Analysis of QE3 and its impact on india

Author:Ravi Srikant,NMIMS,MBA Capital Markets

After the recent announcement by the US Federal Reserve to buy US treasuries and mortgage bonds worth $40 billion a month, aka, Quantitative Easing - 3 (QE3), stock market indices around the world posted heavy gains. In India, the Sensex and Nifty jumped more than 2% each, with the Diesel price hike and expectations of FDI in retail and aviation also contributing to the increase. This is the third such initiative taken by the US Federal Reserve in the past 4 years to improve liquidity and get the US economy growing again by lowering interest rates. This money, which the banks by selling Mortgage Backed Securities (MBS) get at artificially low interest rates, finds its way into commodities and emerging market equities such as India where returns are much higher. Let us first analyse the impact of QE1 and QE2 to try to understand how QE3 may impact the country.

The US Fed bought around $1.45 trillion of mortgage-backed securities and other agency debt during the 14 months of QE1 and around $600 billion worth of securities during the 8 months of QE2.

QE1 came at an important time for the Indian markets as the Nifty hadstarted bottoming out around 2500 after which it began its climb. FII’s withdrew around Rs 54,000 crore from January 2008 to November 2008. After QE1 was announced there was a visible change in sentiment, which led to inflows of around Rs1,00,000 crores from December 2008 to March 2010. The Nifty doubled during this period.During QE2, there were inflows of around Rs 40,000 crores but the Nifty actually fell 6 % after reaching a peak of 6150, just before QE2 was announced. The markets responded positively to QE1 whereas the response to QE2 was muted. This could be attributed to the negative effect of higher commodity pricesespecially Oil and lack of reforms by the Indian government hurting investor sentiment.

The Indian basket of crude bottomed out around 40$/bblaround the time QE1 started after which it doubled to around 80 $/bbl by April 2010. By the end of QE2 in June 2011, the price had moved up to around $110/bbl. It can be seen that both QE1 and QE2 had a direct impact on the price of Oil. A higher price of Oil leads to inflation in the country and as India imports about 70% of its Oil requirement, it affects the balance of payments. Coupled with a higher subsidy bill, itaffects the fiscal deficit as wellThe current account deficit in turn put downward pressure on the Rupee, which inflated the Oil import bill even further.

The price of Gold has gained consistently ever since quantitative easing as a strategy was undertaken by central banks around the world. Gold is considered a hedge against inflation and also against fiat currencies, which are being devalued by loose monetary policies of the central banks. It went from just below $800/ounce to around $1200/ounce by the time QE1 ended. It further went up to around $1600/ounce by the time QE2 ended. Gold imports account for a major part of the current account deficit, so a higher price definitely worsens the current account. Gold imports reached a low of around 450 million tonnes in 2008 and reached around 958 million tonnes in 2010. Strong demand despite higher prices hasworsened the current account deficit even further.

On the whole it can be said that QE1 and QE2 were positive for the markets, whereas on the macro economic front, the current account deficit worsened from 1.3% of GDP at the beginning of 2008 to around 2.7% of GDP at the beginning of 2011 which further worsened to 3.7% of GDP at the beginning of 2012 on the back of higher Oil prices and a weak Rupee.

The Consumer Price Index (CPI) that measures inflation has consistently been above the 8 % mark from 2008 to 2012. It was below 6 % at the beginning of 2008 and reached a peak of 16 % in the beginning of 2010. Inflation has certainly worsened after quantitative easing began and is well above the RBI’s comfort level.

A high fiscal deficit and inflation have forced the RBI to keep interest rates high, which is definitely hurting the growth prospects of India.

QE3 involves a purchase of $40 billion worth of securities a month, i.e., $360 billion a year. Apart from this the ECB has an open-ended scheme to buy the bonds of the debtor European nations, which will act as a sentiment booster. It is difficult to estimate how much of the money will actually be invested in the Indian markets. But if past trends are any estimate, commodity prices are likely to increasewhich will further fuelinflation and due to our weak policies increase the subsidy burden as well as the fiscal deficit as the higher prices are not passed on to the consumers. It is safe to say that India is a net looser from the QE policy, which is popular with the central banks of the West.

Recent efforts taken by the government to reign in the deficit by raising diesel prices by Rs 5, going ahead with disinvestment in 4 PSU’s will have less of an impact if Oil prices begin increasing again. If recent trades are anything to go by, Oil and Gold both skyrocketed after the decision reaching 117$ and 1770$ respectively.

Also, the need for a third QE signifies that the earlier 2 QE’s failed to deliver according to the central bank’s objectives, mainly to get the banks lending again and get the US economy growing again. Unemployment rate in the US has stayed above 8% for a long time now.

As of now, there isn’t much of an inflation problem in the US, but there are worries that if such expansionary monetary policies continue inflation could rear its ugly head which would then force the Fed to raise rates before its stated year of 2015.

A rise in interest rates in the US would certainly be very bad for India, as investors will most likely withdraw money from India to cover up for losses at home which would not only affect the stock market but also the rupee.

Bernanke has exported his problems half way across the globe, when the rest of the world has enough on their plate.