INTERNATIONAL FINANCE TERM PAPER 2015

Quantitative Easing in US and its impact on India

Name: Piyush Ramchandani

Roll No: F-59
M.M.S. II Finance (2014-16)

Table of Contents

Sr. No.

Title

Pg.No.

1.

What is Quantitative Easing

2.

Importance of Quantitative Easing

3.

Myths about Quantitative Easing

4.

Reasons to adopt Quantitative Easing

5.

The downsides of Quantitative Easing

6.

Examples of Quantitative Easing

7.

Quantitative Easing in the US

8.

Impact on US economy

12

9.

Impact on Indian economy

12

10.

Bibliography

13

Piyush Ramchandani | F-59 | MMS-II (Finance) | JBIMS

Quantitative Easing in US and its impact on India

What is Quantitative Easing

The term Quantitative Easing became a popular jargon in 2009. Central banks are
responsible for keeping inflation in check. Before the financial crisis of 2008-09, they
managed that by adjusting the interest rate at which banks borrow overnight. If firms were
growing nervous about the future and scaling back on investment, the central bank would
reduce the rate. This would reduce banks funding costs, encourage them to make more loans
and keep the economy from falling into recession. On the other hand, if credit and spending
were growing out of bound and inflation was rising, central bank would reduce the rates.
When the crisis struck, big central banks like the Fed and the Bank of England initially
reduced the rates to boost the economy. But, even reducing the rate as far as possible, to
almost zero, failed to initiate recovery. Central banks therefore began experimenting with
other tools to encourage banks to pump money into the economy. One of them was
Quantitative Easing.
Quantitative Easing refers to changes in the composition and/or size of the central
banks balance sheet that are designed to ease liquidity and credit conditions. To carry out
QE, central banks create money by buying securities, such as government bonds, from banks,
with electronic cash, that did not exist before. The new money swells the size of bank
reserves in the economy by the quantity of assets purchased hence the term Quantitative
Easing.
The first instance of QE by U.S. was in 1932, when Fed purchased approximately $1
billion in treasury securities. In early 1933, Congress permitted Fed to purchase up to $3
billion in securities directly from the Treasury. The next instance was in December 2008,
when the Federal Open Market Committee announced its intent to purchase up to
approximately $1.7 trillion of agency debt, agency-guaranteed mortgage-backed securities
and Treasury securities.

Importance of Quantitative Easing

Central bankers do not attract much notice if economies are running smoothly. They
usually come across as calm, politically neutral and academic. The global financial crisis
shattered this image. It forced central bank into the middle of policy discussion about key
issues like growth and employment. First off, central banks use QE when their conventional
tools (mainly, interest rate changes) no longer have much effect. In the US, benchmark
interest rates have essentially been at zero since late 2008. Yet US unemployment is at an
alarming 8 per cent with 12.5 million people out of work. QE has been used in large, mature
economies to fight economic growth and high unemployment.
Quantitative easing is the large-scale purchase of assets such as mortgage-backed
securities and Treasury securities. When the Central bank makes such purchases, the demand
for those assets and their prices increase, driving down interest rates. As interest rates fall, the

