The total size of balance sheets of the Fed, ECB, Bank of Japan (BOJ) and People’s Bank of China (PBOC) is USD 14 trillion. This has gone up from USD 5.5 trillion seen in 2008. Central banks have been busy printing money to ward off the effects of the financial market crisis of 2008. The total size of the top four Central Banks balance sheet is growing with ECB and Bank of Japan pumping in USD 125 billion of liquidity a month through bond purchases and PBOC adding on to its fx reserves of over USD 5 trillion.
Dr. Raghuram Rajan, the RBI governor is getting nightmares from the scale of QE (Quantative Easing) by the central banks. He is worried about the repercussions of the excess global liquidity brought about by the swelling central bank balance sheets. Rains bring prosperity but too much of rain causes floods creating havoc and Dr. Rajan is worried about the floods.
Dr. Rajan wants global central banks to focus on the repercussions of their actions on international markets. He wants a common global framework within which monetary policy should operate. For example, Fed when it is undertaking QE or hiking interest rates should take into account the effects of its actions on other economies of the world.
The financial markets are doing the job of internalization of monetary policy at present. The unrestricted movement of capital has ensured that global central bank actions are transmitted globally. Fed, ECB or BOJ QE leads to weakening of the USD, Euro and JPY making these currencies “Carry Trade Currencies” where markets borrow cheap and invest elsewhere in the world for higher returns.
Fed, ECB or BOJ undertake QE to bring about growth and inflation in their economy’s as it is their mandate to do so. The mandate is given to them by their respective political system and to change this mandate is a political process.
Financial markets are prone to euphoria and depression as seen before and after 2008. However, markets are efficient allocators of capital, going to where returns are expected to be the highest. Since 2008, even as central bank balance sheets rose, commodity prices have fallen, USD has appreciated against most emerging market currencies, equity markets have risen to record highs in many countries while bond yields have fallen. Chart 1 to Chart 4. Markets have been selective on where to deploy the liquidity.
The problem countries like India face is the volatility caused by ebbs and flows of global risk aversion. In times of high risk aversion, the currency bears the brunt of capital outflows and a weakening currency becomes politically unacceptable. In July 2013, when the INR went on a free fall on the back of Fed talks of tapering QE, RBI was forced to tighten liquidity and raise cost of overnight funds to stem the currency fall. Usually, such knee jerk reactions to volatility leads to further fear in markets and faster pace of depreciation.
RBI is effectively framing its monetary policy giving a good weight to global central bank actions. Given this, domestic financial markets are discounting global central banks policies in prices, which is actually the “Internationalization of Monetary Policy”.
The need for an International Monetary Policy Framework is not apparent as markets do that job.