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Quarterly Bulletin
April-June 2011
Gauteng Treasury Newsletter
Quantitative Easing
and Its Effects on
Economic Markets
The recent global financial crisis and accompanying world
recession, has pushed the central banks of several advanced
economies to resort to an atypical policy measure known as
quantitative easing. Quantitative easing is enacted when a
central bank deliberately increases the supply of money by
buying financial assets such as government or corporate
bonds. This process leads to the electronic creation of
money. The enactment of quantitative easing has the
potential to affect more countries than just the ones which
enact it and more so emerging economies. The effects of
quantitative easing, amongst others, include inflation and
increasing prices of commodities. The United States of
America enacted two sets of quantitative easing which
helped that economy to come out of deflation. The United
Kingdom enacted a single quantitative easing in 2009 which
was spread through to 2011 and successfully helped to keep
that economy out of deflation. For South Africa, quantitative
easing led to the prices of Brent Crude oil and precious
metals increasing and the Rand Dollar exchange rate
strengthening. This document seeks to analyse both the
nature of quantitative easing and its effects, particularly on
emerging economies such as South Africa.
Economic Analysis Directorate
Gauteng Department of
Finance: Treasury Division
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Quantitative Easing and Its Effects on Economic Markets
1. Introduction
2. QE Related Concepts
2.1 Background to the Financial Crisis
2.2 Monetary and Fiscal Policy
2.3 Creation of Money
3. How QE Operates
3.1 Comparison of QE and Credit Easing
4. QE to Date
5. Effects of QE
5.1 Commodity Prices
5.1.1 Gold
5.1.2 Brent Crude Oil
5.2 Portfolio Investments
5.3 Inflation
6. Impact of QE on South African Economy
6.1 Commodity Prices
6.2 Currency Exchange Rates
6.3 Inflation
7. Conclusion
8. References
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1. Introduction
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Traditionally, when a country‟s central bank seeks to stimulate spending in its domestic economy,
one of the options that could be considered is an adjustment of the repurchase (repo) rate. By
reducing the interest rate which it charges commercial banks when they borrow from it, the
central bank encourages the banks to borrow more money from it. The commercial banks can
then reduce their own rates which they charge for loans. In this way, the central bank intends to
increase credit extension to the private sector and boost spending. This tactic is generally used in
response to a downturn in economic activity.
There are times however, such as the recent global recession, when a central bank lowers its repo
rate repeatedly as it tries to mitigate continuous downward pressure on its domestic economy. If
the repo rate nears zero, further rate cuts become a matter of smaller and smaller fractions of a
percent, reducing their impact. In such times a central bank may resort to other measures.
Quantitative easing (QE) is the term used to describe a central bank increasing the supply of
money by buying financial assets such as government or corporate bonds. This is done by the
bank crediting the accounts of the commercial banks and other financial companies from which it
bought the assets, thereby creating money electronically. This is done with the hope that the
additional money in the economy will promote spending, leading to an increase in economic
activity. QE is an expansion of the money supply and as such, falls under a country‟s monetary
policy operations.
QE is not without risks however, chief amongst these is the risk of inflation. This is because the
amount of money in the economy is increasing but the quantity of goods for sale remains the
same. In this instance, if production does not increase rapidly and the money does not exit the
economy, inflation will result. QE also risks simply being ineffective. It is possible that banks will
not lend out the extra funds and companies will not spend it. Also, the money could flow out of
the economy to seek better returns in countries with higher interest rates. QE was introduced
recently as a way to curb the devastating effects of the global financial crisis that led to the global
recession.
The paper analyses the effect that QE had in countries where it was enacted and also how it
affected markets in terms of commodity prices, portfolio investments and inflation. The effect on
the South African economy is also analysed in terms of the mentioned indicators before the drawn
conclusions.
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2. QE Related Concepts
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This section gives meaning to economic concepts that are related to the subject of QE,
specifically, the financial crisis, monetary and fiscal policy fundamentals and the explanation of
money creation. The section also discusses the recent financial crisis, as QE was implemented as
a response to the effects of that global financial crisis. Monetary policy is related to QE; interest
rates and money creation form the core of all the mentioned processes.
2.1. Background to the Financial Crisis
According to a 2009 report by KPMG1 the financial crisis began when the lending policies in the
United States of America (USA) were amended to allow Americans access to mortgage loans,
even if they had no income and no collateral. These loans were known as sub-prime loans
because their interest rates were below the prime rate. Financial institutions packaged these
loans together because they believed that the risk of the total package was reduced due to
grouping many seemingly unrelated loans. These packaged loans were then sold on, to other
financial institutions from around the globe. South African banks were unable to purchase these
packages due to prudent financial legislation put in place by government recently, namely the
National Credit Act No. 34 of 2005.
The world demand for all products went through a growth phase and prices began to rise.
