QE2 could mean the Cunard ocean liner of the last century or the sequel of a Hollywood movie. Today, it stands for the second round of quantitative easing or creation of extra cash by the United States Federal Reserve. It could set the course of the American economy - or destabilise other economies. Governments and central banks usually have two macro tools to stimulate growth in a recessionary economy - monetary and fiscal. The authorities could use the monetary tool and slash interest rates, thereby boosting demand and, in turn, money supply. Using the fiscal tool entails increasing public spending or cutting taxes or both.
What is QE?
When interest rates go down to a point beyond which they cannot be lowered, central banks pump money into the economy directly. That is quantitative easing. Central banks do this by printing more money to buy financial assets (government or corporate bonds). The institutions that sell the bonds will have more "new money" in their accounts, which, in turn, boost money supply. That is the theory. The first round of QE by the Fed began in September 2008 and continued till December 2008. But the pace of recovery in output and employment continues to be slow in the US, according to the Federal Open Market Committee (FOMC). So, the FOMC is going for QE2. It intends to buy $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.
What Does it Mean for Emerging Markets?
Prima facie, this is good news for the emerging markets as excess liquidity and low interest rates mean higher capital flows into the high-risk but high-return emerging markets. Estimates by the Washington-based Institute of International Finance, or IIF, indicate that net private capital flows to emerging economies are expected to rise to $825 billion in 2010 from $581 billion in 2009.
The wave of liquidity charging towards global commodities and attractive emerging market assets may stoke inflationary pressures and push emerging market currencies upwards. There is also the danger of an emerging market bubble like in 1990-94.
What Does it mean for India?
Given its strong growth momentum and ability to absorb capital inflows because of a large current account deficit, India could be among the key beneficiaries of foreign investment looking for higher returns in the emerging markets. However, large capital flows beyond the absorptive capacity of the economy could pose a major challenge for exchange rate and monetary management.
The fresh bout of liquidity infusion is likely to increase inflows from foreign institutional investors, or FIIs, especially in the context of the capital controls enforced by several developing economies such as Indonesia, Thailand, Taiwan and Brazil.