of total
exposure. These bad assets are large relative to the size of the economy (Figure above, right
panel), even net of provisions, suggesting less active bad debt management and more limited
improvement in corporate indebtedness.
ways:
Nonperforming assets reduce banks’ willingness and ability to supply credit in three key



They are a drag on profitability
They use scarce resources on bank balance sheets
Banks with high levels of nonperforming loans may be less willing to lend to
borrowers with borderline credit quality
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Figure 31: Nonperforming loans, provisions and its consequence
on interest income and lending growth
*Source: National Central Banks and IMF calculations on the GFSR, April 2015
1.3.2 Side effects of Quantitative Easing
A strong portfolio rebalancing channel is a key transmission for QE. Rebalancing could
happen by three means. First, rebalancing lowers risk-free rates, which translates into lower
funding costs. Second, rebalancing from sovereign bonds into more risky assets should reduce
lending spreads and thus credit costs, but it is most likely to benefit big companies that have
access to markets. Third, there could be portfolio outflows from the economies engaging in QE,
primarily to the United States, but also increasingly to emerging markets.
1.3.2.1 Fixed income bubble
As Quantitative Easing aim at pressing down sovereign bond yields, vast demand for
sovereign debt would eventually inflate its price and create a sovereign debt bubble.
There are four main risks that affect sovereign bond prices. First, interest rate fixed by
Central Banks; second, long term expected inflation; third, volatility on this long term expected
inflation; and fourth, country risk, that have pressed down severely sovereign debt prices on the
periphery in the last five years.
Provided that Central Banks keep reference interest rates down at zero (or even below),
investors would go for fixed income assets that are less influenced by an eventual interest rate
hike, that is, short-duration fixed income securities. No wonder why, in light of recent
developments, prices in short term debt, even corporate debt, started yielding very low or even
negative, still in periphery countries such as Spain11.
However, this purchase programmes have to fight with the consequence that it aims. As
the Quantitative Easing leads investor to believe that the economic outlook is improving,
inflation expectations will grow, impacting negatively on sovereign bond prices. Despite this
being good news, if this drop persist, affecting financing cost, it could also impact consumer
and corporate investing, and euro depreciation could back away exporter companies’ progress.
Likely explanation for the lower depth in almost all bond markets, according to James
Dimon, chairman and Chief Executive Officer of JP Morgan, is that inventories of marketmakers’ positions are dramatically lower than in the past. For instance, the total inventory of
11
http://www.ft.com/cms/s/0/35ddc68e-dde7-11e4-8d14-00144feab7de.html#axzz3c5i4t4YU
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Treasuries readily available to market-makers today is down 46% from its peak in 2007, while
the Treasury market is up 104%. Trend in dealer positions of corporate bonds is similar.
Inventories are due to multiple new rules that affect market-making, including far higher capital,
liquidity requirements and the pending implementation of the Volcker Rule. There are other
potential rules, which also may be adding to this phenomenon, like post-trade transparency
making it harder to do sizable trades since the whole world will know one’s position, in short
order 12. Tidjane Thiam, soon-to-be CEO of Credit Suisse, said “Regulation has structurally
reduced liquidity in many key markets” in an interview on Bloomberg Television
Moreover, this bubble bursting would affect sovereign governments, which used to have
incentives to take more and more debt while the Quantitative Easing program was taking place,
and may face a raise on their financial expenses if, during the QE, they didn’t bother in
improving their countries’ economy. Such a raise might be terminal if they can’t face it, hence
the QE would have been no use at all.
1.3.2.2 Burse indexes on an upward curve: Stock market bubble
As debt stock starts to be scarce, investors would seek for stock markets. The crowding
out of the demand would be a cause for investing in equity, but we also considered the
possibility that it may be seen cheaper than ever.
As sovereign debt rate is considered risk free, even if risk compared to sovereign debt
remains the same, the cost of equity would decrease. That is just proof to the idea that, when
comparing two objects with different properties, if one of them increases its price, we would
expect that the price of the second would increase as well, and we would be more likely to buy
it, even though its price never varies.
This would create a breeding ground for a stock market bubble, not just because prices
goes up, but also because spread between high-yield-rate and investment-grade-rate corporate
entities would decrease severely, meaning that risk perception of the market would be blurred
by unconventional monetary policy landscape.
Figure 32: 75 equally weighted CDS on the most liquid sub-investment grade European
corporate entities versus 125 equally weighted CDS on investment grade European corporate
entities spread (bps)
1200
1000
Spread HY vs. IG
800
600
400
200
0
*Source: Bloomberg
12
James Dimon’s letter to shareholders. Annual Report 2014.
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1.3.2.3 International turmoil
There is also a third consequence of quantitative easing: as we live in an even-more
connected world, unconventional monetary policies were implemented with a careful
observation of the global environment where economies live in. Despite US and EU being
among the biggest economies, they are also highly interconnected among them and with the rest
of the world. Thus, it is sensible to measure the consequences of Quantitative easing globally.
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2. LIMITATIONS OF FISHER’S EQUATION IN RESPONSE TO DEFLATION
2.1 INTRODUCTION
The current economic crisis has been a consequence of a financial crisis which started
in 2008, collapsing the liquidity markets. The European crisis has differently affected all the
Euro Zone countries, making manifest of its deficiencies in a common monetary policy and
their distinct fiscal policies.
The European Central Bank, beyond its incapacity of perusing its goals and thus
accomplishing them, has carried out several Non-Conventional measures in order to achieve the
following purposes: flood the markets with liquidity, stimulate credit, achieve economic growth,
avoid deflation and reduce the financing cost for each Member State.
The ECB has employed the ensuing instruments so as to achieve its aims: provide
liquidity with a fixed interest rate and fully allocation, an increase in the amount of guaranteed
assets admitted, liquidity allocation in a wider deadline, liquidity injection in foreign currency,
changes in the reserves minimum required base and acquisition of securities different from
specific shares.
2.2 FISHER´S THEORY
The Fisher’s equation was published in 1911 by Irving Fisher. In the formula addresses
a quantitative approach towards inflation, related to the increase if the general level of prices
and thus an increase in the money supply.
Irving Fisher (February 27, 1867 – April 29, 1947) was an American economist, statistician,
inventor, and Progressive social campaigner. He was one of the earliest American neoclassical
economists, though his later work on debt deflation has been embraced by the Post-Keynesian
school.
The quantitative theory started with the classic assumption in which there is no concern
about the explanation of money supply. However, in the School of Cambridge equation several
factors are considered in order to determine money supply, leaving behind the exclusivity of
being just a way of payment.
2.2.1. Classical approach.
As we have previously mentioned, the classical formulation did not studied the causes
of the money supply. The only reason, for which money was supplied, was in order to use it as a
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way of transactions payment. The global volume of maintained balance depends on several
factors which configure the economic internal structure: perceived income, expenses structure,
expenses distribution and the degree of credit usage.
This approach assessed the hypothesis that these were the short term factors, with which
the relationship among the transactional value and the money balance was constant; this
relationship was known as the average velocity of money.
Fisher’s equation reflects the total expenditure expressed in monetary terms, it coincides
with the total monetary value of all goods traded. The money paid by the buyers equals the
money obtained by sellers.
MxV=PxY
However, this formula application requires three basic assumptions: the variations of
the velocity and the income are independent from the monetary base variation; the velocity and
the income change moderately and thus considered constant and last, the monetary base
produces variations in the general prices level. There is a correlation among M and P, being M
the one producing variations in P but not the other way around.
The quantitative theory of money, is determined by the monetary supply in nominal
terms. Three deficiencies were offset in the School of Cambridge: the constant velocity and the
transactions volume that does not need to by short term accomplished, the equation does not
include interest rate changes and the influence on monetary demand13.
Yet another version of the quantity theory of money is the Cambridge Cash Balance
equation:
M = kd PY
Here kd is the demand to hold money per unit of money income. M and P are causally
related, if kd and Y are constant (Thirlwall 1999). This version of the quantity theory was used
by Milton Friedman.
Milton Friedman (July 31, 1912 – November 16, 2006) was an American economist,
statistician and writer who taught at the University of Chicago for more than three decades. He
received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption
analysis of stabilization policy.
It can be seen that V (whether it is regarded as the income velocity of circulation of
money as in the previous equation) or kd must be constant for the quantity theory of money to
work, as Y (in the first equation).
13
Política monetaria, J.A. Parejo
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Keynes correctly argued that neither kd nor Y is constant. Pre-Keynesians assumed that
Y was constant because of their foolish belief that a free market economy was nearly always in,
or moving towards, equilibrium (i.e., full employment and full use of resources). By contrast,
Keynes, in his criticism this last equation, argued that in the absence of full employment, Y will
not be constant.
John Maynard Keynes, 1st Baron Keynes (5 June 1883 – 21 April 1946), was a British
economist whose ideas fundamentally affected the theory and practice of modern
macroeconomics and the economic policies of governments. He built on and greatly refined
earlier work on the causes of business cycles, and he is widely considered to be one of the most
influential economists of the 20th century and a founder of modern macroeconomics.
Thus the theory breaks down, especially in a recession, depression or even in periods
during expansions in the business cycle where full employment is not reached.
The Neoclassicals also assumed that V was constant because they only accepted the
transactions demand for money. Keynes, however, showed that there are three motives for
holding money:

The transactions motive

The speculative motive

The precautionary motive.
Keynes thus rejected the idea that there is a direct and proportional relationship between
the money supply and the price level. Instead, Keynes argued that the money supply influences
the price level indirectly through its effects on the interest rate, income, output, employment and
investment. Moreover, prices are also influenced by the costs of production. It is only when
there is full employment and full use of resources that money supply increases could then
increase the price level in the way the quantity theory predicts.
We can carry Keynes’s critique even further by adding Post Keynesian criticism of the
quantity theory. In reality, the quantity theory also makes an assumption that is fundamentally
false. The quantity theory assumes this:




An exogenous money supply
A stable V or kd in equation above
A stable Y in both equations above
Equilibrium or near equilibrium (high capacity utilization/high
employment)
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First, Neoclassical Keynesians accepted the idea of an exogenous money supply
determined by the central bank (as did Keynes himself), and notably Keynes never broke with
the quantity theory of money fully, despite his criticisms. But today Post Keynesian economists
have shown that we have an essentially endogenous money supply, so the first assumption is
wrong.
Secondly, we have already seen that the second and the third point are false. The
velocity of money is unstable, subject to shocks and moves pro-cyclically. If the economy is not
at full employment (and has less than full capacity utilization), then Y will actually rise as
income rises, and the price level could remain stable in the face of this rising money
supply/income.
Thirdly, in a recession capacity utilization is low and unemployment is high. The
quantity theory also ignores imports in open economies, which can keep inflation low.
2.2.2. Current situation: the paradox of the deflation and the economic growth.
The economic recovery that the countries, which were affected by the crisis, are living,
is calling into question all the classical economic theories on economic policy and management
cycles. This fact, with many others, is causing that this crisis is lengthening the cycle and the
longest and deep that it has lived up to now.
The current crisis differs, from those previously experienced, in different aspects: the
world is globalized and interconnected technologically, which makes the risk of contagion
greater; we live in completely open economies, so recipes for economic policy, in many cases,
do not have the expected effect since the implementation and outcome depend on also, in the
functioning of the rest of countries with which it operates; the dramatic social crisis has further
increased the mistrust in the political and financial system so lack of stability further hampers
the way out of the crisis; and finally, it should be noted the continuous and unstable regulatory
environment that is causing a lack of legal certainty rather than an environment conducive to
trade and investment.
There has been a lack of coordination, these years, in economic policy measures and the
timing of implementation among the major countries of the O.E.C.D. The main comparison is
between United States and the Euro Zone.
Americans stabilized its financial system as soon as they saw the fragility of this lack of
coordination and the great risk of infection among systemic institutions. They carried out a
series of measures which, although unpopular, has allowed them to recover all financial aid
before time and without prejudice to the citizens and to forge a more solvent banking system
creating more too big to fail bank groups, with a greater global presence. However, the creation
of entities called globally systemic also has risks and, therefore, its supervision and regulation
must be stricter.
In Europe, there has been a lack of coordination between different countries Member,
giving rise to the idea of "Two-speed Europe". Bank bailouts, in many cases, been executed
later by what the amount and extent of subsidies had to be greater and more harmful measures
for investors and shareholders. It has been necessary to bail out certain countries so that they
could deal with their services of prime necessity, that we have supported them financially in
Exchange for harsh measures that have increased social inequalities. The measures required by
the international agencies that have lent support to these countries were, fundamentally,
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contractionary, with the dual objective of achieving fiscal consolidation and reduce the national
debt, which had reached unsustainable levels.
Differences in fiscal policies in Europe, almost all them ineffective, forced the ECB to
begin expansionary monetary measures with the objectives of: increasing liquidity in the
markets, increasing the credit to households and non-financial corporations, moving away from
deflation coming in Europe and reduce the costs of financing for the countries and companies.
This has carried out unconventional measures as the free bar, enlargement of collateral or QE.
All the measures taken by the central bank were in lathe to increase the money supply,
with the premise that by injecting liquidity into the real economy would increase inflation and,
therefore, would make the economic recovery. These measures are realized, mainly in:

Lowering of interest rates: this decline has occurred in the types of open market
operation, which is currently located in the 0.05% and is referenced to the
operations of credit institutions with the ECB, i.e. the cost of the borrowed amount
of the central bank; marginal credit facility and deposit facility, which is the rate
that the central bank pay for the deposits of institutions. This type is currently at 0.20% in order that banks withdraw deposits and injected them into the economy.
Figure 35. Monetary Policy of the Euro system
Monetary Policy of Eurosystem
2,50%
2,00%
1,50%
1,00%
0,50%
0,00%
Marginal Lending Facility
ene-15
sep-14
may-14
ene-14
sep-13
ene-13
may-13
sep-12
may-12
sep-11
ene-12
may-11
sep-10
Open Market Operations
ene-11
may-10
ene-10
sep-09
may-09
ene-09
-0,50%
Deposit Facility
*Source: Bank of Spain

"Open bar": in 2012, the central bank introduced these operations with full allotment, in
a way which was granted the entire amount requested by banks. The first instrument
used was the LTRO (Long Term Refinancing Operations). However, later replaced by
the TLTRO (Targeted LTRO) so the proceeds only could be employed in new loans to
nonfinancial corporations and loans to consumption or other purposes of families, to the
detriment of real estate developers and mortgage loans.
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Figure 36. 12 months interest rates
12 months interest rates
2,50%
2,00%
1,50%
1,00%
0,50%
Euribor
UK
ene-15
jul-14
ene-14
jul-13
ene-13
jul-12
ene-12
jul-11
ene-11
jul-10
ene-10
jul-09
ene-09
0,00%
USA
*Source: Bank of Spain
Figure 37. TLTRO features
*Source: own elaboration from ECB data.
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
QE (Quantitative Easing): as we have explained before, this formula has been also used
in countries such as United States, United Kingdom and Japan. The ECB began in
March 2015 to issue more currency and increase the money supply which would be
reflected through purchases of sovereign debt, covered bonds and certain instruments of
debt of nonfinancial corporations. The target is the purchase of 60 billion Euros a month
until at least September 2016. It is planning the central bank issued new money
amounting to a total of 1.08 trillion Euros.
QE objectives include the reduction of interest rates, and therefore decrease even more,
the costs of funding from States and companies. It is expected that this program
reactivates the banks again to issue larger amounts of covered bonds and securitization
of debt to expand the credit.
Figure 38. Sovereign bond-buying program14
*Source: Bloomberg and ECB.