Inflation all over the globe rose, eating into the disposable income of households, which of course
included the USA households that had taken out sub-prime loans. In response to this inflation,
interest rates were increased world-wide, further eroding disposable incomes and making even
sub-prime loans more difficult to repay than they had been when first taken out. This
combination of factors led to a great many of the sub-prime borrowers, not good credit risks to
begin with, to default on their loans.
The packaged loans consisted, as mentioned above, of sub-prime loans. As such, the loans were
not as unrelated as their packagers and subsequent purchasers had thought. Since the subprime borrowers had similar financial situations, if one borrower in a package defaulted, it was
likely that the same factors which led to that default would apply to most of the other borrowers
in that package and they would thus default as well. The entire loan-package would then
collapse. The financial companies which traded in these packages no longer wished to trade
1
This was a KPMG publication of the Economic Insight Quarterly Review report.
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them. As investors saw the damage being done to financial markets by the loan defaults, they
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began to disinvest, worsening the problem and creating a full-blown global financial crisis.
2.2. Monetary and Fiscal Policy
A country‟s central bank is responsible for that country‟s monetary policy and the government‟s
Treasury Department oversees issues of fiscal policy. Monetary policy measures include the
setting of the repo rate and expanding or contracting the money supply. Monetary policy is further
characterised by the 18 to 24 month lag between its implementation and its effects. According to
Fourie (2006), central banks often make small adjustments through purchases of securities on
their country‟s financial markets; this is a day to day activity known as open-market operations.
QE is very similar to open-market operations, the differences being the intent of the policy, the
size of the transactions and the fact that the intent, size and timing are all widely publicised. To
contrast, fiscal policy refers to government revenue and expenditure and as such, its policies
include taxation and government spending. Monetary policy, with its measures of expanding and
contracting the money supply of a country, is related to the concept of money creation.
2.3. Creation of Money
Fourie (2006) explains the primary means of creating money as credit extension and not printing
banknotes. When a bank receives a deposit it is only required to keep a portion of that deposit,
known as a reserve requirement2 and can lend out the rest. The bank again keeps the required
reserve and lends out the remainder. This process can potentially continue until the initial deposit
has been multiplied by the inverse of the reserve requirement. This is known as the money
multiplier. Figure 1 illustrates the process of how the money multiplier operates.
2
According to the June Quarterly Bulletin of the South African Reserve Bank, the reserve requirement for South Africa is
2.5%.
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Figure 1: The Money Multiplier Effect
Rands Created
500
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400
300
200
100
Initial Deposit
Initial Deposit
Expansion Stage
Accumulation
Current Stage
Final
20
19
18
17
16
15
14
13
12
11
9
10
8
7
6
5
4
3
2
1
0
X
Source: Modern Money Mechanics, 2011
Note: Assumes a 20% reserve requirement and a R100 initial deposit.
As explained by Gonczy (1992), when money from the central bank enters a commercial bank, it
is subject to the multiplier effect. This is because the bank can lend out more money than it has,
needing only to maintain a certain percentage of its deposits as cash, known as the reserve
requirement. For example, if a commercial bank receives R100 and the country has a reserve
requirement of 20%, the bank can lend out up to R80. The person who receives this loan spends
it and the money is then banked. The bank which receives this R80 can keep 20% (R16) and lend
out R64. This process can potentially continue until the initial deposit has been multiplied by the
inverse of the reserve requirement, in this example 1÷0.2=5 which, when multiplied by the initial
R100 gives an amount of R500. Essentially what this means is that R500 was created out of the
original R100 and added to the money supply. Since a commercial bank‟s balance with its central
bank counts as cash for the purposes of reserve requirements, a central bank can start this
process by simply crediting the accounts that the commercial banks hold with it. In QE, this credit
is granted in exchange for financial assets, most often government bonds.
3. How QE Operates
Figure 2 provides a brief overview of the theory of the manner in which QE is intended to work.
When the central bank of a country engages in QE, it boosts the supply of money in its economy
by purchasing assets such as government and corporate bonds. In modern times printing more
banknotes is unnecessary; instead the bank can pay for these assets by simply crediting the
accounts of the entities it bought the assets from, creating money electronically. The Bank‟s
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purchases of these financial assets should push up their prices by creating additional demand. As
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this is new money created by the central bank which is paying for these assets, the quantity of
money in the economy increases.
Furthermore, because the money takes the form of increases in the accounts that commercial
banks hold against their central bank, the commercial banks are able to increase their lending by
an even greater amount as detailed in section 2.3 above. Some of this money is likely to be used
to purchase financial assets, further raising their prices. It is also theorised that the signals a
central bank sends to the market by undertaking QE may have more effect on asset prices than
that had by its actual purchases (Bernanke, Reinhart and Sack, 2004). Figure 2 below gives an
illustration of the situation.
