Sunday, 30 August 2015

Quantitative Easing: Can it make our stock market Uneasy?

An economist is a man who knows a hundred ways of making love but doesn’t know any women.

It is good to start something very serious in a funny note, especially when you are about to sail into dark waters of economics. Many times I have been asked to explain this Quantative easing (QE) thing and there is nothing easy about it. But now there are fears that after USA has ended QE and looking to raise interest rates which may result in fall of Indian stock market as FII’s will be leaving India for higher interest rates. Actually the reality is even i do not understand the real reason behind QE because what we hear in the public stands does not make any sense related to results achieved so far and common business sense. So let’s try this together…

Suppose there is 100 rupees in the market with Mr X, who exchanges it for Wheat from Y, Y exchanges the same for Clothes from Z and Z exchanges the same for Shoes from S. So total goods traded are 100 wheat+ 100 Clothes+ 100 shoes=300. But we were only having 100, so this 100 has done the work of 300, thrice of original money supplied. This 3 is the velocity of money I.e 300/100=3. So base money is never equal to total money gets supplied in an economy, but total money is equal to Base money M multiplied by Velocity V, S=MxV. Now we know money supply is never fixed, it depends on velocity or we can better say propensity of consume by the people. People are more confident so they will do more transactions which means more demand and so more GDP i.e Growth.

Many thinks that this Base money is created by central Banks (RBI or FED) in the form of currency notes or coins or bank credits either by purchasing Govt bonds or giving loans to commercial banks But this is not true at all. This money is just a small part of total money in the economy. In reality, most of the money is created by our Commercial Banks like HDFC, SBI etc. They create the money out of thin air. Commercial banks (we will take HDFC) provide loans to the corporate and general public. But we think that HDFC loans out money equal to its Deposits. If HDFC is having 100000 as deposit then it can loan only upto 100000. But the reality is far from this. Banks are required to keep only a part of their deposits in cash as statutory or necessary reserves (say 10%) they can loan out the balance. Because people are not coming to draw their total funds…they will only need a part of it. That is 10% and with this banks can meet the time cash demand of depositors.

So HDFC can now loan out 90000 out of 100000, keeping 10000 as reserves with RBI. So you think it is all over and no new money is created? No…it is just the start. Suppose Mr X gets the loan of 90000 and he pays  the same to Y for buying a machine. So now what will Y do with 90000/- ? Well, it will surely come into bank in the account of Y, so now bank is having another 90000 as deposit, and so it can loan out another 81000 of it. So Banks can play this game for 8-9 times and total loan amount will be around 7 lac to 8 lac. So with one lac banks can create 8 lac of money…so this is money out of thin air.

And if this money is invested in increasing production, then it is good but if it is invested in buying assets then it may lead to inflation. Like someone can take loan to produce more pulses (India is short of this) or he can buy a house. Pulses will surely lead to growth and it can actually lower inflation due to stoppage of costly imports but buying a house or a car can lead to high inflation if the loan is not supported by rising income or if the cost of loan is higher than rise in income level. And cheap loans can really make people to invest in assets rather than taking risks of production.

That was precisely what happened in USA in 2000. Loans were cheap so people just went on investing in real estate. This only inflated the prices as supply can not be increased as fast as compared to demand. This lead to speculators entering in the game with cheap money…and prices kept on rising. People were just taking loans for buying houses thinking they could sell these for high prices or could rent these for income. But around 2005, interest rates rose as a response to market forces and inflation risk.

This led to a fall in property prices and buying fell. This made speculators to sell houses cheaply to pay out the loans which further reduced the prices. More selling started and prices fell down…some people who could not sell their homes for profit defaulted on their loans. When banks tried to sell those houses, they were getting only a part of their loans…it led to panic selling by banks to cover the losses and hell broke .

This chaos spread to normal spending in the economy as people reduced their spending due to unemployment and insolvency. Banks stopped giving further loans to clean their balance sheet and USA fell into recession. People were focusing on repaying their loans first, so they curbed their excessive consumption. Many of young Americans went back to stay with their parents.

In normal circumstances, a central Bank (FED) can lower interest rates to make people spend more by taking loans cheaply. It is called Monetary policy. Our RBI is trying the opposite by keeping interest rates high as it wants to fight inflation. Fed also tried this by taking interest rates near Zero so that people could take cheap loans for consuming or investing which would give a flip to the economic activity and so as to employment levels. But this looks good only in theory, it never happens in reality. Or we can better say it can happen in an economy where people are saving in excess due to high interest rates (as in China) which is making many productive resources lay idle. Lower interest rates can force people to consume more. China is exactly doing the same by lowering its interest rates.