In addition, the central bank extended the list of assets as collateral for the request for
funds by the banks.
Delegating monetary policy economic recovery has not had the expected effect, since
there have been a number of factors and situations that have not allowed the development and
execution of these. The inadequacy of these measures is due, inter alia, to:

Social panorama
The first effects of the crisis in 2008 were a lack of liquidity in the system and an
absolute confidence in the markets and the financial system. The great increase of
unemployment, as lived in Spain, made that many families had received their only income from
the State social transfers. On the other hand, families who were receiving wage incomes stopped
consuming at the rate that did it before due to the great uncertainty, so consumption during these
14
Amount calculations: (ECB Monthly Buying – Covered Bonds and ABS – European Institution)* Capital Key
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years was falling in favor of saving, which has allowed countries like Spain boost its foreign
trade and boost the growth of the GDP.
Despite the monetary expansion, the deleveraging of the private sector discussed earlier,
being the outstanding balance of credit to families and businesses to follow contract despite the
fact that the new credit granting is picking up. The repayment of credit is still greater than the
new credit production, which leads to a reduction of the monetary base, process it was essential
to face the new economic cycle with greater financial health of the private sector. This makes
that the growth of the monetary base is less than it sought by the central bank.
Figure 39. Spanish unemployment rate
*Source: Instituto Nacional de Estadística (INE)
Figure 40. Disposable income in Spain
*Source: Cuentas Nacionales de la Economía Española.
Ministerio de Economía y Competitividad
• Banking regulation
Continuous and evolving banking regulation: since the financial crisis became clear
excess of banking deregulation and endangered in global financial stability, the various
regulatory agencies aim to seek security in the management of the banking business.
However, the lack of consensus regarding different aspects of the business along with
the uncertainty that possess financial entities and the cost that may result, many are reluctant to
grant new credit with the fear that in the medium and long term the cost of these loans, in terms
of capital and provisions referred to, is greater than the profitability. Therefore, since the banks
are a key tool for the transmission of monetary policy, and are not willing to provide all new
money emitted by very low which is their cost of funding, chain multiplication that should
increase the monetary base stops in such entities.
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Figure 41. Credit to Households and NFC Spain Figure 42. New production of credit in Spain
*Source: Bank of Spain
*Source: Bank of Spain
Figure 43. Stock of credit/Flows of credit to Households and NFC in the Euro Zone.
*Source: Statistical Data Warehouse. ECB
As you can see in the above graphs, families and businesses have led a process of
deleveraging that is greatly reducing the outstanding balance of credit, and therefore a reduction
in the amount of money in circulation. The policies of the ECB regarding the expansion of the
credit are not having the desired effect since the repayment of credit is still very high, the lack
of solvent clientele and the enormous cost regulatory for banks, which leads them to toughen
the criteria for granting.
In the case of Spain, as you can see in the following images, in 2012 occurs the moment
of greater uncertainty about the economy of the country with great pressures from major
international bodies to request the formal rescue of the country. With all of this was a stress test
to analyze the capacity of resistance that had Spanish banks to face a series of scenarios and
analyze their creditworthiness in such situations. The result was that they were needed between
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26,000 and 54 billion Euros of capital, which necessarily must be covered by contributions of
capital and a drastic reduction in credit to improve the ratio of capital and reach the required
thresholds. All measures of recapitalization and strengthening of the institutions had been a
sharp decline in its loan portfolio.
Figure 44. Capital needs for Spanish Banks in base/stress scenario
*Source: Results of 2012 Stress Test. Bank of Spain
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2.2.3 Critical currents
The first idea that causes differences between the main economic schools is if it is
necessary to generate inflation to achieve economic growth, or the economic growth is one of
the reasons why inflation is generated. Regardless of the differences of approach, which is
showing the European economic situation is not inflation that brings with it economic growth.
In the case of Spain, the country has seven consecutive quarters of economic growth with a CPI
close to zero, which is in negative values from July 2014.
Figure 45. CPI growth (%)
Figure 46. GDP growth (%)
*Source: Instituto Nacional de Estadística (INE)
Figure 47. Spanish current account balance
Figure 48. Spanish current account balance
*Source: Cuentas Nacionales de la Economía Española. Ministerio de Economía y Competitividad
The second idea that is contradicted, according to the school, is that the consumption is
the main engine of growth of an economy. One of the reasons for the expansion is monetary is
the promotion of consumption by granting new credit for this purpose, through the TLTRO that
since its inception has awarded 212.440 million Euros. Once again, the Spanish case, at least,
shows is not quite true. Consumption in the country has been drastically reduced due to the
uncertainty, the steady growth of unemployment and lower disposable income of families. You
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can see in the previous graphic, a change of trend in foreign trade that has led to that the current
account balance is over a deficit of €Bn. 46 to a surplus of €Bn. 8, granting the country
financing capacity. This reinforces the idea defended by classical and Austrian schools of that
country always grows through savings and not so much by the consumer.
In fact, as shown in the following graphs, the consumption collapses in the year 2013,
which coincides with the time that Spain finally out of recession, while saving has picked up
slightly. While saving has fallen since 2009, there be put in since context which in turn also
reduces wage incomes, so the proportion of these savings is greater. This saving has been which
has allowed that in 2014 the consumption has rebounded by the decrease of unemployment and
the increase of confidence in the economic recovery. These savings, as we have already
mentioned above, has also been that has allowed families to deleverage and not rely on both
bank credit.
Figure 49. Spanish families’ savings
Figure 50. Spanish families’ consumption
*Source: Cuentas Nacionales de la Economía Española. Ministerio de Economía y Competitividad
Figure 51. Spanish families’ salaries
*Source: Cuentas Nacionales de la Economía Española. Ministerio de Economía y Competitividad
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The third idea is precisely about the measures applied, and more specifically on the QE.
There is diversity of opinion in this regard since many economists advocate the idea that flood
markets with new money is the only way that increases the credit and the economy returns to
work properly.
The critical current, however, argues that the printing of banknotes leads to generate
inflation, which is considered unnecessary as it is proving, a distortion of the risk of financial
assets since the increase of the money supply reduces interest rates which, in many cases, do not
reflect the true risk of the assets and, finally, the creation of a credit bubble and stock market
that leads investors to take big risks. So far, the measures taken by the ECB have achieved:

Slightly correct the details of CPI, which is moderating its fall although it remains in
negative values. The strong monetary expansion is failing to get prices up, among other
things, because the new money issued is not reaching the real economy as a whole. In
addition much of the continuous drop in the CPI is the composition of the ratio.
Certain currents of thought defend that prices are not really falling, but the CPI, which
is a way of measuring inflation, is not correctly measuring the trend. Inflation is defined
as the widespread rise of prices in an economy. However, these economists argue that
prices are not falling in a widespread manner, but only in a series of goods and services,
so it could not speak of deflation. Within the values taken to measure the ratio, there are
two concrete that have experienced a very strong fall in its price, which together with its
specific weight within the computation, have burdened the global result of the price
index. Therefore the conclusion obtained is that the CPI is not a reliable index that
reflects the reality of price levels in an economy.
Figure 52. Spanish CPI composition
Figure 53. CPI, Energy composition growth
*Source: Instituto Nacional de Estadística (INE)
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Figure 54. Brent price evolution
*Source: Bloomberg

Figure 55. House price evolution
*Source: Instituto Nacional de Estadística (INE)
Decreasing market interest rates, that’s why types of new issues of corporate and public
debt are touching historical minimum rates. In fact, in some emissions rates are
negative. In some cases, due to the excess liquidity of the markets that leads to this
reduction in rates, the expectations of these issuers with negative rates and buyers of
titles are "deflation" is going to be greater than these types, so that in real terms the
profitability is going to be positive.
Figure 56. Zero Coupon Curve
*Source: Bloomberg
The zero-coupon curve of Spain, which serves as reference for emissions in different
installments interest rate, has shown a decrease in generalized for all deadlines, providing
wholesale financing of States and companies.