Figure 2: Supply and Demand for Bonds
25
0
5
20
15
10
Yield
Price
10
15
20
5
25
0
30
0
100
200
300
400
500
600
700
Bond Quantity
Demand
Supply
X
Source: The Economics of Money, Banking and Financial Markets, 2011
Higher asset prices mean that holders of those assets are wealthier than they were before the
purchases began. The prices of financial assets are also inversely related to their yields, meaning
that higher prices make it cheaper for companies to borrow by issuing these assets because they
are able to offer lower yields. The rise in wealth and the increased ease of borrowing should
encourage both households and businesses to increase their spending in general. This increased
demand for goods and services should deplete the inventories which were built up in the
economic downturn, signalling to producers that they should increase production. Raising
production should require business to hire more workers and then the increased demand for
workers should raise wages; both these effects should raise income levels in the economy. This
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should encourage further spending, reinforcing earlier gains and creating a virtuous circle.
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However, if production does not rise to meet increased demand then the amount of money in
the economy will have risen but the quantity of goods and services will have remained the same.
Thus, money will be relatively less scarce, reducing its value. More money than before will be
required to make purchases and inflation will result. Figure 3 below gives a graphical illustration
of the QE operation as explained in this section.
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Figure 3: Theoretical Ideal of Quantitative Easing 3
Central Banks purchases assets
from private sector. New
money is created electronically.
Purchases of financial assets
increase their prices.
Higher asset prices increase
total wealth.
Asset purchases by private sector.
Higher asset prices mean lower
yields, making borrowing
cheaper for business.
Money supply increases as money
is pumped into the economy.
More money in their reserves
means banks can increase lending
to households and business.
Increased wealth and easier borrowing should encourage households and business to increase their spending.
Increased spending should deplete inventories, which in turn should encourage business to employ more workers and
raise income levels. This further increases spending, creating a virtuous circle.
3
This illustration was inspired by the Bank of England‟s pamphlet, “Quantitative Easing Explained.”
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3.1. Comparison of QE and Credit Easing
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The USA Federal Reserve Bank (Fed) Chairman Ben Bernanke has argued that the policy being
enacted by USA‟s Fed is distinct from quantitative easing 4. Mr Bernanke claims that, “the Fed's
credit easing approach focuses on the mix of loans and securities that it holds and on how this
composition of assets affects credit conditions for households and businesses,” while pure QE
focuses on expanding the quantity of bank reserves. The policies can resemble one another in that
they both involve an expansion of the central bank‟s balance sheet. The difference, however, is
that in quantitative easing this is the ends while in credit easing it is the means.
According to Bernanke et al (2004), the effect of credit easing is very much dependant on exactly
which securities a central bank buys and exactly what loans it extends in the course of enacting
the policy. The authors argue that in a perfect financial market, the central bank‟s ability to
change the supply of financial assets by purchasing them would not have any effect because the
pricing of any such asset would depend entirely on the date and value of its maturity. However, in
the real world transactions have costs attached and financial markets are far from perfect. As
such, a central bank‟s purchases may be capable of influencing the premiums paid on factors such
as term, risk and liquidity and thus affect overall yields. The paper also states that the prevailing
view amongst financial economists is that the quantity of assets that the USA‟s Fed has purchased
in the past is insufficient to have the desired impact. The Fed has been successful in similar
policies in the past, however, it is possible that by demonstrating its intention to achieve its goals,
the Fed causes other market participants to act in such a manner that the other participants bring
about the Fed‟s intended effect. The paper cites USA President Franklin Roosevelt‟s successful
defeat of deflation as an example.
4. QE to Date
The First round of Quantitative Easing (QE1) began in December 2008 in the USA and continued to
March 2010. The Fed purchased US$1.73 trillion worth of financial assets over that period, raising
the value of its balance sheet to US$2.3 trillion by March 2010. Blinder (2010) argues that QE1
seems to have been partially successful in reducing interest rate spreads, as spreads tumbled
dramatically at the time that the Fed engaged in heavy quantitative easing. The financial crisis
caused some governments to respond drastically; for an example, the Fed responded by lowering
the target federal funds rate from around 5.25% to a range of zero to 0.25% over and above the
4
This was in Mr. Bernanke‟s January 2009 speech at the London School of Economics.
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application of QE5. The second round of QE (QE2) started in November 2010, after economic
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performance which the Fed considered less than satisfactory and was intended to keep going
through to the end of the second quarter of 2011, with the purchase of $600 billion of USA
Treasury bonds in the open market planned. The Fed is still debating whether or not to implement
a third round of QE.
In the United Kingdom (UK), the British Parliament‟s Chancellor of the Exchequer gave
authorisation to the Bank of England (BoE) to set up its Asset Purchase Facility (APF) to buy
assets financed by the issue of Treasury bills and the cash management operations of the Debt
Management Office6 (DMO), in January 2009. The intention of the APF was to improve the liquidity
in and flow of credit markets. At the request of the BoE‟s Monetary Policy Committee (MPC), the
Chancellor also allowed the APF to be used as an additional monetary policy tool by the MPC.
