The truth about unlimited quantitative easing and what it means for Asia

Learn why the European Central Bank's so-called 'sterilization' comes with false advertising.

Here's a view from David Carbon, analyst at DBS Group Research:

As we go to press, the Fed deliberates on whether to introduce a third round of quantitative easing, or QE3. Markets have priced in a near certainty of this occurring and even were Fed to demur, only the expected due-date would change. Another chunk of change will likely be spent, if not this week, then next.

Not to be outdone, the ECB has already announced a new bond buying plan of its own: the Outright Monetary Transactions (OMT) program. Under its auspices, the ECB will purchase bonds of struggling Eurozone economies in ‘unlimited quantities’. This is a new and important step – it’s the first time the ECB has thrown open its vaults to any and all comers and the ability to buy bonds in unlimited quantities means that speculators shorting those same bonds might want to reconsider or at least stand aside while the ECB train passes.

In the event, the balance sheets of the world’s two largest central banks are about to expand again. How much bigger can they get? They’ve already doubled or tripled in size. Since Mar08, the Fed’s balance sheet has grown by 3.1x to USD 2900bn. The increment – $1900-odd billion – equates to 13% of GDP [1].

The ECB’s balance sheet hasn’t grown quite that fast – it’s only expanded by 2.2x since Mar08. But the ECB’s was bigger to begin with. Back in Mar08 it was 15% of GDP; today it’s 32% of GDP, thanks to all kinds of emergency loans and bond purchases (LTRO, ELA, SMP) that can only be called quantitative easing too. In dollar terms, the ECB’s balance sheet has expanded by even more than the Fed’s: $2100bn vs $1900bn [2].

If you add it all up, that’s 4 trillion dollars of balance sheet expansion from the Fed and the ECB. That’s a big number. Now grow it by QE3 in the US and an ‘unlimited quantity’ in Europe and you get, well, an even bigger number.

Is all this money ever going to bring a US recovery? Is it going to end the European crisis? And what does another round of QE in the US and in Europe mean for Asia?

In the US, our view is that QE3 won’t hurt. But it’s won’t help much either. The Fed has been pushing on a string for two years. Pushing on a longer string doesn’t change much.

In Europe, the QE/OMT program has solid chance of doing a lot of good. This is the ‘big chunk of money’ that was always needed to ‘ringfence’ vulnerable assets and to keep speculators at bay. Keeping yields on sovereign bonds at manageable levels is critical to keeping debts from spiralling out of control.

But OMT won’t solve the ‘real economy’ side of the problem. Competitiveness differentials lie at the heart of the debt crisis and OMT won’t eliminate them. On the contrary, keeping the euro intact practically guarantees that competitiveness differentials will persist. Slow growth and painfully high unemployment will remain for a long time, with or without the OMT. Thus, risks to the euro from this side of the equation remain as high as ever.

What does another burst of QE/OMT mean for Asia? Will all that money come rushing over to Asia, pushing interest rates down and currencies, growth and equity markets up? Is Asia looking at 2010 all over again?

Probably not. First of all, one should recognize that most of the injections undertaken by both the Fed and the ECB never went into the real economy, the money stayed at the central banks in the form of reserves / deposits. The ECB calls this ‘sterilization’ and they note that whatever OMT money gets injected into the system will get mopped right back up again into central bank deposits.

This is false advertising. Banks can withdraw these deposits any time they wish and put them wherever they want. If voluntarily leaving money at the central bank is ‘sterilization’, then the Fed’s QE program has been sterilized even more effectively than the ECB’s – 80% of the increment in the Fed’s balance sheet since Mar08 has been absorbed by increases in reserves / deposits. Only 52% of the ECB’s balance sheet growth has been absorbed this way.

Still, the point remains that most of the QE undertaken on both sides of the pond isn’t entering the economy. And if it’s not entering the local economy, it can’t come ‘flooding over to Asia’ a day later.

Does this mean Asia won’t see any inflows in 2013? Not at all. Inflows have been strong in recent years and they should rise modestly in 2013. But it’s not coming from QE at the Fed or the ECB. It’s coming from investors seeing growth and opportunity to profit from it in Asia. And it ebbs sharply when those investors see risks such as a break-up of the euro.

To the extent that the ECB plan lowers the risk of a break-up – and it certainly does in the short-run – flows (and stronger growth) will come back to Asia. Not from QE per se but from the perception of lowered risk that QE brings.