Discuss about the Impact of Quantitative Easing on the Credit Risk.
During 2015 January, ECB embarked in Quantitative Easing or expanded asset purchase program for reducing the negative impact from low inflation. This relevantly helped European Central Bank to achieve their monetary objective of price stability. According to Ecb.europa.eu (2018), year on year increase in harmonised index mainly helps in increasing price stability, where consumer price for euro area are below 2%. The European Central Bank conducts Quantitative Easing by buying predetermined amount of euro sovereigns and institutions investment grade debt securities. This measure would allow European Central Bank to increase money supply and reduce market interest rate. This relatively allows the bank to increase their lending and introducer cheaper loans. This could allow the consumers to spend more and business will increase their investments.
Figure 1: Inflation rate of Euro Area
(Source: Tradingeconomics.com, 2018)
The above figure mainly depicts the overall change in inflation rate of Euro area after the implementation of Quantitative Easing by European Central Bank. The inflation was lagging behind, which increased after the measure and hovered around 2% inflation rate. This raising inflation rate would negatively impact bond prices and value.
European Central Bank has used Quantitative Easing previously during the economic crisis of 2008, which helped in piking up the EU economy. During 2015 the main concern faced by European Central Bank was deflation risk and economic downturn. Hence, for curbing the negative impact of risk Quantitative Easing is used to control the problems faced by Euro zone. The Quantitative Easing method mainly used €1.1 trillion for easing the euro market, where €60 billion has been used for buying treasury bonds every month. This measure has mainly allowed European Central Bank to raise the level of monetary policy, which could instigate their financial performance. Claeys & Leandro (2016) argued that increment in inflation rate could raise prices of the essential goods, where it hampers livelihood of individuals. The European Central Bank has increased the buying pressure on Bonds and allowed banks with high liquidity, which in turn would increase low cost loans that will be provided by banks. This might increase cash flow in the economy and boost purchasing power of consumers. This high consumer purchasing power would increase inflation rate and prices of the products, which could boost financial performance of organization. In this context, Fratzscher Lo & Straub (2018) stated that rising inflation rate would eventually allow the company to generate high revenue, as it increase prices of the product.
This rising cash flow in the economy would eventually hamper the valuation of bond, as rising inflation rate could nullify the actual return from investment. From the evaluation it could be understood that inflation rate is mainly analyzed by investors to understand the actual value of bond. Moreover, the increment in inflation rate by government intervention would hamper investment in bond, as it increases loss for investors. The inflation rate mainly erodes the benefits, which is provided by bonds. Furthermore, being a fund manager rising inflation rate would raise concern, as relevant portfolio will incur loss due to the erosion of profits by time value of money. This would hamper profitability and return from investment of the designed portfolio. The European bonds will be affected by the rising inflation in Euro zone from the steps taken by European Central Bank. In this context, Braun (2016) mentioned that after Brexit and Greece on the brink the use of quantitative measure would allow European Central Bank to improve the deflating inflation condition. Moreover, the first bonds that will lose value is zero coupon bonds, as value of bond will erode due to sudden rise in inflation rate. The inflation rate before 2015 was mainly at the level of 0.61%, while it increased to 2% in 2017. Therefore, it could be assumed that investors having investment in bond when inflation rate of 0.61%, will lose 1.39% return in 2017 in accordance with the rising inflation rate. This could eventually reduce the attraction of bond and force the investor to exit the investment. However, Koijen et al., (2017) argued that bond investment during high inflation reduces its value and attractiveness, while demand for stocks fairly increases in the expectation of high return provided by the companies.
Figure 2: Investment in bonds by European Central Bank
(Source: Ecb.europa.eu, 2018)
The above figure indicates the overall investments, which is been conducted by European Central Bank. This detection of investment would eventually help in understanding the overall cash flow from investment, which increase cash in the market and motivate customers to spend more. The investment is mainly conducted on public sector, corporate sector, asset-backed securities, and third covered bonds Moreover, the rigorous investment increased inflation rate in euro area, which could increase cash flow in the market. The data in figure 1 indicates that inflation rate was negative, which indicates reduced growth in Euro area. However, there are negative impact from the quantitative easing used by European Central Bank, where asset shortage, problems in structural reform and chances of financial bubbles was identified. This relatively indicates that Quantitative Easing would eventually raise problems for investors having portfolio consisting of both bonds and shares. The problems faced by investor will be the declining value of bonds and chance of financial crises due to bubble creation (Blinder et al., 2017).