When the APF is used for monetary policy purposes, purchases of assets are financed by the
creation of central bank reserves and thus is an example of QE if enacted in a sufficiently large
amount. When its purview was expanded, the APF was authorised to purchase, for monetary
policy purposes, up to £150 billion of assets, including UK government securities, of which up to
£50 billion could be used to purchase private sector assets. At the request of the BoE‟s MPC, that
limit was increased twice, to £175 billion in August 2009 and £200 billion in November 2009. As of
the 7th of April 2011, the BoE had purchased £200 billion of assets and the MPC voted to maintain
the APF‟s size at £200 billion and to keep the UK interest rates unchanged7 at around 0.5%. Since
its inception, the APF has purchased £198.3 billion in UK government securities, £8 billion in
commercial paper and £1.6 billion in corporate bonds. Gross redemptions of commercial paper
during the period were £7.8 billion and the APF has sold £0.1 billion in corporate bonds.
It is important to track the effect of QE on inflation, specifically for the USA and UK as the
countries mentioned for the purpose of this research. The figure below tracks the two countries‟
trends in inflation in order to show the effect of QE on the indicator.
5
This information was obtained from the IMF Working Paper of April 2011 by Medeiros and Rodriguez.
“The DMO is an Executive Agency of Her Majesty's Treasury. The DMO's responsibilities include debt and cash
management for the UK Government, lending to local authorities and managing certain public sector funds.” –
www.dmo.gov.uk
7
This is according to information accessed from http://www.gaurdian.co.uk/2010
6
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Figure 4: Annual Inflation Rates, USA and UK, 2003–2011*
4.5
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4
3.5
3
2.5
%
2
1.5
1
0.5
0
-0.5
2003
2004
2005
2006
2007
2008
2009
2010
2011*
-1
UK
USA
X
Source: World Economic Outlook, April 2011
Note: * indicates a forecast
Figure 4 shows that quantitative easing appears to have successfully kept the UK out of price
deflation8 and pushed the USA back out after briefly dipping into it in 2009. In 2010, the latest
inflation rates for both countries have rebounded from large falls in 2009 and are projected to
continue in an upward trend in 2011. For the BoE in particular, getting inflation back up to its
2% target was a stated aim of QE. It can also be seen from the figure, however, that the
annual inflation rate in the UK never quite fell to 2% and the International Monetary Fund
(IMF)9 expects the UK‟s inflation rate to increase further above the 2% mark in 2011, to over
double the target at 4.2%.
5. Effects of QE
The section that explained how QE operates made a conclusion that the application of QE,
amongst other factors, likely results in inflation. QE can also influence prices of commodities
because of the carry trade concept as explained in the section under commodities below. This
section provides the trends in commodity prices, portfolio investments and inflation in order to
analyse the impact of QE on these variables as it was enacted after the global financial crisis.
8
Deflation is the opposite of inflation and the Oxford dictionary of Economics defines it as a progressive decline in the
level of prices.
9
This information is as per the IMF‟s World Economic Outlook of April 2011.
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5.1 Commodity Prices
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Some of the money being pumped into developed economies by their central banks has found
its way into the commodity markets. Near-zero interest rates enable speculators to make profits
by borrowing money at almost no expense, though transaction fees still apply and investing it in
almost anything that shows even the slightest return. This phenomenon is known as the carry
trade. The increased demand for commodities has pushed up prices, whether this is good or bad
for emerging economies depends in part on whether they export or import the affected
commodity. Sumner (2010) argues that even the idea that QE could successfully boost world
output may be contributing to increasing commodity prices as investors move in, anticipating
future gains10. A rise in the price of an exported commodity most often helps the exporting
country because it increases the returns the economy receives for the product. However, it is
possible that a sufficiently large rise in exports could reduce sales volumes enough to hurt
rather than help.
5.1.1 Gold
Gold is an example of a commodity exported by South Africa which has been increasing in price
in the last few years. Figure 4 tracks performance by this commodity to show the effect on its
price, specifically for the period when QE was implemented.
Figure 5: Gold Price, Monthly Average, January 2005–February 2011
1,400
US$ per Ounce
1,200
1,000
800
600
QE1
400
2005
2006
2007
2008
2009
2010 2011
X
Source: South African Reserve Bank, 2011
10
This is according to a publication in the Economist by Sumner, S, and Economics Professor at Waltham‟s Bentley
University.
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The figure shows that the gold price has risen quite steadily over the period 2005 to February 2011
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as per the information from the South African Reserve Bank (SARB). There are, however, some
fluctuations which coincide with global events over this period under review. As the global
recession began, the price of gold increased as investors seeking a safe investment pushed up
demand. It began to fall again in April 2008, before increasing again in December that same year,
the very month that QE1 was enacted. Thus, it could be reasonably assumed that money from QE
moved into the gold market and increased the price of one of South Africa‟s major exports.
5.1.2 Brent Crude Oil
An increase in the price of a vital import commodity harms a country because more money is paid
for the same quantity of the product. A higher price for one product can even have a knock-on
effect, raising the prices of even locally-produced products and thereby increasing inflation. This is
particularly likely in the case of imports used in a country‟s own production processes. Oil makes a
suitable example of this for South Africa and most other countries.