Piyush Ramchandani | F-59 | MMS-II (Finance) | JBIMS

Quantitative Easing in US and its impact on India

cost to businesses for financing capital investments, such as new equipment, decreases. Over
time, new business investment should bolster economic activity, create new jobs, and reduce
the unemployment rate.
Quantitative easing is supposed to benefit the economy because the cash that the FIs
receive from the central bank for the assets can then be loaned to borrowers. Hence
consumers and businesses will borrow and spend more as interest rates drop. Through the
purchase of long-term government bonds, the central bank decreases yields and,
consequently, overall financial costs. QE also impacts the economy by devaluing the home
currency hence making export goods more competitive. Therefore it is believed that the
increase in government expenditure will lead to increased consumption, which will further
increase the demand for goods and services, thus fostering job creation and, ultimately,
creating economic vitality.
Myths about Quantitative Easing
QE is printing money: Politicians, journalists and market participants often refer to QE as
printing money. But, it doesnt actually do anything to increase the amount of money in
circulation. When government buys bonds from banks, it merely rises the price of that
particular type of bond and lowers the interest rate. Lower interest rates might encourage
consumers to take out loans, but it wont actually lead to more money in the system unless
banks create money through making loans. And banks wont do that unless they identify
profitable lending opportunities.
QE will eventually lead to inflation: In economics, inflation is defined as an ongoing rise
in the general level of prices. During inflationary periods, a single dollar buys less every
year. Since the central bank is not printing money and not directly increasing the amount
of money in the system, it is not stocking inflation. This does not imply that Central
Banks policy cant ever lead to inflation. But the idea that interest rates are low right now
doesnt make a lot of sense given the large amount of slack in the economy as shown by
high unemployment and stagnant wage growth.
QE is responsible for recent stock market highs: Central bank buying bonds will cause
bond prices to go higher and interest rates to be lower, and this will encourage investors to
choose stocks over bonds at the margin. But no amount of federal bond buying is going to
cause a particular stock to be a good buy if an investor doesnt think that the stock will
provide a return. QE may boost profits by reducing the interest rates firms have to pay on
their debt, but it is not going to create profitable enterprises out of this solely.
Central bank is financing the treasury: Central bank buys bonds in the secondary
market that have already been issued by the treasury. Central bank is not buying
treasury securities because there is a lack of demand in the open market, but because it
is implementing its monetary policy. The only time a central bank would be required to
purchase bonds to meet a Treasury funding shortfall is if investors refused to purchase
them and the Central bank had to step into the breach.

Piyush Ramchandani | F-59 | MMS-II (Finance) | JBIMS

Quantitative Easing in US and its impact on India

Reasons to adopt Quantitative Easing

Under extremely adverse circumstances, a Central Bank can cut the nominal interest
rate all the way to zero and still be unable to stimulate the economy sufficiently. Such a
situation in which the nominal rate hits its zero lower bound, is called liquidity trap. If
inflation then falls, the real interest rate rises, squeezing the economy even more. If flattening
the yield curve and shrinking risk premiums can boost aggregate demand, then monetary
policy is not powerless at zero lower bound.
Quantitative Easing is an unconventional and often assumed to be the last resort to
restore the economy. Various reasons to adopt QE can be: Prevalent low interest rates with low scope to lower them further
To stimulate economic growth by increasing lending to private sector
To tackle deflation or to prevent inflation to fall below a set target in the short term
Downsides of Quantitative Easing
The first potential danger of QE is that it increases the likelihood that long run inflation
could increase well above the Central banks inflation objective. The supply of money
(M1) can be increased massively with a relatively small reduction in excess reserves
because the effective reserve requirement is at a historically low level. Hence, the current
level of excess reserves could create a massive increase in the money supply should banks
significantly increase their lending or investing.
A second reason is the considerable disagreement between economists and policymakers
about whether and to what extent money growth per se is inflationary. In the macroeconomic model commonly used for the analyses of monetary policy, inflation is
determined by inflation expectations and the gap between actual and potential output.
A third reason for concern is that employment growth is uncharacteristically slow during
this recovery. Let us take an example of US post financial crisis. At fifteen months past
the recessions end, employment was only slightly above its post-recession trough.
Given that additional quantitative easing may have only modest effects on economic
growth, employment or inflation and the potential to significantly exacerbate the Central
Banks problems when the time comes to restore the balance sheet to a more normal
configuration, it is easy to understand the considerable disagreement about the desirability of
such a policy. Some policy makers believe that potential benefits of Quantitative easing are
lower than the potential costs.