At the same time, it has resulted in an effect that is double-edged. Continuous injections
of new money have caused a depreciation of the euro against other currencies, including
the dollar. This can assume an increase in our exports to other countries before the
currency benefit and achieve this balance increased current account of the Euro Zone.
However, commodities, especially oil, is traded in the international markets in dollars,
by that, in recent months the European economies have not failed to fully benefit from
the depreciation of this.
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Figure 57. USD/EUR evolution
Figure 58. USD/EUR evolution. Base 100=2009
*Source: Bloomberg
2.2.3.1. The case of the United States as a prelude to the future of Europe
United States began the process of monetary expansion much earlier than the Euro
zone. The initial idea was the same as in the Euro zone: had to get economic growth increasing
money in circulation and credit. In addition, to the Monetary Authority, the government led by
Barack Obama launched a program of economic measures in order to cover the lack of domestic
consumption through spending and make strong investments in infrastructure and health
system-Keynesian based.
Figure 59. U.S. M3 aggregate
Figure 60. U.S. Monetary Base
*Source: Federal Reserve Economic Data - FRED - St. Louis Fed
The Federal Reserve began to inject money into the economy, thus increasing the
monetary base. The economic policy carried out by the Government had influences Monetarist
and Keynesian: an increase in the amount of money in circulation will increase the pressure on
the price level in order to avoid falling into deflation and generate GDP growth; and on the
other hand, before a poor domestic consumption, must be the Government who take the
necessary measures to prevent the GDP to contract. The first result of the policy pursued was to
return to economic growth after a sharp contraction in 2009 and restore growth in the CPI, after
falling a 0.36% in 2009.
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Figure 61. U.S. Real GDP and CPI
Figure 62. U.S. Government deficit
*Source: Federal Reserve Economic Data - FRED - St. Louis Fed
Monetary independence allows countries to more effectively manage crises and
economic cycles have more measures to combat them. However, there may also be perverse
effects that lead to a bad practice in the use of the money. In the case of United States, spending
and investment policies meant a sharp increase in the deficit, which can only be financed
through debt, which inevitably will be acquired in large by the central bank to facilitate and
cheapen the debt. That's when the primary goal of a central bank is lost before the political use
of this instrument.
Figure 63. U.S. Government Debt (as % of GDP)
Figure 64. U.S. Government Debt ($Bn.)
*Source: Federal Reserve Economic Data - FRED - St. Louis Fed
The goal of a central bank focuses on price stability and, therefore, to control inflation.
At the time when they begin to finance the deficit of the State in the first place can give rise to a
conflict of interest, and secondly the State should have no grounds to reduce its debt as it has
support for new emissions. Here it's been something similar, and the Fed has large amount of
public debt, which is acquired through new issuance of money that would supposedly cause an
increase in inflation.
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United States is currently in an environment of political instability, as budget concerns,
because of the use that has been given to the central bank. Public debt and the deficit have been
increasing over the years, although the latter has been declining by strong pressures.
There is no doubt that United States is returning to the path of economic growth and
that it is fighting against their two large current woes: deficit and public debt. If it would have to
take into account that the implementation of these policies in the Euro zone could lead to major
long-term structural differences since the 19 countries are very different between them, and a
difference between the different economic policies with the same monetary policy could lead to
a greater fragility of the Union.
2.3. CONCLUSION
The conclusion obtained from the analysis made previously can be described in two
sections:

Currently we cannot speak of truly deflation. Adhering to the purist definition of the
term, the European and Spanish economies are going through a situation of disinflation,
according to many economists.
The CPI, which is nothing more than a tool to measure inflation and which has lacks
and defects, shows negative results although they are correcting that trend due to an
increase of its components that have increased recently. We cannot speak therefore of
deflation because the drop in prices is not widespread.
The last few months, its evolution has followed a negative trend, caused mainly by the
fall of energy prices, especially motivated by the decrease of oil prices and a further
optimization of the energy resources management, which is not reflected in the ratio.
In addition to the energy, housing, which is another important factor of the ratio, has
suffered a big price correction due to the housing bubble in Spain. These two factors
add about a 12.50% of the CPI, which is a considerable weight to interfere in the
evolution of the result.

A money supply expansion in a great recession period without an appropriate fiscal
policy and structural reforms, are not key to economic growth.
The Fisher equation showed us that an increase in the monetary base, led to an increase
in the price level. This formula can be true if the new money reaches the real economy,
a circumstance that is not happening at the present; and the CPI being proved to not be
the best inflationary indicator.
Many relied on this equation during the recession period since an increase in the
monetary base carries, with a rise of inflation that the increase would lead, in turn,
growth of the GDP. However, this is not true. An economy can grow with low inflation
rates, and even deflationary, according to the CPI. The fear that have always existed
towards deflation and the need to establish the rate of inflation at a 2% is unnecessary
for the proper functioning of the economy.
Major analysis of the macroeconomic situation can claim as untrue that it is necessary
to generate inflation to achieve economic growth premise, but inflation is one of the
consequences of growth. The sustained growth of GDP only will be motivated by good
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economic governance of all policies, not a monetary expansion when there is no
coordination between the rest measures.
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3. GLOBALIZATION AND MONETARY POLICY
According to Mr. Friedman the simple definition of globalization is “the interweaving
of markets, technology, information systems and telecommunications systems in a way that is
shrinking the world from a size medium to a size small, and enabling each of us to reach around
the world farther, faster, deeper, and cheaper than ever before, and enabling the world to reach
into each of us farther, faster, deeper, cheaper than ever before” 15
Due to globalization and thus the interconnection of the markets, global economies are
affected by the decisions taken in the main economies. Along this part we will discuss how the
United States and the European Quantitative Easing, is affecting emerging markets.
3.1 CAPITAL OUTFLOWS
The adoption of quantitative easing policy by the United States Federal Reserve Bank
since early 2009 has aroused widespread concerns in Asia and elsewhere regarding its possible
impact in terms of the weakening of the US dollar and stimulating capital outflows to emerging
economies that might increase inflationary pressures in them.
Figure 65 Federal Reserve Outright Holdings of Securities
*Source: St. Louis Federal Reserve FRED data base Available at: http://research.stlouisfed.org/fred2/
This figure shows the increase in the Fed´s outright holdings of long-term securities as a
result of all LSAP16 programs. Since January 2009, the FED has purchased about $900 billion
of mortgage backed securities, $90 billion of agency securities, and $1.17 trillion of Treasury
securities, for a total of $2.2 trillion. This represents about a 28% of the outstanding amount of
these securities, a huge amount. Between March and October 2009, the period of first round of
Treasury purchases, overall purchases under LSAP were much larger than the $300 billion of
15
16
The Lexus and the Olive Tree: Understanding Globalization- Thomas Friedman
http://www.federalreserve.gov/newsevents/speech/bernanke20120831a.htm
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Treasury purchases, about $1.1 trillion in all. Between November 2010 and June 2011, the
period of the second round of Treasury purchases (QE2), total outright purchases amounted to
about $593 billion, actually less than the total increase in Treasury holdings in this period of
$773 billion, mainly reflecting declines in holdings of asset-backed securities.
Figure 66. Components of US Monetary Base
*Source: CEIC Data Company. Available at: http://www.ceic.com
This figure introduces the corresponding increases of the US monetary base, the vehicle
by which liquidity in the overall economy is normally created. From March through October
2009 (QE1), base money rose by $374 billion, due almost entirely to the rise in reserves held at
the Fed (increase of $356 billion).
This was somewhat larger than the amount of Treasury purchases during this period, but
much smaller than the total outright purchases, reflecting offsetting declines in some of the
Fed’s other asset programs, including term auction credit, that were winding down during that
period. This shows that the net impact on liquidity should be gauged in relation to all of the
Fed’s operations, not just Treasury purchases.
Figure 67. US Gross Private Capital Outflows
*Source: CEIC Data Company. Available at: http://www.ceic.com
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This figure shows that, after large repatriation of flows at the height of the global
financial crisis in the three quarters from April through December 2008, US gross capital
outflows resumed in January–March 2010, and continued through January–March 2011.
However, they returned to a net repatriation of $23 billion in April–June 2011, mainly due to a
massive reverse inflow of other investment of $196 billion. Remarkably, almost all of this
inflow ($186 billion) came from "Other Western Hemisphere," i.e., presumably from offshore
centres such as the Cayman Islands.
This reversal probably reflected increased concerns about the Euro zone crisis and signs
of weakening growth in the US. Interestingly, this amount was much larger than outflows seen
during the peak of the global financial crisis in 2008. This new factor most likely overwhelmed
the tendency of the QE2 policy to encourage capital outflows. Unfortunately, it is not possible
to trace which countries the funds ultimately were repatriated from, although it seems likely that
it was primarily from Europe. How much of those capital outflows from the US ended up in
Asia?
Figure 18. Gross Capital Outflows from US to Asia-Pacific (Blue Emerging Asia excluding
Australia and Japan)
*Source: US BEA Available at: http://www.bea.gov/international/index.htm#bop
Somewhat surprisingly, for Asia-Pacific as a whole, there were no excess outflows
during either the QE1 period or the QE2 period. These results would hold even if direct
investment was excluded. Although there were excess outflows on the portfolio side, especially
during QE2, these were offset by larger repatriation of other private claims (mainly loans). The
results for Emerging Asia (Asia-Pacific excluding Australia and Japan) are the same—no excess
outflows during either QE1 or QE2. Again, excess outflows on the portfolio account were more
than offset by repatriation of other private claims.
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Figure 69. Portfolio investment: US Outflows and Asian Inflows
*Source: Asian inflows are sum of: PRC; Hong Kong, China; Korea; Malaysia; and Singapore. Source: CEIC Data Company.
Available at: http://www.ceic.com
3.2 SPILL-OVER EFFECT
Quantitative Easing affects cross-border capital fluctuations, asset prices and economic
activity through several channels, which are not mutually exclusive, since some may be at play
simultaneously.

