EMs join QE club: The context you need

Emerging markets (EM) central banks across the globe have recently unveiled asset purchase programs loosely referred to as “quantitative easing (QE).” Our macro team takes a closer look and considers potential investment implications.

Views expressed are those of the author and are subject to change. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional or institutional investors only.

Emerging markets (EM) central banks across Latin America, Asia, and Eastern Europe, as well as Turkey and South Africa, have recently unveiled asset purchase programs loosely referred to as “quantitative easing (QE).” This raises questions around what actually constitutes QE, why some EM countries are taking these measures amid the COVID-19 crisis, and the risks involved.

For many investors, such questions can best be approached via comparison with developed market (DM) QE programs. Through that lens, the differences between DM and EM varieties of QE are so great that we think the term “quasi-QE (QQE)” better describes the latter.

1. Different starting points

  • Policy rate: In DMs, QE typically comes into play when the policy rate is already at or near the zero lower bound (ZLB), making additional easing possible only through non-conventional measures. The US Federal Reserve (Fed), the Bank of England (BoE), and the Bank of Japan (BoJ) all opted for QE after reaching the ZLB. As shown in Figure 1, few EM central banks are currently facing this situation.

FIGURE 1

Monetary policy rates (%): Most EMs far form zero lower bound
  • Inflation rate: In contrast to tame inflation in most of the developed world, inflation in many EM countries that have implemented asset purchase programs is relatively high – in some cases, even above target levels. Although inflation risks appear to be firmly to the downside from here, the only EM countries we consider even remotely at risk of falling into deflationary traps are Thailand and Chile.

2. Different purposes

As non-traditional monetary policy tools, DM QE programs are designed to stimulate economic activity and to increase inflation toward target by lowering the medium- to long-term expected real interest rate. Generally speaking, the purpose of QQE in EMs falls under three categories:

  • Deficit financing: COVID-19 turmoil has exacerbated EM fiscal deficits, sharply reduced capital flows to EMs, and led many foreign investors to exit EM bond markets. All of this has put pressure on a number of local markets to finance government spending.
  • Liquidity provisioning: As bond markets froze in the early days of COVID, some EM central banks stepped in to provide liquidity and help smooth financial-sector functioning. The need for this type of QQE is generally (but not uniformly) expected to be short-lived.
  • Monetary stimulus: In a handful of EMs, QQE can be characterized as something conceptually closer to DM-style QE, with policy rates close to the ZLB and asset purchases intended to shift the yield curve downward.

3. Differing scale and scope

  • Scale: Most EM central banks have been vague about the size and scale of their asset purchases. But no EM QQE program comes anywhere close to the large-scale asset purchases to which DM central banks have committed. For example, the QE measures recently launched in the US amount to nearly 30% of the nation’s GDP! EM countries’ efforts pale in comparison.
  • Scope: Through their QE programs, DM central banks lowered longer-term rates by buying a wide range of securities. For example, the Fed’s purchase list included US Treasuries, agency mortgage-backed securities, and debt of government-sponsored enterprises. In contrast, some EM central banks are allowed to purchase only a narrow list of bonds due to laws prohibiting monetary financing of government deficits.

4. Different macro objectives

From a macro perspective, unlike in DMs, bringing up inflation is not a goal of most EM central banks at this juncture. Rather, the primary objective of EM QQE is essentially to support economic growth and/or financial stability, depending on the category of QQE.However, the GDP impact in EM countries is bound to be substantially lower than in their DM counterparts because:

  • As discussed above, the scale and scope of EM QQE measures are much more contained than that of DM QE.
  • EM financial markets are not nearly as deep as those in DMs, potentially limiting the impact of QQE.
  • The “informal” economy, which cannot be reached through the credit channel, is much larger in most EM countries.
  • Importantly, QQE measures are often intended to be very temporary in nature.

Bottom line: It’s not clear that QQE will have any meaningful direct effect on EM countries’ GDPs, but these programs are likely to have a more important impact on financial stability through the initial phase of this crisis.

5. Differing risks

The potential negative effects of QQE vary by EM country of course (Figure 2), but overall are somewhat different from those to which QE may expose DMs:

  • Institutions and governance: Perhaps the most significant risks relate to the credibility and quality of monetary and  fiscal policy institutions. For example, an independent central bank with a strong inflation track record is less likely to: a) give in to government demands for continued deficit financing; b) cause a drop in confidence, which can lead to unchecked inflation and currency weakness.
  • Debt sustainability: While monetary financing can be used as an emergency option for stronger EMs, its long-term risks, including higher levels of public debt, could be considerable. If a country’s debt looks unsustainable, QQE heightens the risk of the country getting hooked on debt monetization for an extended period, while risk premiums may increase as the market casts a suspicious eye on government policies.
  • FX mismatch and dollarization: QQE-related risks associated with a depreciating currency increase when FX liabilities exceed assets and when confidence in the local currency erodes, resulting in “dollarization.” Such currency substitution can magnify an initial shock to the exchange rate.
  • Strength of banking system: QQE in the form of liquidity provisioning has been accompanied by regulatory forbearance, easing capital adequacy, and regulations to avoid a freezing of the banking system. This may make sense provided the country’s banking system starts off on solid footing, but it can elevate future financial risks.
  • Scope of QQE: Naturally, the smaller the scope of QQE, the fewer and lower the risks are likely to be. Also, QQE aimed solely at liquidity provisioning carries less risk than fiscal-financing forms of QQE.

FIGURE 2

Risk of QQE by country (green+low risk, yellow+medium risk, red+high risk)

6. Different investment takeaways

Broadly speaking, the potential implications of QQE for investing in EM countries depend on one’s investment time horizon:

  • Short term: In general, we believe the inception of QQE should be viewed as a positive development for EMs. Given the relatively small size and scope of these programs, along with their temporary nature in many cases, they are unlikely to have much impact on credit quality in the short term, but they may help ease near-term financial stresses.
  • Medium/long term: The longer-term outlook is less clear, but as noted above, some EM countries may have difficulty weaning themselves off of central bank financing systems. This will be an important risk factor to watch going forward and could become a key source of EM credit-quality differentiation and country selection over a longer time horizon.

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