Piyush Ramchandani | F-59 | MMS-II (Finance) | JBIMS

Quantitative Easing in US and its impact on India

Examples of Quantitative Easing

ECBs Fix ed Rate tende r , full all otm ent progr ams: - The 3-month Euribor /
overnight indexed swap (OIS) spread widened as financial conditions deteriorated. On
October 10,
2008, the spread hit an all time high of 198 basis points, which reflected the sharp rise in
counterparty risk. The ECB responded to these widening spreads on October 15, 2008,
with first measure of QE: The ECB announced it would lend as much as banks wanted at
a fixed-rate tender provided the banks had collateral while also expanding the list of
eligible collateral. These fixed-rate tender, full-allotment (FRFA) operations reversed the
ECBs conventional policy of offering a fixed allotment of funds at rates determined by
the bidding process.
The ECB implemented the FRFA liquidity provision through its usual lending
procedures. In normal times, the ECBs primary policy instrument is refinancing
operations, direct lending to banks against eligible collateral at two maturities. Main
refinancing operations (MROs) have a period of two weeks and longer-term refinancing
operations (LTROs) have a period of three months. In the usual MROs and LTROs, the
ECB predetermines the amount of funding available and auctions those funds by price.
Under the new policy, the ECB filled all MRO and LTRO loan requests at the ECBs
primary policy rate, the main refinancing rate. From October 2008 to May 2009, the
ECB cut this rate from 4.25 percent to 1 percent.
Bini Smaghi (2009) calls the FRFA liquidity policy endogenous credit easing
because banks demand for liquidity at the fixed-rate tender determines liquidity.

Piyush Ramchandani | F-59 | MMS-II (Finance) | JBIMS

Quantitative Easing in US and its impact on India

 Feds Q E1 Programs: While the ECB expanded bank lending operations, the Federal
Reserve pursued outright asset purchases. On November 25, 2008, the Federal Reserve
announced plans to purchase $100 billion in government-sponsored enterprise (GSE)
debt and $500 billion in mortgage-backed securities (MBS) issued by those GSEs (Table
1A).15 On March 18, 2009, the Fed announced additional purchases of $100 billion in
GSE debt, $750 billion in MBS, and $300 billion in long-term Treasury securities.
The Feds November 2008 and March 2009 asset purchase programscommonly
called QE1were designed to support the entire economy but they naturally
prioritized housing credit markets, which had been especially hard hit by the 2006-08 fall
in U.S. real estate prices, sales, and construction. Housing GSE debt and MBS accounted
for more than 80 percent of the assets purchased by the Federal Reserve in its first round
of QE, or LSAPs; these assets were directly linked to housing market credit. The Federal
Open Market Committee (FOMC) stated that the goal of the initial LSAPs was to
reduce the cost and increase the availability of credit for the purchase of houses, which
in turn should support housing markets and foster improved conditions in financial
markets more generally.The November 2008 and March 2009 purchases lowered longterm real U.S. interest rates through their effect on term premia. These purchases
substantially increased excess bank reserves.
The B ank of J apans spe cial -funds-suppl ying operations: Following closely on the
heels
of the Feds November 25 asset purchase release, the BOJ announced on December 2,
2008, that it would lend unlimited amounts to banks at near-zero rates through specialfunds-supplying operations (SFSOs), which were much like the ECBs lending
operations. The SFSOs offered 3-month loans to banks at the uncollateralized overnight
call rate, which was then at 0.3 percent. The only limit on the size of the loans from the
BOJ to banks was the amount of available collateral (commercial paper and corporate
debt). The SFSOs, like the ECBs FRFA repurchase agreement (repo) auctions,
constituted QE because they increased the monetary base. On December 19, 2008, the
BOJ followed this action by lowering the overnight call rate to 0.1 percent and
announcing an increase in outright purchases of Japanese government bonds (JGBs) and
a new program to purchase corporate financial instruments.
The B ank of En glands p rograms: After some initial reluctance to engage in credit
easing or QE, U.K. authorities announced plans to purchase assets for these purposes in
January and March 2009. On January 19, 2009, Her Majestys (HM) Treasury announced
the establishment of the Asset Purchase Facility (APF), which was to be operated by the
BOE. The BOE conducted two separate and distinct asset purchase programs through
this newly established APF: private asset purchases to ease specific credit conditions and
more traditional QE for monetary stimulus. HM Treasurys January 19, 2009,
announcement inaugurated the private asset purchase program; it authorized the BOE to
buy up to 50 billion in high quality private sector assets to increase the availability
of corporate credit, by reducing the illiquidity of the underlying instruments. Because
HM Treasury issued (sold) short-term gilts to finance the purchases, every asset that the