Portfolio-balance channel: QE involves the purchase of longer-duration assets such as
government bonds and mortgage-backed securities. These purchases reduce the supply
of such assets to private investors, compressing the term premium, which, in turn,
increases the demand for all substitute assets, including emerging-market assets, as
investors turn to riskier assets in search of higher expected risk-adjusted returns.6 Such
portfolio rebalancing lowers risk premiums, boosts asset prices and lowers yields in
EMEs, effectively easing their financial conditions.

Signalling channel: If QE is taken as a commitment by the Federal Reserve to keep
future policy rates lower than previously expected, the risk-neutral component of bond
yields may decline. Large interest rate differentials with respect to EMEs will be
expected to persist, which, in turn, prompts carry trades and capital flows into EMEs.

Exchange rate channel: The portfolio flows discussed above could result in a
depreciation of the U.S. dollar. This would act as a drag on U.S. demand for foreignproduced goods and services relative to those produced domestically. Consequently,
emerging-market exports could be negatively affected.

Trade-flow channel: QE would boost the demand for emerging-market exports, since it
supports domestic demand in the United States. This may fully or partially offset the
negative effect from the exchange rate channel on emerging-market exports.
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The spill-over effects of QE may have been amplified by the differences in the
macroeconomic and financial conditions of advanced economies and EMEs in the period
following the global financial crisis of 2007–0917.
3.2.1 Spillovers during QE episodes
Gross capital inflows (excluding foreign direct investment) to EMEs rose steadily
during the years before the crisis, peaking at about $660 billion in 2007. Inflows turned to
outflows during the crisis, reaching $221 billion in the fourth quarter of 2008; however, they
recovered quickly, averaging nearly $112 billion per quarter in inflows between the second
quarter of 2009 and the fourth quarter of 2013. While this recovery took place at the same time
as QE was implemented by the Federal Reserve and other advanced economies, several countryspecific “pull” factors were also at play during the period. In particular, interest rate and growth
differentials supported flows to EMEs in the years following the crisis, when the economic
performances of advanced economies and EMEs differed significantly.
Figure 70. Capital inflows to emerging-market economies, and interest rate and growth
differentials.
* Source: International Monetary Fund
17
9 Glick and Leduc (2013); IMF (2013b); Moore et al. (2013); Rosa (2012); Wu and Xia (2014).
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3.2.2“Spillbacks” from Emerging-Market Economies to Advanced Economies
Policy-makers in emerging markets have argued that the negative effects of QE on their
economies would ultimately “spill back” to advanced economies 18 .Indeed, since EMEs
represent a large and rising share of the global economy; there is growing evidence of spillbacks
from EMEs to advanced economies, primarily through trade, financial and commodity-price
channels.
Specifically, weak economic activity in EMEs may lead to softer demand for advancedeconomy exports, as well as lower equity and commodity prices. Preliminary analysis
conducted by the IMF suggests that spillback effects from EMEs tend to be modest, but could
be larger in crisis periods. In addition, the effects are larger for countries or regions with greater
trade exposure to EMEs, such as Japan and the euro area (IMF 2014). Moreover, major
advanced-economy commodity exporters, such as Canada and Australia, may be negatively
affected by lower prices for commodities due to slowing growth in EMEs that are major
consumers of commodities.
Given the available evidence, QE appears to have increased capital flows to EMEs,
although there is no convincing proof that the overall effects are significantly different from
conventional monetary easing. Moreover, diverging fundamentals between advanced economies
and EMEs were likely at least as important. Overall, the benefits of QE appear to outweigh the
costs, especially if advanced economies withdraw exceptional monetary easing in an appropriate
fashion as economic conditions improve. Nevertheless, there could be instances of volatility in
global financial markets, particularly in EMEs, when advanced economies begin to normalize
monetary policy, highlighting the need for policy-makers in both EMEs and advanced
economies to remain vigilant.
For central banks in advanced economies, recent experience underlines the importance
of ensuring that monetary policy normalization be communicated as effectively as possible in
order to appropriately shape market expectations. Even if the exit is well managed, a certain
amount of capital-flow reversal and higher borrowing costs are likely in some EMEs. Higher
bond yields will prompt portfolio rebalancing, the effects of which could be amplified in the
presence of market imperfections.
The effects of policy normalization on EMEs will thus depend on their resilience and
the extent of their vulnerabilities. EMEs with strong fundamentals and sound macroeconomic
and financial policies will likely be better able to insulate themselves from any excessive
negative spill-overs as the monetary policy of advanced economies normalizes. 19
Raghuram Rajan (2014)
19
Comments by Federal Reserve Chair Janet Yellen in the “Inaugural Michel Camdessus Central Banking Lecture,” at the IMF in
Washington, D.C. (2 July 2014), at http://www.imf.org/external/np/ seminars/eng/2014/camdessus/.
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3.3 EUROPEAN QE
The European Central Bank has initiated an unprecedented asset-purchase program
worth at least 1.1 trillion Euros ($1.3 trillion) to stimulate the economy.
Figure 71. The MSCI Emerging Markets Index has seen a rise during the last months,
since the QE plan.
*Source: Financial Times MSCI Emerging Markets Index (MIEF00000PUS:MSI) 6 months.
There are five main issues that have aroused after the ECB’s Quantitative Easing.
Positive rates for high yielding currencies. The ECB is flooding the markets with Euros,
providing investors with cheap funding to buy higher yielding currencies such as the Indian
rupee, Turkey’s lira and the South African rand, according to Société Générale.
Positive returns for emerging-market bonds. The two-year German bund now yields a
record low of minus 0.2 percent. That compares with an average yield of emerging-market
local-currency bonds of 6.1 percent. Two-year Brazilian papers offer yields of 12.4 percent.
There have been more interest-rate cuts, especially in Eastern Europe. The ECB is the
latest major central bank to ease monetary policy to fend off deflation after policy makers in
Denmark, Turkey, India, Canada and Peru all announced surprise rate cuts.
More developing-country central banks will join the bandwagon, including Eastern
European nations, Simon Quijano-Evans, the London-based head of emerging-market research
at Commerzbank AG, said. Poland’s benchmark interest rates remain at 2 percent while
Hungary’s are at 2.1 percent.
The ECB’s move is “yet another loud signal to Central and Eastern Europe central
banks that rates need to be cut,” Quijano-Evans said in an e-mail. “They can’t continue having
rates that are 200 basis points or more above the benchmark ECB rates that are essentially
negative with QE.”
Russia may be a winner. The Ruble rallied 2.2 percent against a basket of Euros and
dollars on Thursday while the Micex stock index jumped 3 percent. Should the ECB succeed in
reviving the euro zone economy, Russia may emerge as one of the beneficiaries, given that the
euro zone is the world’s biggest oil importer, according to Bank of America Corp.
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3.4 EMERGING MARKETS QE.
3.4.1 China.
Emerging markets are also trying to replicate the American and European QE, in order,
to try to generate the benefits mentioned along this paper.
Several news reports have suggested that the Chinese government is weighing various
options to expand its balance sheet and inject more liquidity into the system. There are three
potential scenarios regarding what Peoples Bank of China may do:



Provide liquidity to the policy banks through collateral or non-collateral
mechanism, and the policy banks then pass on the liquidity to the real economy (the
PSL option).
Cut Required Rate of Return.
Directly purchase local government debt and therefore free up banks' balance sheets
to create space for more bank credit (call it the local debt option).
Figure 72. PBoC attempts to compensate for the slowdown of base money generation
*Source: PBoC, Credit Suisse
We believe the PBoC will be more active in liquidity injection via Pledged
Supplementary Lending (Lending facility under which the central bank directly provides loans
to banks for their re-lending20), but this is hardly a new policy invention. PBoC passed on
Rmb300bn liquidity to the China Development Bank in the middle of last year in a three-year
Rmb1tn program.
It did it again recently through CDB, providing a Rmb2tn credit line to local
governments for city redevelopment projects. Our understanding is that the central bank is using
selective easing measures to monetise fiscal expansion. This happened before and will happen
in the future, but it did not accelerate the expansion of the central bank’s balance sheet. The
RRR option fits a similar purpose—injecting more liquidity to the system, but it goes through
commercial banks instead of policy banks.
20
https://www.bbvaresearch.com/wpcontent/uploads/2014/08/B1_China_Economic_Outlook_3Q14_maq1.pdf
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What does PBoC want to achieve?
FX reserve accumulation used to count for more than 80% of PBoC’s balance sheet, but
that channel has slowed during 2014. PBoC ignored such a change for most of 2014, resulting
in a de facto tightening in liquidity last year. Since 4Q14, PBoC attempted to ease RRR and
interest rates, not having easing in mind, but to compensate for the lack of liquidity generation
due to declining needs of the intervening FX market. By cutting RRR, the PBoC gives more
space for banks to lend in general. By using PSL, the central banks have attempted to deliver
liquidity to specific areas that the government wants to promote.
We believe that PBoC is using policy tools to make up the slowdown in base money
creation, instead of actively creating any large scale fresh liquidity at this time. The process has
already started and will continue.
We do not believe that adopting the US style of QE by buying bonds, including local
bonds, is likely or practical, unless it is justified in a crisis situation. Still, moving from de facto
tightening to neutral in monetary policy stance is positive. How effective the new policy can be
would depend on banks' willingness to lend. Banks have been reluctant in lending amid the
growth down-cycle and rising default risks.
The private sector has also shown little interest in borrowing for long-term investment.
Without addressing the underlying fundamental and structural problems for investment, an ease
in monetary policy alone may not help the real economy much. Instead, liquidity should create
flows into financial markets, similar to the QEs delivered in the US, Europe and Japan.
We have observed several interesting changes in Beijing’s policy priority and execution:




Emphasizing capital markets more and de-emphasizing bank lending.
Tightening and standardizing local debt for 'orderly de-leveraging'.
Encouraging equity financing throughout the entire spectrum.
Securitizing local infrastructure projects.
3.4.2 Japan.
Japan is undergoing a major political and economic experiment which has been
generally unpopular with vested interests, as well as workers (with real wage growth and real
rates both falling). Therefore, it is crucially important to have political backing for the change.
This appears to have been achieved thus far with Prime Minister Abe having won a super
majority for the Liberal Democratic Party until December 2018, and the main opposition
Democratic Party of Japan electing a relatively unpopular leader.
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Some commentators (for example, the FT, March 26th 2015) have claimed that Abe has been
able to marginalize the LDP faction system, leaving disproportionate power in the office of the
Prime Minister and that of his Cabinet Secretary, Yashidide Suga.
Despite Europe being the focus of much investor attention in recent months, Japan has
been the strongest performing major region for equities in US dollar terms in 2015. Euro area
equities are up by 8.0% in USD terms year-to-date, emerging markets, the second best
performing region in USD terms, are up 8.5%, while Japan has risen by 13.7%.
There are three main reasons why we see a further expansion of Bank of Japan (BoJ)
stimulus as likely:
-
Inflation appears set to miss the BoJ's target.
We believe that Japanese inflation will substantially miss the BoJ's target of 2%
inflation 'at the earliest possible time'. Given recent developments, it seems very unlikely that
2% inflation will be reached over the next 2 years.
“Our economists predict that CPI ex fresh food will not rise above zero for the rest of
this calendar year, and, even if we exclude energy, in addition to food and VAT, then CPI
inflation is set to hit only 0.3% in March 2016, as illustrated below. This is in sharp contrast to
the BoJ's own projections: the most recent minutes of the BoJ's Monetary Policy Board
concluded that "many members (thought) CPI ex fresh food, was likely to reach 2 percent in or
around fiscal 2015"21.
Figure 73. Headline inflation (ex VAT) had been driven higher by import price inflation, but
import price inflation is now consistent with sub-zero core CPI
*Source: Thomsom Reuters - Credit Suisse Research
21
Global Equity Strategy, 16th April 2015- Credit Suisse Research
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Figure 74. Forecast, Japanese CPI will remain less than half the BoJ's 2% target for the coming
years
*Source: Thomsom Reuters - Credit Suisse Research
-
The political risks against doing more Qualitative Quantitative Easing seem to have
diminished slightly in recent months
The limitations for QE are more political than economic, in our view, given the negative
impact it has had on real wages. However, the political risk now seems more manageable with
Prime Minister Abe having won a super majority in December's Lower House Election, while
his approval ratings are still relatively high.
Figure 75. Abe's popularity has moderated, but remains high for this point in the electoral cycle
*Source: NHK, Credit Suisse research
Support from the BoJ for the programme also appears solid. At the most recent BoJ
meeting, the Monetary Policy Board voted 8 to 1 in favour of the programme, as opposed to a 5
to 4 vote in favour of the additional ¥10-20trn of QQE when it was extended in early
November. In addition, the Governor of the BoJ, Haruhiko Kuroda, has insisted that the BoJ is
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ready to act "without hesitation" to hit the 2% target. Moreover, one of Abe's key advisors,
Kozo Yamamoto, appeared to step up the pressure, saying the BOJ must ease again on 30 April
2015.
We would note that, even when there appeared to be a strong political backlash against
QQE in October of last year (when the central bank governor Kuroda was summoned to the
Diet for the first time in 17 years to explain why the yen had weakened so much), a few weeks
later the BoJ surprised by announcing its programme expansion.
So what will the BoJ do?
The alternative to further stimulus, i.e. doing nothing, does not seem feasible to us.
Japan’s economists discussed22 the outlook for the BoJ's monetary policy in their piece, Japan
Economic Adviser (7 April 2015), and we would summarise the central bank's options as
follows:

Reiterate a belief that inflation will accelerate to 2% over the next 1-2 years. This
strategy, which the BoJ appears to be pursuing currently, could risk the central
bank's credibility, in our view, given the low probability of the inflation target being
hit.

The BoJ could lower its inflation target to say 1%. If the BoJ were to do this, we
think it would in all likelihood leave core inflation dangerously close to deflation.