The performance and evaluation of the portfolio needs to be conducted, which will be negatively affected by rising inflation rate. The pumping of adequate capital by European Central Bank in the eurozone would eventually increase cash flow, which will increase the inflation rate and consumer price index. This rising inflation rate would eventually erode all the returns that will be provided by the current portfolio, as high inflation rate would nullify the gains obtained from investments. Therefore, adequate changes in the portfolio needs to be conducted, where concentration on bond valuation is essential. The changing inflation rate will negatively affect the returns provided from Bond, as it will reduce the evaluated returns of bonds. In this context, Fawley & Neely (2013) mentioned that bonds are evaluated on yield, which is relatively less and can be eroded by rising inflation rate. this would decline the actual value of the bond in few years and nullify the returns from investment. For example, if a zero-coupon bond is bought on inflation rate 1%, whereas after sometimes if the inflation rate Rises to 2% then the market bond value will fall increasing the losses of the investor.
Therefore, changes in Bond section of the portfolio is essential, as inflation rate is rising. Moreover, the rising inflation rate would also raise the chances of financial bubble, which could hamper portfolio performance. Hence, relevant evaluation of the organization needs to be conducted, which will be or is present in the portfolio. This evaluation would eventually help in identifying the actual financial position of the company and its value, where inflated share prices could be ignored by the investor. On the other hand, Joyce, M., Miles, Scott & Vayanos (2012) argued that during the financial crisis of 2008 portfolios having high value generating stocks and bonds had low impact from the free fall of capital market. This indicates that using adequate measures, the rising inflation created in eurozone could allow the portfolio to generate high returns and reduce its risk.
However, there are many negative terms, which would happen due to the rising inflation conducted by European Central Bank. The devaluation of Euro against USD will also be conducted, which might hamper the international currency exchange market. Moreover, the rising inflation rate would provide consumers and companies with extra cash, which would increase imports and strengthen the US dollar against Euro (Albu et al., 2014). Therefore, it could be said that the measures used by European Central Bank would backfire and increase Problems for the Euro Zone, as the currency would reduce strength against USD.
Conclusion:
The evaluation quantitative easing mainly indicates the problems that will be faced by portfolio managers having stocks and born from US and Europe. The increment in inflation rate as targeted by European Central Bank will increase problems for the bond valuation and reduce return generation capacity of the portfolios. Moreover, being a portfolio manager changes in European stocks and bonds need to be conducted, as increment in inflation rate would boost share price, while decline bond value. European Central Bank uses intensive buying of bonds, which help in increasing the cash flow of money in the economy. However, the continuous buying of born at normal rates would raise the inflation rate and hamper returns of those bonds. Therefore, relevant changes in portfolio needs to be conducted, where selling of current European bonds should be instigated. This would help in reducing the losses, which might incur due to rising inflation. Furthermore, evaluation on current shares of European sector needs to be conducted, which might help in identifying the future growth and profitability of the organization. Lastly, investment in European shares would be much profitable, as European Central Bank is aiming to increase cash flow and improve financial position of companies.
Reference:
Albu, L. L., Lupu, R., Calin, A. C., & Popovici, O. C. (2014). Estimating the Impact of Quantitative Easing on Credit Risk through an ARMA-GARCH Model. Romanian Journal of Economic Forecasting, 17(3), 39-50.
Blinder, A. S., Ehrmann, M., de Haan, J., & Jansen, D. J. (2017). What will monetary policy look like after the crisis?. Research Bulletin, 39.
Braun, B. (2016). Speaking to the people? Money, trust, and central bank legitimacy in the age of quantitative easing. Review of International Political Economy, 23(6), 1064-1092.
Bruegel.org. (2018). The European Central Bank’s quantitative easing programme: limits and risks | Bruegel. Bruegel.org. Retrieved 14 March 2018, from https://bruegel.org/2016/02/the-european-central-banks-quantitative-easing-programme-limits-and-risks/
Claeys, G., & Leandro, A. (2016). The European Central Bank’s quantitative easing programme: Limits and risks (No. 2016/04). Bruegel Policy Contribution.
Ecb.europa.eu. (2018). Asset purchase programmes. European Central Bank. Retrieved 14 March 2018, from https://www.ecb.europa.eu/mopo/implement/omt/html/index.en.html
Fawley, B. W., & Neely, C. J. (2013). Four stories of quantitative easing. Federal Reserve Bank of St. Louis Review, 95(1), 51-88.
Fratzscher, M., Lo Duca, M., & Straub, R. (2018). On the international spillovers of US quantitative easing. The Economic Journal, 128(608), 330-377.
Joyce, M., Miles, D., Scott, A., & Vayanos, D. (2012). Quantitative easing and unconventional monetary policy–an introduction. The Economic Journal, 122(564).
Koijen, R. S., Koulischer, F., Nguyen, B., & Yogo, M. (2017). Euro-area quantitative easing and portfolio rebalancing. American Economic Review, 107(5), 621-27.
Statista.com. (2018). Inflation rate in EU and Euro area 2022 | Statistic. Statista. Retrieved 14 March 2018, from https://www.statista.com/statistics/267908/inflation-rate-in-eu-and-euro-area/
Tradingeconomics.com. (2018). Tradingeconomics.com. Retrieved 14 March 2018, from https://tradingeconomics.com/european-union/inflation-rate
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