But USA was different, people were already having high debt…debt to income ratio was very high. So low interest rates could not seduce people to take even more loan when there was already an environment of fear and low growth. Corporates were having spare capacity and high cash. So it did not worked at all. Public just never went for cheap loans. Instead they were paying back their loans. Banks were also reluctant to create more loans as they wanted to clean the earlier mess. As no new loans were getting created and old one was paid back…it was destroying money. Low interest rates could have made people with excess savings to spend more but instead many of them invested in foreign assets like stock markets for better returns. You cannot take people as dumb, who would throw their money just because it is not earning. They can look to Gold for parking.

So Fed tried something extraordinary. It went for Quantative easing which was meant for pumping more cheap money into the economy. People are thinking that by QE, Fed just put more money into the economy but how Fed did this…not many are aware of this. Actually Fed thought that if people are not taking loans…so let’s give them money.

Government treasury Bonds and other financial assets like bonds etc are bought by Pension funds, insurance companies and commercial Banks.  These Bonds have coupon rate of interest which is payable yearly. Like 10% for a 1000 Rs. Face value Bond for 3 or 10 years. It means by paying 1000 I’ll be getting 100 rs every year as interest. But these bonds are traded in secondary market also, so if interest rate falls to 5% in the economy (mostly bank rate on deposits), then the price of this Bond will rise to 2000 which will make interest of 100 exactly as 5%. So on this basis prices of bonds keep fluctuating.

So Under QE, what Fed did was buying these bonds from the market at very high rates so as to bring the effective yield on these to near zero which made institutions holding them to sell these to Fed. And what was the result, Banks got huge amount of deposits after Pension funds and Insurance companies sold their bonds and got huge amount of money from Fed. so banks were in the position to lend this money to the public cheaply and economy would perform. But in general pension funds are not going to keep their money idle at banks with zero interest rates so they would invest this in other avenues like stock market or real estate which would raise the wealth of the public holding these , so in result confidence would rise and so as spending. 

But the money , which are invested by fund houses into stock market etc will not leave banks at all as the same will anyway come back to banks in the form of deposit but from other source.

Also the money paid by Fed to commercial banks for their Bonds also increased the reserves of these banks with Fed and so banks used this for making more loans.

How banks Make Loans

But if Fed was really thinking like this then there is one very fundamental flaw in this model. I am not an economist but i dont think banking acts like this in real life.When someone approaches to bank for Loan, bank never checks if they are having adequate reserves or not. They just simply approve the loan and in the evening if they find they are short of reserves at RBI, then they can take short term loans (one day) from other Banks or even from RBI. So banks are never short of Reserves. Banking is always demand side economics where supply can be raised as per demand. Banks are never short of reserves but of capital. This is the way banks operate and they can create any amount of money if it is demanded by public by way of debt. So this debt is the primary source of our money supply and it may look very scary for a common man.

So just by having deposits and reserves at Fed can not result in more lending. If people do not want to take any loan and banks are reluctant to take risk then nothing will work. So it is only wishful thinking that more reserves and deposit will spur credit demand.

But nothing like this happened, Fed bought around $ 4 trillion under QE-1, 2 ,3 but 80% of this is still in Fed’s reserve held by Commercial banks. This amount was never lent to the public so it was never used for the purpose for which it had been created. Stock markets did rise in US but not Gold, not Oil and not any other commodity like copper, Zinc etc. if rise of stock markets is linked with QE than why the same is not true for commodity market.

Surprisingly Fed started paying Interest to Banks on their reserves with Fed which further prompted banks to not to lend this money to risky loans as they were happy earning .25% interest from Fed with no interest payments on deposits. Banks have earned a windfall from this interest in this period and banks’ balance sheets have never been in this good shape. This step is confusing us about the motive of Fed, whether it wants to lend or keep this money into reserves. If it was concerning with possible high inflation but inflation was already very low in USA!!

Why QE

This makes me think that Fed is actually helping Banks in coming out of the mess created in last decade with reckless lending. Fed may have bought many of the not so good or Junk bonds mainly related with real estate (I do not have any data for this, but need to check this one out). This step of Fed provided banks with much needed cash and capital (profit earned is part of capital). Stock prices of banks skyrocketed after this. This have also stopped the possible panic that could have crept in general public after the demise of Lehman Brothers, and people might have lost interest in banks and that would have created havoc in the USA Banking and economy. So this QE may not be looking like achieving what was planned but it may have prevented a disaster.

And by making all this noise, Fed is actually creating feel good factor. I am always of the view that most important factor that can bring growth in an economy is not Capital and technology but CONFIDENCE of general public in the system and government’s capability. And by paying interest on reserves Fed is purposefully keeping the money with itself as money belonging to those bonds is already in the economy. Fed may be looking to sell these bonds when USA looks like coming back on track to these banks. Because if that money is again absorbed in the economy then it will become very difficult for Fed to sell these bonds into the market as this will drop the prices of these bonds significantly and interest rates will skyrocket.

