While gigantic monetary stimulus in the G7 over the years – and most recently in the form of quantitative easing (QE) by the US Federal Reserve and the ECB’s long-term financing operations (LTRO) – has been designed to reflate Western bank balance sheets, it’s never been clear just how much capital has flooded directly into emerging markets thanks to the liquidity injections.
Enter Barcap analysts Laurent Fransolet and Guiseppe Maraffino. In a new research report examining how the funds from the first round of the ECB’s first three-year LTRO were used, the BarCap analysts suggest that the direct impact of the ECB’s actions on EM market liquidity, capital flows and currency valuations was likely extremely limited.
Fransolet and Maraffino calculated that of the €489 billion in total borrowing under the three-year LTRO, 63% was borrowed by banks from peripheral European countries, with almost all of this used to pre-fund maturing bank bonds and to replace lost market funding, while much of the borrowing from core eurozone banks was also likely for pre-funding purposes. As a result, they estimate that just €50 billion of the net new borrowing as a result of the LTRO was for carry-trade purposes – i.e. – could have directly resulted in inflows into EM asset classes, although the likelihood is that the bulk of these funds was directed elsewhere.
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The analysts predict that total borrowing under the ECB’s next three-year LTRO, scheduled for late February, will be lower, at between €250-350 billion, of which around €50-75 billion will be for carry trade purposes. Now clearly €100-120 billion in net new borrowing for carry trade purposes is by no means insignificant. But at the same time, it is hardly likely to trigger a tidal wave of capital inflows into emerging markets, and pales in comparison to the Fed’s QE efforts.
On the latter, Fed chairman Ben Bernanke signalled last week thathe was prepared to sanction a further round of quantitative easing should the Fed deem that “the recovery is faltering or if inflation is not moving toward target”.
This has prompted predictions of a fresh flood of fund flows to higher-yielding emerging markets, pointing to the impact of QE1 and QE2 on emerging market capital flows and currencies.
However, its likely impact will be indirect. For example, as Bank of America Merrill Lynch analysts Claudio Piron and Christy Tan point out, from an Asian currency perspective at least, while QE1 resulted in a major FX rally, QE2 had much less of an impact due to the negative growth outlook and mounting eurozone concerns (see chart, courtesy of BofAML).
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What’s more, base effects matter, as Nomura’s Peter Attard Montalto told Emerging Markets:
| We’ve already had two bouts of QE in the US before, so any third bout is likely to be of less impact. |
IMF chief economist Olivier Blanchard has argued forcefully on a number of occasions that the view that previous rounds of quantitative easing have directly exacerbated capital flows to emerging markets is incorrect. As he told an Emerging Markets Forum meeting in October 2010:
| The notion that the Fed’s expansion of its balance sheet has by itself – that is independently of its effect on interest rates – had an impact on capital flows to emerging markets is not correct. There is no mechanical link between the size of a central bank’s balance sheet and capital flows, especially to emerging markets. |
Nevertheless, Montalto added that liquidity action by the ECB, either in the form of a second round of its long-term refinancing operations (LTRO) due at the end of February, which Montalto described as “QE light”, or through liquidity-boosting measures, would likely have a greater market impact than a third round of QE by the US Fed.
Of course, a second round of the ECB’s LTRO would have a significant impact in helping to shore up EU bank solvency, while QE3 would undoubtedly boost market sentiment in the US, all of which would in turn likely have a knock-on impact on EMs.
But the direct cash flow transmission from the Fed/ECB’s coffers to EM is likely to be limited.