Piyush Ramchandani | F-59 | MMS-II (Finance) | JBIMS

Quantitative Easing in US and its impact on India

BOE purchased was matched by a sale of a short-term gilt and so the BOEs liabilities
(the monetary base) did not initially increase. That is, this was not initially QE. The BOE
later described its private asset purchases as an example of the Bank acting as market
maker of last resort (BOE, 2012). The BOE likewise purchased corporate bonds through
a reverse auction; potential counterparties bid on the price at which they would sell assets
to the BOE. The program was designed so the BOEs appeal as a counterparty would
diminish as market conditions improved.

In summary, from 2008 through 2012, three central banks (the BOE, BOJ, and ECB)
purchased assets with private credit risk exposure, removing such risk from the publics
balance sheet. Three central banks (the Fed, BOJ, and BOE) attempted to use asset purchases
to stimulate the economy through traditional interest rate channels by purchasing long-term
assets, reducing the amount of duration held by the public and thus lowering long-term real
interest rates. All four central banks used asset purchases to improve the functioning of
specific markets.

Piyush Ramchandani | F-59 | MMS-II (Finance) | JBIMS

Quantitative Easing in US and its impact on India

Quantitative Easing in the US

In 2008, the Federal Open Market Committee (FOMC) lowered the federal funds rate
to zero, forcing the FOMC to rely on non-traditional monetary policies such as Quantitative
Easing (QE). QE occurs when the Federal Reserve increases its balance sheet through the
purchase of long-term securities to lower long-term interest rates in order to avoid deflation,
and simulate the economy. Currently, there have been three rounds of QE in the United
States: QE1, QE2, and QE3.

QE1:
The FOMC November 25, 2008 announcement indicated the Federal Reserve would
purchase up to $100 billion in agency debt and up to $500 billion in agency MBS through
a series of competitive auctions over several quarters. This event marked the beginning of
QE1, a change in monetary policy unanticipated by the market.
The FOMC December 16, 2008 announcement stated the Federal Reserve would
purchase large quantities of agency debt and mortgage backed securities and stood ready
to expand its purchases. The Federal Reserve December 30, 2008 announcement stated the
Federal Reserve expects to begin operation in early January announced program to
purchase MBS and that it has selected.
The FOMC March 18, 2009 announcement further increasing the size of the Federal
Reserves balance sheet by purchasing up to an additional $750 billion of agency MBS
and $100 billion of agency debt

Piyush Ramchandani | F-59 | MMS-II (Finance) | JBIMS

Quantitative Easing in US and its impact on India

 The FOMC November 4, 2009 announcement indicated $175 billion of agency debt
would be purchased, far less than the previously announced maximum of $200 billion,
and reiterating the program would be completed by the end of the first quarter of 2010.
The Committee followed through and by the end of March, the remaining purchases had
been completed and QE1 came to a close.

Federal Reserve System Assets: January 2007 December 2014

QE2:
The FOMC August 10, 2010 announcement in which the Federal Reserve implemented a
new policy to keep constant the Federal Reserves holdings of securities at their current
level by reinvesting principal payments from agency debt and agency mortgage-backed
securities in longer-term Treasury Securities.
After the initial expansion of the Federal Reserves balance sheet during QE1, the Federal
Reserve did not pursue additional purchases or re-investment of MBS and agency debt
which resulted in a decrease in the size of the Federal Reserves balance sheet.
The Federal Reserve changed its policy to prevent possible deflation from a decrease in
the money supply.

