Why arguments against quantitative easing hold no water
- Chris Malikane
The Reserve Bank should be allowed to buy more government bonds and securities to support the liquidity of the banking system.
Some analysts, including myself, have argued that the SA Reserve Bank should have long started the local version of quantitative easing (QE), which involves the central bank buying long-term securities on a large scale.
In addition, and contrary to the Bank’s initial position, I have argued that the law allows it to directly finance the fiscal deficit, and it could refinance government debt to open fiscal space for an effective response, not just to Covid-19 but also to the underlying structural economic crisis.
I estimate that the limit imposed by the SA Reserve Bank Act implies that the Bank’s balance sheet could absorb at least R239bn worth of direct bond purchases from the government. This excludes loans and other advances the Bank could extend to development finance institutions and municipalities.
The limits in the act do not provide sufficient flexibility and space for the Bank to play its developmental role given the scale of the structural historical problems, which have not been adequately addressed for far too long. The finance minister should by now have tabled amendments to the act to lift those limits, with new provisions that would permit the Bank to broaden the types of securities it may acquire in response to the crisis.
There are, however, those who oppose these proposals. The first view is that QE is strictly applied when economies face deflation, which is an absolute fall in prices, and when short-term interest rates are at 0%. The argument is that in deflation people delay buying goods and services in anticipation of prices dropping. This and other forces, such as debt deflation, reinforce a fall in demand and drive the economy into a severe contraction. Because the short-term interest rate is impotent at 0%, the use of QE aims to raise inflation, to make people anticipate a rise in prices in future and buy goods and services now.
The second view holds that outright financing of fiscal deficits and refinancing of public debt by the Bank would undermine the central bank’s “hard-won central independence”, which would weaken its ability to meet its monetary policy mandate. The argument is also that money creation to finance deficits would cause inflation to breach the Bank’s target, in much the same way as QE.
The argument that direct financing of the government undermines central bank independence is not necessarily correct. First, whether central independence is undermined depends on how the interface between the central bank balance sheet and that of the government is designed, particularly the need for transparency, accountability and the specification of limits in the use of such financing mechanisms.
Second, if the monetary policy mandate of the central bank — the inflation or long-term interest rate target — provides an explicit overarching device to co-ordinate fiscal and monetary policies, the ability of the central bank to achieve its monetary mandate will not be jeopardised. In fact, it may be enhanced. Third, in this arrangement the Bank remains independent to choose whatever instrument it deems fit to pursue its mandate.
In a number of cases central banks that directly finance their governments exhibit a higher degree of independence than the Reserve Bank. The Bank of Thailand directly subscribed to a variety of government debt instruments, yet it scores substantially higher than the Reserve Bank when it comes to independence. The same is true for the Bank of Korea, which lends directly to its government. The central banks of Uganda, Nigeria and Malawi all score better than the Bank on independence, and directly purchase bonds and make advances to their governments. This is also the case with the Central Bank of Cuba, which exhibits more independence than SA’s central bank.
The argument that direct money financing of the government necessarily undermines “the hard-won independence” of the Bank is therefore not correct. It all depends on the institutional design, transparency and accountability in the interface between the Treasury and the central bank. The proposals for the Bank to adopt unconventional measures do not tamper with the requirements for transparency and accountability.
The second view maintains that short-term interest rates, those that are charged for lending for less than one year, should be 0% before QE can be applied. I have argued elsewhere that this view is erroneous for an emerging market. To have a stable exchange rate the short-term interest rate in an emerging market should equal the interest rate of an advanced economy plus a sovereign risk premium.
When the advanced economy hits a 0% lower bound, the emerging-market interest rate will equal the sovereign risk premium, which is not 0%. Therefore, while the advanced economy embarks on QE at a 0% interest rate, the emerging market does so at some positive rate equal to the sovereign risk premium. It is wrong to expect SA to hit 0% interest before QE can be pursued. By extension it is also incorrect to say the currency will automatically depreciate if QE is implemented. It depends on the specific aims and design of the QE.
A related argument against the QE proposal is that it is strictly for economies on the verge of a deflation. This is also not correct. When an advanced economy hits its inflation target, say 2%, the emerging market hits its own target of say 4.5%. Now if the advanced economy hits 0% inflation, the emerging market reaches 2.5% inflation. Therefore an inflation rate that is on, or below, the target and an interest rate that is at the sovereign risk premium are sufficient conditions for an emerging market to embark on QE. This is where SA is now.
To expect the emerging-market inflation rate to be on the verge of 0% before embarking on QE is to allow the unemployment rate to soar to high levels because demand would have to fall significantly to pull inflation down to zero, before aggressive measures to counter the downturn are implemented. Such a haemorrhage of the real economy would be made worse if inflation expectations are anchored, as they should be, at the target.
The Bank should not be shy to acquire more government bonds and other securities to support the liquidity of the banking system, even if the short-term interest rate is above 0%. The R11bn purchases of government bonds is a step in the correct direction, but it is sadly inadequate.
Because the banking system is increasingly facing defaults and high risk aversion, the Bank should be legally empowered to broaden the types of securities it could purchase from the entire financial system, to effectively secure financial stability and drive progressive structural change. The Bank should also explore more channels of credit transmission to the real sector, beyond the conventional banking channel, such as direct lending to development financial institutions, securitised commercial loans, acquisition of government-guaranteed securities and direct lending to government. All this should be done in a transparent and accountable manner, in much the same way as the budget process.
In short, a new financial architecture needs to be established that is informed by a vision and mission to address the historical and structural fault lines of SA society, beyond the pandemic.