Figure 6: Brent Crude Oil Spot Prices, Daily, January 2005-April 2011
X
Source: U.S. Energy Information Administration, 2011
Figure 6 shows the daily Brent crude oil spot prices from the 4 th of January in 2005 to the 5th of
April in 2011. The oil price was increasing from 2005 and reached just below $80/barrel by the
middle of 2006, before declining to less than $60/barrel by the end of that year. In 2007, the price
experienced a continual increase and reached a high of over $140/barrel. In early 2008, the
reduced global production caused by the recession lowered demand for oil, dropping the price to
multi-year lows. Prices began to recover at the very end of 2008, around the time of QE1. The
price has since continued on an increasing trend, although it has not reached the higher level of
over $140/barrel of 2008.
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5.2 Portfolio Investments
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Another port of call for investors flush with QE cash and looking for a way to earn even a small
return, is emerging economies such as South Africa. With their rates of interest and growth
both higher than advanced economies, emerging markets are an attractive prospect and the
risk associated with them seems less worrisome when investing easy QE money. Seeking profit,
investors buy bonds issued by emerging economies and shares in their companies. As this
money enters the emerging economy, spending rises, increasing economic activity at first.
However, when investors spread the benefits of QE they also spread its risks, most notably
inflation.
The foreign money flowing into the emerging economy also strengthens the local currency, as
does the direct purchasing of that currency by return-seeking investors betting on the strength
brought on by their actions and those of others investing in the country. In the short term a
stronger currency can make life more challenging for exporters as their goods become less
competitive. Furthermore, the ease with which foreign investors can withdraw the money they
put into local shares and currency can also cause instability. Should any event occur which
causes skittish investors to decide that it is time to pull their funds back out, the sudden
withdrawal of their money could cause a huge drop in the local share prices and currency,
upsetting the domestic economy.
5.3 Inflation
Inflation is one of the most serious potential risks of QE and its threat is not limited to those
countries which introduce the policy. QE by design increases the money supply of the country in
which it is enacted. As with all things in an economy, the value of money is dependent on its
scarcity; that is the quantity of it which is available in relation to other goods and services. If
the amount of money in an economy rises but the quantity of other goods and services remains
the same, it should result in each unit of money being reduced in worth compared to before the
increase. More money would then be needed to buy products, this means that the general price
level would rise, which is by definition inflation.
Generally, QE is a policy enacted by countries whose interest rates are already near zero and is
enacted by advanced economies that have low growth rates in general. As such, those who
receive QE money have reason to take that money out of their country and seek returns
elsewhere. This tendency is exacerbated by the accompanying low interest rates which allow
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investors to obtain loans so cheaply that a profit can be made by investing the funds in nearly
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anything that shows even a slight return. In the current times much of this money has flowed into
commodities and emerging economies; with their higher rates of interest and growth.
The increased demand for commodities naturally puts upward pressure on their prices and the
currency flowing into emerging economies increases their money supply and creates inflation in
the same manner. As the money first pours into an emerging economy it almost uniformly begins
with positive effects. As the foreign investors buy up financial assets, they put money into the
pockets of those local persons from whom they buy the assets. The increased demand pushes up
the prices of those assets which increases the wealth of domestic holders of financial assets who
retain them. Higher financial asset prices also make it cheaper for businesses to borrow money by
issuing bonds and similar instruments. Increased supplies of cash, increased wealth and easier
borrowing should all result in higher spending, resulting in higher economic activity in the short
term. The longer term effects are less unambiguously positive. Increased spending means a
general rise in demand for all products in the economy, if producers cannot increase supply
rapidly enough to keep up, then demand growing faster than supply would translate into price
inflation.
Stimulating inflation, however, can be the intention behind QE for central banks whose economies
are facing deflation. The BoE11 illustrates quantitative easing as a method for the institution to
raise inflation to the bank‟s target of 2%. Deflation is a serious concern for an economy as falling
prices can cause consumers to defer spending, slowing economic activity. Central banks need to
be careful with this policy, though, because the full effects of monetary policy are generally not
felt for an average of 18 months. It is possible that policy enacted today to keep inflation from
falling too low could push future inflation too high.
It is worth noting at this point that the first recorded instance of QE, that of Japan in 2001, did not
result in rampant inflation, rather Japan‟s inflation has in fact remained close to zero. Shirakawa
(2002) describes the QE enacted by his country as largely ineffectual, though he states that the
policy could support a rise in demand originating from another source. Japan‟s early experience of
QE, however, is not necessarily what is going to be played out now in the rest of the world as
differing circumstances should create different outcomes to some extent.
Figure 7 tracks inflation trends in the advanced and emerging economies during a period that
includes QE enactment to see how these countries were affected.
11
This information was obtained from a document “Quantitative Easing Explained” published by the BoE.