Ramchandani | F-59 | MMS-II (Finance) | JBIMS

10 Piyush
Quantitative Easing in US and its impact on India

 The FOMC November 3, 2010 announcement marked the official beginning of QE2. In
the announcement, the FOMC declared it intends to purchase a further $600 billion of
longer-term Treasury securities by the end of the second quarter of 2011, at a pace of
about $75 billion per month.
QE3:
The FOMC September 13, 2012 statement marking the official announcement of QE3.
The FOMC stated it intended to purchase additional agency mortgage-backed securities
at a pace of $40 billion per month.46 In contrast to QE1 and QE2, no time table was
given for the end of the program and the total size of the stimulus remains unknown.
Nov 2008 - Mar 2009
QE1 initiated. Fed buys $100 billion of agency debt, and $500 billion of MBS

Mar 2009 - Mar 2010

QE1 extended. Fed purchases another $750 billion of MBS

Nov 2010 - Jun 2011

QE2 initiated. Fed buys $600 billion of long term treasury bonds at $75 million per
month until mid 2011

Sep 2011 - Jun 2012

Operation Twist initiated. Fed buys $400 billion worth of treasuries with maturities
between 72 and 360 months, and sold off treasuries with maturities between 3 and 36
months

Sep 2012 - Oct 2014

QE3 initiated. Fed buys $40 billion worth of MBS
QE Timeline
Ramchandani | F-59 | MMS-II (Finance) | JBIMS
11 Piyush
Quantitative Easing in US and its impact on India

Impact on US economy
In the years following the recession and financial crisis, private sector forecasters
pushed their expected time for the tightening of monetary policy progressively further into
the future, presumably in response to the Federal reserves quantitative easing and
increasingly aggressive forward guidance for the Federal funds rates, in the context of a slow
economic recovery with moderate inflation. Although the Federal reserves quantitative
easing program likely helped to stabilize the economy during the financial crisis it provided
liquidity in financial market, the FOMCs unconventional policy actions provided no material
additional monetary policy stimulus in the first two years following the financial crisis.
The Dollar base grew tremendously and was responsible to pull USA out of deflation.
The Inflation figure was successfully maintained near the 2% mark. An independent study
also suggested that there was Leakage of the money being pumped into the system. About
40% of the money pumped in during QE1 leaked out as Gross Capital Outflows. The amount
stood at 33% during QE2. FOMCs actions do appear to have appreciably sped up the pace of
recovery from 2011 on as the private sector began to learn that monetary policy was going to
remain substantially more accommodative than usual over a long period of time.
Impact on Indian economy
India has been significant beneficiary from the Global Monetary Easing program.
India received as much as $88 billion of capital inflows, despite deteriorating macroeconomic
conditions, as also weak corporate fundamentals. The impending QE tapering should,
therefore, have consequences for India and this is unlikely to be painless, especially when the
current account deficit CAD 2013 is unlikely to be much less than $100 billion.
Immediate impact would be in the bond market where the FII investors had some $30
billion of investments, with an outflow of just under $10 billion by the FII from the Indian
bond investment since June 2013 has created veritable turmoil in the Indian currency market
with rupee plunging in excess of 10 percent against the dollar during the period. The rupee
fall has started affecting the equity market, too with weakening corporate
Fundamentals Unabated global liquidity on the back of QE has lead to increase commodity
prices, which in turn worsened Indias CAD. Increased inflation, reduced domestic saving
and moderated profit margin, In addition to it $170 billion of foreign currency short-term
borrowing remains unhedged. The monetary policy that India hopes to revive was
substantially delayed; the rupee could continue to be under pressure if the financials of
corporate India could be further weakened.

Ramchandani | F-59 | MMS-II (Finance) | JBIMS

12 Piyush
Quantitative Easing in US and its impact on India

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Ramchandani | F-59 | MMS-II (Finance) | JBIMS

13 Piyush
Quantitative Easing in US and its impact on India