Quantitative easing is a good way to address the current challenges, but care must be taken to deal with the possible consequences.
Readers may be familiar with the term "quantitative easing" that is being increasingly used to describe the monetary policy currently pursued by the developed markets, in particular the United States. Many people talk about the authorities "printing money", which may be easier to understand. But quantitative easing does not involve the actual printing of more banknotes. Rather, it involves flooding the money market — or more precisely, the interbank market of the domestic currency — with liquidity, so that the supply of money, at least among the banks, is abundant, and the price of money (interest rates in the interbank market) is kept very low. The hope is that this will benefit all borrowers and therefore provide support to the economy.
In practice, whether quantitative easing produces the desired results depends on the behaviour of the banks, in particular whether they pass on the abundant supply and low prices of money to borrowers. The credit-worthiness of borrowers may be a concern and the banks' capital adequacy for supporting the increased lending may also be a constraint. But normally quantitative easing does provide support to the economy and is helpful for cushioning or arresting a downturn.
Technically speaking, to effect quantitative easing, the central bank lends to or buys assets from the market. To settle these transactions, the central bank credits the clearing accounts of the banks with corresponding amounts. Money is therefore created, in contrast to the normal situation in which the central bank funds the acquisition of assets by some form of borrowing in the market so as not to affect monetary conditions - a practice called sterilisation in central-banking jargon. In Hong Kong, the sum of the mandatory clearing accounts of all the licensed banks with the HKMA is called the Aggregate Balance. If we were engaged in quantitative easing in Hong Kong, it would be effected through the HKMA buying assets, for example US dollars, from the licensed banks and settling the transactions by crediting the corresponding Hong Kong-dollar amounts required for the purchases to the banks' clearing accounts. The Aggregate Balance would increase as a result. This would increase the supply of money and lower the interest rates in the interbank market.
Central banks may or may not pay interest on the clearing balances of the banks, depending on the practices of different jurisdictions. In Hong Kong, the HKMA does not pay interest on the Aggregate Balance. In other jurisdictions, particularly those where reserve requirements are used as a tool for monetary control, requiring the banks to maintain reserves with the central bank, interest may be paid. This is the case, for example, on the Mainland. Whatever the case may be, the banks have little incentive to maintain balances in their clearing accounts above what is needed to fulfil the reserve requirement (if any) earning little or no interest. They would always prefer to lend the money, subject to proper management of credit risks, making borrowing easier and cheaper.
All this is fine in the short term and hopefully the economy will recover following the implementation of quantitative easing and other public policies. But, with a lot of money chasing a limited supply of goods, inflation is a potential risk, although it is not a matter of concern at the moment. The effect of very easy monetary conditions on asset prices is also a matter to be careful about; but again, in the heat of a global financial and economic crisis, this is not a major problem. Nevertheless, as I said a few weeks ago, it is never too early to talk about exit strategies from extraordinary actions taken to address a financial crisis. As more and more jurisdictions engage in quantitative easing, I believe it is important to establish effective exit strategies. Otherwise, different types of risks could be building up in the global financial system.
The past 18 months, in particular the last six, have been very eventful on the financial front, characterised by a near collapse of the banking systems in the developed markets of the United States and Europe. By comparison, Hong Kong has done well, with our financial system, in particular the banking system, remaining robust. But we all need to remain alert, particularly to the possible monetary and economic consequences of the extraordinary actions being taken by the authorities around the world.
26 March 2009
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