Currency war ! US$ going bananas over QE2

By IZWAN IDRIS
izwan@thestar.com.my

 Question mark over Fed's decision to print more money to revive economy

"As long as the world exercises no restraint in issuing global currencies...then the occurrence of another crisis is inevitable, as quite a few wise Westerners lament" - Advisor to China's Central Bank Xia Bin

DURING World War II, the Japanese military government minted the infamous “duit pisang” notes to replace colonial currencies used in occupied territories of Malaya and Borneo island.

The new money entered circulation in 1942 but, as the tide of war in the Pacific turned against the Japanese, the price of what available goods in the local market sky-rocketed.

To raise funds for its war efforts and pay local producers, the Japanese simply printed more money and in bigger denominations.

Barely three years after “duit pisang” went into circulation, the market was awashed with cash that had no value. By 1946, these notes were worth less than the paper they were printed on.

According to my late grandmother, a sackful of “duit pisang” would get you a decent pillow – if you had sewn the bag with the cash in it.

Fast forward to today, the US Federal Reserve’s decision to print more money to revive its ailing economy would seem foolhardy. At least one member of the Federal Open Market Committee (FOMC) was against the plan.

The Fed’s latest round of asset purchases will add to the US$981bil of excess deposits that banks held in the central bank as at Oct 20.

“This suggested that a big proportion of the Fed’s quantitative easing had failed to generate growth and is sitting idle,” RHB Research Institute economist Peck Boon Soon says.

The idle funds, he says, may fuel inflation once confidence returns and money creation starts rising rapidly.
“Perhaps the Fed believed that it is easier to control inflation rather than deflation,” Peck says.

The Fed on Nov 3 announced a widely-anticipated move to buy more bonds from the market. This time around, it will limit itself to US Treasury and will spend an additional US$75bil a month doing that through June next year.

The latest “quantative easing” by the Fed, dubbed the QE2, will create US$600bil in greenback cash like magic.

It will add to the US$1.7bil the Fed injected into the economy between 2008 and 2009 under the first QE.
One key difference between the latest round of asset purchases and the 2008-2009 programme was the focus on actively pursuing the dual mandate of “sustainable employment and price stability” this time around.

But that is easier said than done.

“In reality, determining the scale and pace of purchases by tying them to statutory mandate will be challenging simply because there is no historical precedent to this policy approach,” says Thomas Lam, the economist at Singapore-based DMG & Partners Securities.

The company estimated that the US$600bil cash injection was equivalent to a “pseudo reduction” of 50 to 100 basis points on interest rate.

The FOMC on Wednesday left the key policy rate unchanged at near 0%, and continued to pledge to keep interest rate low for an extended period.

Money printing pushes yields down, which has the same effect as lowering interest rates by reducing borrowing costs.

While the Fed’s QE2 gamble was widely anticipated by the market, the news of its implementation had drawn strong criticism from China, major developing economies and even Germany.

Across the region, policymakers are fuming over the Fed’s loose monetary policy.

In recent months they have been struggling to control incoming waves of funds from overseas that fuelled unwarranted currency appreciation and rising prices.

“As long as the world exercises no restraint in issuing global currencies such as the dollar – and this is not easy – then the occurrence of another crisis is inevitable, as quite a few wise Westerners lament,” Xia Bin, an advisor to China’s central bank, wrote in a newspaper managed by the bank.

The report was quoted by Reuters on Thursday.

At home, Bank Negara governor Tan Sri Zeti Akhtar Aziz says Asian central banks are “willing to act collectively if the need arises to ensure stability in the region.”

South Korea says it will “aggressively” consider controls on capital flows.

Analysts say the implementation of QE 2 will likely fan new bubbles across the region that is already frothing.
“For emerging markets, the combined impact of QE2 and the still accommodative monetary conditions in Asia could fuel a new round of asset price appreciation as investors borrow cheap money to invest in high-yielding assets,” CIMB Research’s economist Lee Heng Guie said in a report.

This high-yielding assets include property, gold, other commodities, as well as currencies.

Meanwhile, Fitch Ratings warns that strong performing markets in Asia risk importing the inappropriately loose monetary condition in developed countries, which in turn can lead to higher inflation and volatility in asset prices.

The Fed’s first round of QE totalling US$1.7 trillion, combined with Bank of England’s £200bil and Bank of Japan’s 21 trillion yen stimulus, fuelled a powerful rally in key commodity markets last year.

The UK’s Monetary Policy Committee on Thursday refrained from printing more money through QE, but kept rates at near zero on a raft of positive economic data.

The commodity rally fizzled out sometime in March this year, after the Fed completed its 12-month buying spree of Treasury and mortgage-backed loans under the first QE.

The run-up to QE2, which started way back in September, provided the second wind and boosted prices from gold to grains to new highs.

The markets may have greeted the QE2 with indifferent, but this is only because it was priced in months ago. Sugar price, for example, reached a 31-year high the day before the QE2 was announced.

“QE2 could spawn a commodity boom and inflate prices in nominal terms and bring about inflation, which could derail the recovery,” CIMB Research says.

The QEs were cooked up with the intention of lowering borrowing cost and boost the US recovery.

But, for all its intent and purpose, it now looks more like a dangerous gamble that puts the US dollar credibility at risk without delivering much growth.

By design, the QE was supposed to be pro-growth and pro-inflation, but the impact is being felt the most in emerging economies where price increases will do more damage than good.