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Figure 7: Inflation in Advanced and Emerging Economies, 2006-2010
10
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8
%
6
4
2
0
2006
2007
Advanced Economies
2008
2009
2010
Emerging Economies
X
Source: WEO database, April 2011
Inflation for emerging economies is relatively higher when compared to that for advanced
economies. However, the two regions seem to be following the same trends, increasing and
declining during the same periods. Inflation for advanced economies was at 2.3% in 2006 and
increased to 3.4% by 2008, the percentages were 5.3 and 9.3 respectively for the emerging
economies. After the increases of 2008, both inflation rates declined to 0.1% and 5.2% in
2009. This period of decline was immediately after the year that QE1 was enacted. However,
inflation started on an increase after 2009, to reach 1.6% and 6.2% for the advanced and
emerging economies respectively. This shows that if QE had any effectiveness at all in
increasing inflation, it was subject to significant lag.
6. Impact of QE on South African Economy
Despite the fact that the SARB has not implemented QE-style policies in the domestic
economy, the country is still affected by QE. As mentioned earlier, this could occur through
rising commodity prices and currency exchange rates. Notable commodities for South Africa
include gold, which is a major export and platinum; oil is the country‟s major import. To
participate in international trade, every country has to pay in foreign currency and receive
payment in its own currency. These kinds of financial transactions create a necessity for the
currency exchange rate market in order to facilitate payments and receipt of income.
This section discusses the effects of QE on the South African markets by analysing the trends
within commodities and the currency exchange rates markets during the period that QE was
enacted. The section ends by looking at the trends in inflation in light of the effect of the inflow
of QE funds in the country, in the form of the carry trade.
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6.1 Commodity Prices
The South African economy partakes in the trade of many commodities, including gold and
platinum. The country imports oil as transport forms the life blood of the economy and fuel is
an integral part thereof. Figure 6 has shown that the price of oil started falling at the beginning
of 2008; which was the time when the global financial crisis struck. This makes economic sense
as business activity had started to slow down. The oil price had reached a peak of about $140
per barrel by the end of 2007. The declining price reached a level of about $40 per barrel by
the end of 2008, before a gradual recovery that ended at $120 per barrel by February 2011.
The declining oil price during the period that QE was enacted augured well for the country as
this means that the petrol price would stay stable and inflation would be kept within the
SARB‟s target band.
Gold is regarded as a safe haven by investors and as financial uncertainties strike markets,
most investors would hedge their bets by turning towards investment therein. Figure 4 has
shown that the general trend in the gold price was increasing since 2005 before declining in
2008. By the end of 2008 when QE was enacted, then the price of the commodity experienced
a gradual increase. For South Africa, this would be a benefit as the country is one of the main
three producers of gold, globally.
Platinum has gained prominence as a precious metal in the past few years and South Africa is
also one of the largest producers and exporter of this commodity. The figure below tracks the
monthly average price of platinum over the period 2005 to 2010 in order to analyse the effect
of QE.
Economic Analysis Directorate
18
Quarterly Bulletin
Figure 8: Platinum Price Performance, 2005-2010
2,500
Gauteng Treasury Newsletter
US$ per Unit
2,000
1,500
1,000
500
QE1
0
2005
2006
2007
2008
2009
2010
Source: London Fix Historical Platinum Results, 2011
X
The figure shows that the average monthly price of platinum has been on the increase since
2005 before declining towards the end of 2007. During this period, the price fell below the
previous level of under $1,000 per unit (2005) by the beginning of 2008. By the third month of
2008, the price of platinum experienced a free fall but by the end of that year, it was increasing.
It is evident from the figure that the price increased during the period that QE1 was enacted.
Although the platinum price has not returned to the high levels of around $2,000 per unit of
2007, it has been boosted by the enactment of QE. The price increase is beneficial for the
country because as the price increases, the country earns more for its exports of the commodity.
The assumption made in this paper is that the enactment of QE did affect the prices of
commodities and caused them to increase. The global financial crisis led to the oil prices
declining, although gold was affected to a smaller extent. However, as QE was enacted by the
end of 2008, prices started rising again. The effect to the country is twofold; as the increase in
the price of gold and platinum brings more revenue to the country in the form of exports, the
increase in the Brent crude oil price means fuel becomes more expensive and could lead to
inflationary pressures.
6.2 Currency Exchange Rates
The currency exchange rate is the price of one unit of currency in the terms of another currency.
According to a 2010 report by the Organisation for Economic Co-operation and Development
(OECD) the links between QE and exchange rate intervention are intricate and provide different
Economic Analysis Directorate
19
Quarterly Bulletin
outcomes across countries and conditions. The effect of QE depends on the levels of public
Gauteng Treasury Newsletter
debt and interest rates. The experience at the end of 2008 and early 2009 has shown that each
official announcement of future large-scale asset purchases by the Federal Reserve has been
followed by a fall in the value of the dollar. The effective external value of the dollar fell by an
average 1.3% two days after the statement. Since central banks prefer to buy government
debt, due to its low risk, when enacting QE, economies whose governments have issued larger
amounts of debt are more easily affected by QE and thus their currencies are more easily
affected as well12. It is also possible, however, that central banks of economies which have
little government debt as to eliminate the purchasing of that debt as a viable QE channel may
attempt to enact the policy through the currency market itself.