After this QE, USA has not experienced any material rise in GDP and employment rates. The small rise witnessed may not be due to QE alone. But there are views that it has prevented a complete failure. So this QE can either be failure of Fed or there is something more to the story. I am just guessing because I need to gather a whole set of data to testify this which currently I am not having.

There is another way except for QE to spur growth. That is instead of giving money to fund houses and banks, Fed can simply give money to USA government by subscribing to their zero rate bonds. So USA Govt will now have the money and it can spend where it feel is necessary. It can also waive the taxes from citizens leaving more money with them and so more demand and goodwill factor. Government can invest this money in sectors which are deprived of investments like it can provide free loans to Shale Gas producers to reduce their cost of production. But only problem with this is that it will increase the already high Government debt to GDP ratio. It will also be very difficult to get the approval for it politically. But I feel this is a much better chance as government knows better than citizens where there is over supply and where is under investment.

Now coming to Indian stock market

There is widespread fear that as USA has ended its QE program and will be raising interest rates which will prompt USA investors leaving emerging markets and this will create panic in the stock markets of those countries. Now as we know not much of the QE money has left USA. After excluding Fed reserves, the most of the balance is invested in USA stock market and real estate. I feel that not much of QE (Cheap money) has come into Indian stock market. The money which in fact has come into Indian market may be savings of the general USA public which are hard hit by this zero interest rate policy. Savings of the life of so many of USA citizens have become worthless and are not earning anything in USA. This money was looking for profitable avenues and Indian stock market was one of them.

Even so this money was invested into Indian market when rupee was much stronger. So there will be a loss if they sell it due to rupee fall if this money is invested for short term. FII’s are generally in india for long term and they are here because they have faith in Indian story. Most of all, FII’s are just around 20% of total Indian stock market and this is not big. Indian domestic investors are much stronger and bigger now and they can absorb any such plight of FII’s. No McDonalds and KFC will leave india as they have faith in Indian story and they have invested for long term. Much of the FII money is invested in Indian Bonds which still provide more interest rate but may be with lower ratings.

Demand by USA may be fuelling growth in china now and in Japan in the past, but Indian story is built upon domestic demand and creation of adequate infrastructure. India just need cheap commodity prices which are here. Recent recorded Growth in USA failed to lift commodity prices. There are also fears that further lowering of oil prices may hit USA shale gas producers hard as they are incurring losses even at $ 50 for oil and this may result in low investments and employment.

RBI is having large reserves of dollars of around 400 billion which are more than sufficient to support the Indian rupee in case of selling by FII as they will demand  dollars in exchange of rupee. Also most of these fears have already been discounted for in the Indian market since last year. Also I do not think that rate increase in USA will be massive as this will severely hit any recovery made so far. This small increase will be more than offsetted by rupee fall which has already taken place and more of that will occur in case if FII’s are selling. Moreover there are high chances that USA will further delay its rate increase as economic data needs to be tested over long term to confirm whether it is sustainable or not.

So I feel India will be able to withstand any rise of interest rates in USA much better as we are in much better place.


  1. Thanks Gurpreet for writing things down to layman's level . Only now i understood few things like bond price change and QE.

  2. I really like it....the way u educate a layman like me nd so many other people.....thankyou bhaiya

  3. Hi Gurpreet,

    Thanks for the valuable information. Could you please advise on the following:

    1. The below chart shows how FED pumped money through QE and S&P Index reacted over these 6 years.Your opinion please

    Also it is worth noting that Rs.16700 cr outflow by FIIs in equity but just 700 crore from debt.

    2. Despite the Oil prices are very low , why some of the companies are trying to invest a lot.
    I follow a company called "Mercator" and it found 2 oil wells recently.Also Italian energy company Eni says it has unearthed a “super-giant” gas field in
    the Mediterranean Sea covering about 40 square miles and that’s the energy equivalent of about 5.5 billion barrels of oil.I think this is very costly affair.
    One of the Indian company "Video-con" also found similar ones in Brazil along with BPCL.
    Surprisingly Buffet takes 11% stake in Oil Refinery Philips 66.
    Your view on investing these folks in these business at wrong time?

    3. China has $3.7 TRILLION Forex reserves and still Yuan falling.Would $380bn forex reserves for our country be sufficient enough to support rupee as Rajan keeps pointing that out.
    4. As we are short on pulses and import a lot from countries like Srilanka , Bangladesh,Indonesia etc..Recently there was a announcement to barter trade with
    those countries of exporting sugar in lieu of imports to fix sugar surplus in our country. Better soil is needed to grow these pulses using fertilizers like SSP.
    So is it an indication that the government is not inclined towards quality of soil?

    5. As the foreign investors are more inclined towards India , Will there be a chance that the rupee be strengthen and can regain it past glory, say < rs.50 or below.

    6. Also curios to know that if they invest in India they can get 10-15% CAGR and no interest hike can even give double digit figure , Is that right ?