Quantitative Easing and the Chaos in Global Markets.. lets make some sense out of it.

A recent furore in the international markets, made it unavoidable for me to dig deep down to know more about the Issues, Context and Solutions of Quantitative Easing. So here I present you a sojourn from Japan, Iceland, Europe and the inevitable US.

The global financial system already has seen a long and unsuccessful catastrophe in quantitative easing(QE) in Japan. The carry trade that sprang from Japan's financial bubble bursting event after 1990, BOJ's liquidity enabled the banks to lend yen credit to arbitrageurs at a low interest rate to buy higher-yielding securities. Iceland was paying 15 per cent. So the Japanese yen were converted into foreign currencies,which in turn pushed down its exchange rate.

Japan that refined the business of carry trade and is responsible for what it is today. After its financial and property bubble burst, BOJ empowered its banks to earn their way out of negative equity by supplying them with low-interest credit for them to lend out. Japan's recession shrunk the demand at home, so its banks developed something called as "the carry trade":a process of lending at a low interest rate to arbitrageurs at home and abroad, to lend to countries offering the highest returns. Yen were borrowed to convert into dollars, euros, Icelandic kroner and Chinese renminbi to buy government bonds, private-sector bonds, stocks, currency options and other financial instruments. This carry trade was capped by foreign arbitrage in bonds of high growth(read GDP)countries such as Iceland, who payed up to 15 per cent. This kind of funding was not used to finance formation of new capital or revenue generation. It was purely financial in character serving extractive, not productive purposes.

By the year 2006, after a self funded war on an already inflating budget deficit, the US and Europe started experiencing a Japanese dejavu financial and real estate bubble. After Freddie Mac and Fannie Mae pin-pricked the bubble in 2008, they did what Japanese banks had done after 1990. Seeking to help U.S. banks work their way out of negative equity, the Fed flooded the economy with credit. The idea was to provide banks with more liquidity, so that they would lend more to domestic borrowers. As was thought, the economy would engage itself in constructive investment and a new boom market would start. It was strongly believed the economy would borrow its way out of debt. But what happened was really dreadful, the extra sloshing money fuelled the speculative investments and re-inflated asset prices in real estate, stocks and bonds so as to stop home foreclosures and thus starting another series of optimistic loans from banks which ensured the total wipe out of all the collateral on bank balance sheets.

The same kind of Phenomenon is happening again,albeit on a much global scale, where the U.S. liquidity is spilling over to foreign economies, increasing their exchange rates. In a sense, instead of helping the global recovery, the "flood of liquidity" from the Fed and ECB is causing "chaos" in foreign exchange markets in the name of Quantitative Easing (QE).

The most recent debatable Quantitative Easing has been pinned on the echelons of hope and false optimism. It provides bank customers, not banks, with loanable funds. Central Banks supply commercial banks with liquidity in order to facilitate smooth functioning of interbank payments and customer and government transactions, but what banks lend is their own debt, not that of the central bank. The purpose of the funds will depend not only on the adequacy of the supply of fund, but evaluting if the environment is encouraging to real investment. QE subsidizes U.S. capital overdraft, and flushes money in a spillover effect to push non-dollar currency exchange rates. There is an amazing video which tells what is QE doing for America.

http://www.youtube.com/watch?v=PTUY16CkS-k.

The Team Bernanke's credit creation measures is not in any way increasing bank loans to real estate, consumers or businesses. The Banks are not lending, at least in the US. They are collecting on the past defaulted loans. This is why the U.S. savings rate is suddenly spiking. We could compare this phenomenon in the same way as hoarding diverts revenue away from being spent on goods and services, thus debt repayment shrinks the disposable income which can be spent.

So The Ben Bernanke(Fed) created $2 trillion in new Federal Reserve credit last year, and again another $1 trillion over the coming year. This is what has led gold prices to surge and investors to move out of weakening paper currencies, since September 2010. On the contrary, it is surprising to note that banks are not lending to an economy which is in need of liquidity and is being shrunk by debt deflation. The quantitative easing has been sent abroad with an purpose to gain from maximum returns. It is been pushed to the BRIC countries: Brazil, Russia, India and China. The frenetic borrowing from U.S., Japanese and British banks to buy bonds, stocks and currencies in the BRIC and Third World countries is on a self-feeding expansion. Speculative inflows into these countries are pushing up their currencies as well as inflating their asset prices.

Now lets see what it is doing for THE REST OF THE WORLD.

Central Banks are trying and insulating their economies, in a way immunizing or delineating itself from the Volatile Dollar. This measure has now come been criticized by the US. Japan is trying to hold down its exchange rate by selling yen and buying U.S. Treasury bonds. China has tried ways to recycle its trade surplus, by buying out U.S. companies. The US, on he other hand, did not let CNOOC buy into U.S. oil refinery capacity a few years ago and is now urging the Canadian government to block China's attempt to purchase its potash resources. This leaves little option for China and other countries but to hold their currencies stable by purchasing U.S. and European government bonds. Brazil has been more a victim than a beneficiary of capital inflow. The inflow of foreign money has pushed up the Brazilian Real by 6 per cent in just three months. This has eroded the competitiveness of Brazilian exports. Thailand's is considering taxes and currency trade restrictions like one on the purchases of foreign bonds in wake to stop the rising Baht. The RBI's steps are very shaky on acting against the threat of inward capital flows, albeit their government inclinations towards would diplomacy seems to be more than its people.

Such inflows cannot be trusted as they are very volatile and short term parkings. They can never be considered as tangible investment. These funds cause currency fluctuations and disrupts trade patterns as they create and serve the purpose of Short term Speculators. It is also a shame that Speculators also encompass large financial institutions and their customers. Most of the academic and policy-making discussions about the exchange rate treat the balance of payments and exchange rates as determined purely by commodity trade and purchasing power parity. The reality speaks a different tale where the foreign financial flows and military spending that actually have generally been seen dominating greater portion of the balance of payments.

This capital outflow from the U.S. has indeed helped the US banks rebuild their balance sheets, as the Fed wamted to. In the process, the international financial system has been plagued by more damages than it has rescued America.