Charles Purdy (2010) a Director at Smart Currency Exchange 13 has argued that as soon as
investors sense that quantitative easing is on the cards, then the currency of that country will
lose value. This is explained by figure 2 of the supply and demand for bonds. International
investors want to protect their returns and when a government enters into a programme of QE,
the end result is that this will reduce yields on the government bonds. When government in
fact buys it own bonds, it increases the demand for those bonds thus increasing the price and
reducing the yield. Therefore an international investor looking to buy those bonds which
currently are at a higher price and lower yield, would want their own currency to appreciate
and the currency of the country practising QE to depreciate in order to make the same return.
Charles Purdy (2010) gave an example that “if the investor was expecting a yield of say, 3%
and the QE resulted in the bond price increasing by 10%, the yield would fall to 2.7%. The
investor would then want their currency to appreciate by 10% so that the effective yield they
received was back at 3%.”
South Africa plays an important role in international trade and is therefore affected by currency
exchange rates. Pearls, precious stones and metals formed the country‟s largest export
category14 in 2008. Amongst the country‟s largest export markets were Japan, USA and the UK
in the same year. The largest import categories were machinery & mechanical appliances,
mineral products and vehicles & transport equipment. These imports were sourced from
Germany, China and the USA. Figure 9 shows the country‟s trading partners in terms of
imports and exports for the year 2009.
12
A country such as Switzerland that has very low debt will find difficulty undertaking QE in a government bond market
and will have to look towards the private sector bond market.
13
Charles Purdy is one of the co-founders of Smart Currency Exchange, a company that helps clients to effectively and
efficiently send and receive payments internationally.
14
This information is according to the 2010 Provincial Economic Review and Outlook of Gauteng Department of Finance.
Economic Analysis Directorate
20
Quarterly Bulletin
Figure 9: Major International Trading Partners, 2009.
Gauteng Treasury Newsletter
Exports
Imports
UK, 4
UK, 4.96
China,
9.6
China,
13.1
Japan,
4.9
Japan,
6.7
USA, 7.6
Germany,
6.4
German
y, 11.6
USA, 8.1
X
Source Quantec Research, 2011
Figure 9 shows South Africa‟s major trading partners in 2009, with only the countries with
significant contributions included15. According to the figure, China (13.1%) was the country‟s
major trading partner in terms of imports in 2009, followed by Germany (11.6%) and the USA
(7.6%). China was also the country‟s top export partner at 9.6% in the same year, followed by
the USA (8.1%) and then Japan (6.7%). It is important to track the performance of the
currencies of these trading partners as shocks in their currency values would also have
consequences for the South African Rand. The assumption by this paper is that QE affects the
exchange rates, strengthening currencies of emerging markets countries because of carry
trade. This section analyses the trend of South Africa‟s major trading partners in order to
determine whether this was in fact the case. Figure 10 below tracks the currencies of these
major trading partners for the reasons mentioned. The currencies tracked are the Japanese
Yen, Chinese Yuan, British Pound, European Euro and USA Dollar. A higher figure in the
exchange rate of any of the currencies translates into a weaker Rand value, since it then
requires more Rands to purchase one unit of the other currencies.
15
The contributions are calculated in percentages but because only a few countries have been selected, the percentages
do not add up to a 100%.
Economic Analysis Directorate
21
Quarterly Bulletin
Figure 10: Major Trading Partners’ Currency Exchange Rates, 2006-2010
Gauteng Treasury Newsletter
18
1.50
16
1.25
14
1.00
12
0.75
10
0.50
8
0.25
6
0.00
2006
2007
Pound
2008
Euro
Dollar
2009
Yen
2010
Yuan
X
Source: SARB, 2011
The left y-axis of Figure 10 shows the Rand exchange rates of the Pound, the Euro and the
Dollar with the y-axis on the right showing the rates for the Yen and Yuan16. The figure shows
that the USA Dollar exchange rate has been the most consistent currency over the period 2006
to 2010, trading between R6/$ and R8/$. The exception was during the period when QE was
enacted, late in 2008 to the beginning of 2009, when the Rand depreciated to about R10/$.
During this period, investors frightened by the global recession began quickly selling Rands,
pushing the currency from R8.05/$ in September 2008 to R9.67/$ in October. After the
weakness of the fourth quarter of 2008 to early 2009, the Rand began to strengthen again as
foreign money started to flow into the country from the USA which had been flooded with cash
in December 2008 in that country‟s first round of QE.
According to the figure, the Euro was following more or less the same trend as the Dollar
although its exchange rate has been higher throughout the review period. The Rand had
depreciated higher against the Euro during the financial crisis and gained strength around the
period of QE1‟s enactment. The Pound also followed the same trend of the Dollar and the Euro,
a clear indication that QE helped strengthen the local currency after the global financial crisis.