The third and most likely outcome, in our mind, is that the BoJ increases further its
expansion of the framework and targets asset purchase amounts.
We note that the BoJ's balance sheet has expanded by around ¥155trn since the start of QQE in
April 2013. That has boosted core inflation (ex VAT, food and energy) by c.1.2% (from -0.9%
in March 2013 to 0.3% currently).
Figure 76. Given net foreign assets of 63% of GDP, there is no theoretical limit, other than
inflation, to the amount of printing that the BoJ can do.
*Source: Thomson Reuters, Credit Suisse research
Any move toward more QE is, we think, going to have to be associated with the need to find
more sellers of JGBs (for the BOJ to buy) and thus a further change in weighting.
22
Source: Global Equity Strategy 16th April 2015 – Credit Suisse Research
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4. THE EFFECTS OF NON-COVENTIONAL MONETARY POLICIES ON
SOCIETY: POPULISM AND WEALTH’S DISTRIBUTION INEQUALITY.
4.1 INTRODUCTION
Throughout this paper, we have tried to explain in a clear way the different effects that
the unconventional monetary policy has gotten on the main occidental economies. We have paid
special attention to its effects in the markets and the performance of the assets, taking into
account the inflationary process that has generated and what is the role of globalization in the
future of the emerging and developed economies.
In this section we will discuss the impact that has been on social policy as a possible
explanation for populist movements that have emerged in Europe. We will also discuss the
wealth distribution inequality that appears to be around the world and how Unconventional
Monetary policies such as the Quantitative Easing, favors it.
4.1.2 What is Populism?
The fact that radical movements, better known as populism, have emerged within
Europe, is closely related to the financial crisis that began in the US in 2007 and came to Europe
in 2008. However, the measures implemented since the crisis erupted have caused and favored
such populist movements to emerge and even worse, been consolidated as we have seen in the
last European elections.
The measures proposed from the ECB have been focused mainly in deficit control and
austerity, something that had a particular impact in Southern and Eastern Europe. This measures
led rich people to become richer and thus, foster the gap between the most privileged and poorer
classes. Hence the rise of populism is derived from a social frustration that has been exploited
by populist movements to increase the number of supporters.
The radical parties grow in Europe not only because of the policies pursued by the ECB.
Note that other aspects greatly favor the consolidation of populism. An example of this is the no
full democratization of the European institutions. It also can be mentioned, many corruption
issues that have occurred in some countries, for example in Spain, immigration policies that
have led to the rise of political parties like Le Pain in France, etc.
In short, populism is a reaction to different conditions and measures that have emerged
since the economic crisis that led to the despair of many Europeans. It is not surprising the great
acceptance that, populist proposals are gaining, as it is extremely easy to impose them in the
wake of a decline of the institutions, discredited of political parties, economic crisis, social
inequalities and lack of prospects for young people.
4.2 TAKING A LOOK TO USA: STOCKS BUYBACKS.
We have described throughout the previous section the results of applying nonconventional monetary policies, some of them favorable. However, some of them such as the
massive liquidity injection in the system can led to adverse effects. It can exalt inequality in
terms of wealth that favors the rise and consolidation of radical political movements like
populism. This wealth inequality distribution is something that has already happen in the United
States and it’s simple to analyze.
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Europe is imitating some of the non-conventional policies that have been implemented
within the United States. We have mentioned the effects of those measures in financial assets,
such as stocks and bonds that have resulted in an overvaluation of them. The final effect on the
Real Economy is easy to understand: make the rich people become rich. The massive liquidity
injection and the purchases of assets, make the price of them to highly increase. This provokes
inequality wealth distribution as the only people that can afford to invest on those assets are the
richer ones.
In addition to this effect on asset prices, we have noted that a massive buyback in stocks
has been taking place within the United States. Checking the S&P 500 we show this chart that
represents the monthly Buyback Announcements sin 2000.
Figure 77. S&P 500 Monthly Buyback Announcements
*Source: Bloomberg Finance LP, Deutsche Bank
Last February, an historic record was achieved ($98 billion) in terms of stocks buybacks
announcements. We have also to notice the forecast benefits of the S&P 500. For the first
quarter of 2015 the forecast benefits were -7.4% as you can observe in the next chart:
Figure 78. S&P 500: Change in Q1 EPS vs. Change in Price
*Source: FactSet
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Taking into account these two graphs, it seems that the amount of stocks buybacks is
going to be even greater than Goldman Sachs predictions for 2015 ($450 billion).
Figure 79. Goldman Sachs forecast of 2015 US net equity flows (in $ billions). January 7, 2015
*Source: Federal Reserve Board and Goldman Sachs Global Investment Research
The result of a stock buyback is a higher price. Imagine that total benefits of a company
remain the same. As the number of stocks in the market is reduced it seem logical that the price
gets higher. Thus, the return on the stockholder´s investment increases. Usually, stocks
buybacks are welcome in the market since it represents positive signaling regarding future
perspectives of the company and valuation of it (companies may perform stocks buybacks since
its managers are sure that the company its more valuable than it market capitalization).
However, we must pay attention to the reasons that lead a company to perform stocks
buybacks. In the particular case of the United States, this strategy is taking risks in terms of
growth and employments. What lead American companies to purchase their own stocks is the
lack of business investment. We can see in the next chart the performance of business
investment since 2009.
Figure 80. Falling Business Investment: Orders for nondefense capital goods excluding aircraft,
change from year earlier
*Source: Commerce Department. WSJ.com
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Companies perform a buyback strategy because they do not invest. We can see that
since 2013 investment has barely reached a 10% and at the beginning of 2015 is almost 0%. As
a consequence, a financial return is being created without the backup of a solid strategic plan
that affects future growth and employment.
Other motives that threats the future growth is the fact that the majority of the
companies is taking advantage of the minimum interest rates policy. This can lead to the
deterioration of the companies’ capital structure increasing the investment risk. The use of debt
for the stocks buyback within the United States has resulted in a highly increase of total debt
(35% higher than in 2009).
Figure 81. Historical debt and cash levels of S&P 500.
*Source: SG Cross Asset Research
The use of debt affects also to valuations that include it. It is the case of the multiple
Enterprise Value (EV) that has reached 10 times EBITDA.
Figure 82. The S&P 500 is trading at historically elevated valuations as of February 19, 2015
*Source: Compustat and Goldman Sachs Global Investment Research
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We have so far described the situation within the United States and how the stocks
buybacks affect companies’ valuations. It seems clear that the ones benefiting from this strategy
are the stockholders that see its return on investment increased. However, this higher return on
investment does not support business investment, so it is more fictitious rather than real. This
“improvement” will disappear at the moment that companies stop stocks buybacks.
Despite what we have analyzed, J.P Morgan recommended following this strategy in
Europe through very active companies in stocks buybacks like IBERDROLA.
Figure 83. J.P. Morgan European buyback basket-JPDEBB15
*Source: Data Stream. Bloomberg. J.P. Morgan.
“We continue to believe that investors will not outperform by focusing on the “low for
longer yield” theme. We note that despite the further move lower in bond yields, the stocks with
the highest dividend yield within the equity market performed poorly so far this year, losing
10% relative to the stocks which have the lowest yields. This is the case in every single market
sector. We think that yield plays will continue to lag. Instead of the high yield, the exposure we
would want to have is to buybacks candidates – JPDEBB15 – basket is up 19% ytd.
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How we can match all of this with Populism? We have noticed the lack of business
investment of companies. The market capitalization of the S&P 500 is increasing but it is not
supported with strategic business investment. This affects future growth and employment and at
the moment that company’s stop stocks buybacks policy employment will be destroyed. This
leads to the frustration of citizens which is one of the main sources for Populism to consolidate.
4.3 WEALTH’S DISTRIBUTION INEQUALITY.
“CAPITALISM IN THE 21ST CENTURY”.
ANALYZING
PIKETTY’S
When talking about wealth’s distribution inequality it is interesting to take a look to
Thomas Piketty book: “Capitalism in the 21st Century”. It is a book that tries to explain the
behavior and evolution of different variables such as output, capital or income. It also asserts the
evolution and concentration of wealth and it concludes with some policy recommendations.
Thomas Piketty is a French economist specialist in economic inequality and income distribution.
At the beginning, Piketty defines the different variables that will be the base of his
theory: GDP, Income and Capital. All the book is also based in what Piketty calls the
“Fundamental Laws of Capitalism”:
1. “The First Fundamental Law of Capitalism”: this first law states that the share of
capital income depends on the profitability and on the relative amount of it. It is
represented by the next equation:
Where  is the share of capital in national income (what capitalists take of national
income),  is the capital - income (K / Y) ratio and r the rate of return (net) of the
capital. It is important to understand Piketty’s work what is capital. He defines capital
as:
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Where Housing includes the land on which they are built; Domestic Capital
includes other buildings and land used in business: machines, computers, patents, etc.
Net Foreign Capital, which refers to national ownership of foreign assets minus foreign
assets in the country.
2. “The Second Law of Capitalism”: with this law what Piketty is trying to explain is the
behavior of the K/Y ratio. That is, the relative amount of capital depends on saving and
inversely on growth.
Where β, as in the "First Law ", is the capital - income ratio; s is the rate of net savings
as a percentage of income and g is the real growth rate of the economy. To test his
theory, Piketty focuses especially on the period of increase in capital stock since the 70s
in a number of developed countries.
Figure 14. The world capital/income ratio, 1870-2100
*Source: http://piketty.pse.ens.fr/en/capital21c2
With these two "Laws" (  r *  and   s / g) and having presented historical data and
estimates for s and g (and therefore ), he begins his inquiry about the last two variables:  and
r. For this, the author presents series from the late nineteenth century for  (the share of capital
in income) and 1 (the labor share) for France and England.
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Figure 85. The capital-labor split in the Britain, 1770-2010
*Source: http://piketty.pse.ens.fr/en/capital21c2
Figure 86. The capital-labor split in France, 1820-2010
*Source: http://piketty.pse.ens.fr/en/capital21c2
With these series is able to clear from
the "average real return r" of capital.
Here Piketty reflects on the elements that define the rate of return: technology and relative
abundance (or lack) of capital summarized as the marginal product of capital, ie, the additional
product obtained from an additional unit of capital. Piketty asserts that significant increases in
the amount of capital hardly affect the profitability of the same especially in the long term.
To recall, Piketty’s analysis on the variables of his Fundamental Laws of Capitalism
state that:




g is low
s is relatively constant
the ratio K / Y will be high
r is relatively insensitive
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With all of this in mind, Piketty is undertaken to show how rich people concentrate their
wealth and how has it evolved over time. Moreover he insists that the origin of inequality comes
from inherited wealth. Specifically, he argues that there would be two ways to achieve a very
unequal society. The first is through a "hyper patrimonial society" such as the Belle Époque in
France. The second way to achieve extreme inequality was created in recent decades by the US
and is explained by “hyper meritocratic societies” where a very few receive high salaries. If
r  g the world will be increasingly unequal.
Figure 87. Rate of return vs growth rate at the world level, from Antiquity until 2010
*Source: http://piketty.pse.ens.fr/en/capital21c2
Because the growth rate is much slower than the rate of profit from holding capital
assets, the asset-holders’ wealth increases much faster than the wealth of workers. In other
words, working stiffs can’t keep up with those who make their money from investing in land,
stocks, bonds and other assets.
Finally one of the most controversial things that Piketty proposes in his book is the
global tax on capital. He states that in a globalized world where capital moves from one country
to another, the best way to encumber it is through a global tax. In order to implement this tax
every country will share records so the total patrimony will be known. He raises two objectives
for this measure:

Redistibutional objective: Piketty states that when implementing personal taxes, no
matter how rates are progressive, it only affects the part of income that is withdrawn
and distributed by the capital owner. So, in search of greater progressivity he proposes a
system that combines a global tax on capital, which raises could reach a 10 % annually
for the largest fortunes, and a progressive tax rates for considered exorbitant salaries,
supplemented by a progressive inheritance tax. Piketty completely forgets the existence
of tax on profits of companies in which capital is invested, beyond personal taxes,
which are charged independent of whether the owners of capital withdraw more or less.
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
Incentives objective: according to Piketty, taxing on the stock of capital obliges the
owners to find better uses for it. Thus, the tax will be higher for a person who remains
on returns of 2-3% than for an entrepreneur who achieves a 10% of returns. This logic
estimates that capital will end in “dynamic investors” since the ones that do not achieve
high returns will be forced to gradually sale their assets in order to pay the new tax on
capital.
Additionally Piketty also considers a unified global system two estimate individual’s
wealth that allows collecting this tax. He will expose capital to what he denominates
“democratic scrutiny”. Which, according to his opinion, will allow people improving their
decisions, regarding the type of society and tax system, they want to live with.
4.1.2 Critics and limitations.
Since Piketty published his theory, there have been appearing lots of critics to his work
from high influential people such as Clive Crook, Nassim Taleb or Tyler Cowen and economic
institutions like the French Institute of Economic and Fiscal Studies. After analyzing several
papers we have tried to summarize them in this section:

Data: as we have shown before, Piketty bases his theory on the compilation of huge
amounts of data. However many researchers and economists have questioned the
accuracy of this data. In particular, Chris Giles an economist editor form the Financial
Times has investigated these “data problems” by trying to recreate the graphs that
Piketty shows in his book. 23 One of the main ideas of Piketty’s work as we have
described before, is the fact that wealth inequality has been raising in Europe and the
United States since 1980’s.
After reviewing and attempting to reconstruct Piketty’s graph, Giles concludes “Wealth
concentration among the richest people has been pretty stable for 50 years in both
Europe and the U.S. There is no obvious upward trend. The conclusions of Capital in
the 21st Century do not appear to be backed by the book’s own sources”.
Figure 88. Wealth inequality gap. Share of top decline or percentile in total wealth, U.S,
1810-2010
*Source: Paris School of Economics, Financial Times. National post.
23
http://blogs.ft.com/money-supply/2014/05/23/data-problems-with-capital-in-the-21st-century/?Authorised=false
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Giles is not the only one who doubts about Piketty’s data base. Nassim Taleb, author of
“The Black Swan” states that the measures and calculations of Piketty’s data base are
biased and show a high deviation.24 So, Piketty has been accused of cheating on the data
he presents.25

His definition of Capital does not include Human Capital. We consider that Human
Capital is as real as other type of Capital. Despite the difficulty of its measure, Human
Capital must be considered as a portion of a country’s wealth. When someone receives
education he/she is investing in his/her future. This investment generates future returns
in the form of higher salaries. Thus, the share of income of workers will be different
depending on their qualifications and if there is an accumulation of capital.

Finally, there have been lots of critics on Piketty’s political proposals. In particular
regarding the tax system we explained before. He thinks that this system is one of the
measures to be taken in order to fight inequality. In our opinion, Piketty is wrong. We
think that the best way to contribute people to live better is not by preventing wealth
generation (with Piketty’s tax system is what is going to be achieved) but enabling
people to get access to it. The key for this is to facilitating people their access to capital.
To conclude, we are not trying to discredit Piketty’s work, in fact we think that his
theory is useful when trying to explain wealth inequality. However, we have tried also to show
some of its limitations.
4.4 FINAL THOUGHTS.
In this final part of the paper we have explained the consequences of the nonconventional monetary policy on society relating it with the tremendous rise that Populism has
experienced. We have demonstrated that monetary policy have caused a huge inflation on asset
prices and on the other hand a deflation of income. This has resulted in an increase of the gap
between the poorest and the wealthiest people as Piketty tries to demonstrate in his work
“Capitalism in the 21st Century”.
We have seen the case of United States where one of the effect of a Quantitative
Easing has been the massive stock buybacks. This particular effect has created a fictitious return
by reducing the number of stocks in the market. As we have stated before, the problem is that
this stock buyback policy is not supported by business investment and the return created today
will be destroyed when stock buybacks is finished. Thus, the effects of monetary policy on
companies (increasing stock buybacks and lack of business investment) threatens future growth
and employment.
So the Financial Crisis of 2007 and monetary policies implemented have caused a
break between the Real Economy and the Financial Economy that provoked the frustration of
citizens leading to the rise of Populism, especially in European countries.
24
http://www.fooledbyrandomness.com/inequality.pdf
http://www.eleconomista.es/internacional/noticias/5805607/05/14/La-gran-mentira-de-Thomas-Piketty-el-Financial-Timesencuentra-errores-en-sus-hojas-de-calculo.html
25
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5. CONCLUSION
Thought this paper, we have exposed the last eight years economical path,
analyzing the causes and consequences of the 2007 Financial Crisis and studying in depth
the Monetary Policies utilized in order to confront the situation aroused; being orthodox at a
first glance and non-conventional in a later phase. Once enumerated and analyzed, we have
evaluated its implications in the short and long term in different spheres, not only socially
but geopolitically. We have seen how Monetary Policies do influence in the globalization
process since the Berlin wall fall.
We have not only focused in the most relevant macroeconomic variables, but in
core concepts such as inequality, future growth, labor market perspectives. In this route we
have used traditional financial concepts in order to analyze its concrete application to the
present situation; being everything written from a personal overview, without giving factual
assumptions.
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