The Rand exchange rate against the Yen and Yuan is much stronger, at averages of less than
25 cents and less than R1.50 respectively over the review period. The Yen had a rather
consistent exchange rate against the Rand but the Yuan had a more fluctuating one. The Yuan
strengthened against the Rand towards the end of 2006 and into 2007; again in the period of
global financial crisis. The strengthening of the yuan in 2007 was as a result of the new policy
reform that China had applied to its exchange rate. The new policy reform entitled the Yuan to
Economic Analysis Directorate
16
22
The Yen and Yuan have been separated to the secondary axis because of their comparative small values.
Quarterly Bulletin
be adjusted based on market supply and demand forces. The currency was allowed to fluctuate by
Gauteng Treasury Newsletter
0.3% daily; an undervaluation. According to Wayne (2008) other countries regarded this
undervaluation as being unfair since during that period, exports from China had become much
cheaper and their imports very expensive. China however explained the reason behind modifying
their currency as fostering economic stability and not to favour exports over imports 17. In general,
the results for the currency exchange rate shows that the QE helped strengthen the Rand after it
was negatively affected by the global financial crisis. The strength of the Rand is advantageous for
the import industry as the country pays less for goods bought abroad and all domestic concerns
are helped by the reduced price of oil in Rands. However, this comes at a cost to exporters as the
country‟s goods become more expensive in international markets.
6.3 Inflation
It was pointed earlier in this paper that the carry trade that results from QE cash injections into
emerging economies as portfolio investments could lead to such economies experiencing
inflationary pressures. It is important to look at the trend of the inflation rate in the country, to
ascertain whether the arguments have played out in practice.
Figure 11: CPI Inflation, 2006-2010
16
QE
%
12
8
4
0
2006
South Africa
2007
2008
Advanced Economies
2009
2010
Emerging Economies
X
Source: Stats SA, 2011
Figure 11 tracks the inflation trend in the country over the period 2006 to 2010. Inflation was
within the SARB target range of 3-6% from the beginning of 2006 to the second month of 2007.
After this period, the Consumer Price Index (CPI) increased to levels outside the target range and
Economic Analysis Directorate
17
This information was sourced from CRS Report RL32165 on China‟s currency.
23
Quarterly Bulletin
reached a peak of 13.7% in August 2008. Stats SA attributed the higher CPI mainly to the
Gauteng Treasury Newsletter
increase in electricity tariffs and food inflation during that time. The CPI experienced a free fall
thereafter, reaching 8.1% in January 2009. The CPI continued on a gradual decline from 2008
and by February 2009, it had returned within the SARB‟s target range. The assumption that QE
would lead to inflationary pressures increasing in the emerging countries where the investors
would flood their extra cash, did not hold true for South Africa. Statistics displayed by figure 11
shows that inflation continued to decline during and after the enactment of QE1.
7. Conclusion
The global financial crisis and its resultant recession exhausted the traditional tools used by
advanced economies‟ central banks to help their countries‟ economies through difficult times.
Central bankers in many developed countries turned to QE and began to enlarge their
respective money supplies by buying financial assets in exchange for central bank reserve
deposits. This practice allowed their commercial banks to lend on many times more money than
they had received. The advanced economies response to the global recession, of increasing
their money via QE, seems to have been successful for them so far, in that they have avoided
falling below the inflation minimums they set for themselves. The enactment of QE helped the
UK avoid price deflation and the USA rebound from a small dip into deflation. Commodity prices
were held at high prices and investors flooded emerging economies with cash. It remains to be
seen, however, what the future impact will be, for the rest of the world.
Much of the money using QE in the world‟s advanced economies has left those countries for
commodity and emerging economies. Zero interest rates make it possible for speculators to
turn a profit by borrowing money for next to nothing and investing it just about anywhere that
shows any return at all. This carry trade has already had noticeable effects on emerging
economies. The effect of QE for South Africa has shown that the enactment made the prices of
commodities to increase. The country benefitted from the prices of precious metals increasing
and the Rand exchange strengthening against the basket of currencies. The detriment was the
increase in the price of Brent Crude oil. A rise in the general price level of not only commodities
is another potential consequence of QE. However, this theory did not hold true for South Africa,
as the country‟s inflation rate was declining following the period when QE was enacted. It is
possible that the effects are still to be felt, as monetary policy is subject to significant lag. It is
also possible that markets have successfully adapted to quantitative easing and avoided the
policy‟s pitfalls.
Economic Analysis Directorate
24
Quarterly Bulletin
8.
Bank
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For a full set of research documents produced
by
the
Economic
Analysis
Unit,
visit
the
departmental website and the Intranet and click
on documents and publications. For further
information
contact
Gauteng
Finance: Treasury Division, 14
Department
th
of
Floor Standard
Bank Building, 78 Fox Street. Tel: 011 227 9000
Fax:
011
227
9055
or
email
[email protected]
Economic Analysis Directorate
27