Apr 01 2020
In the face of an unprecedented public health crisis, the Reserve Bank of Australia has embraced quantitative easing – printing new money to pour funds into the strained financial system. Amid surging unemployment, the largest oil price shock in recent memory, and a sharp deterioration in consumer sentiment, this once unconventional monetary policy has quickly become mainstream. Over the past two weeks, the RBA has started printing money to prop up liquidity in the financial system, provide $90 billion in cheap loans to small businesses, and increase the supply of United States dollars. Such a drastic policy prompts the question, can you fight a health crisis with monetary policy?
What is quantitative easing?
Quantitative easing (QE) can take many forms, but essentially involves the creation of new money to purchase financial assets. Under the RBA’s announced QE policy regime, new money will be created and used to buy long-term bonds. The RBA will buy bonds to drive down the yield on these financial assets to a target level. The RBA has pledged to print as much money as necessary to achieve this aim. Borrowing costs for corporations and businesses are partly determined by the risk-free rate of return, which is the return on government debt. By reducing long-term interest rates on risk-free government debt, the cost of borrowing in more risky corporate debt markets should also fall. In theory, this should incentivise greater borrowing and investment, creating employment and economic growth.
In the United States, QE has been used since the global financial crisis to purchase government bonds and control long-term interest rates. Japan, one of the most indebted countries in the world, has been the most adventurous with QE, using new money to purchase government bonds, residential mortgage-backed securities and even share market equities.
Will QE work in Australia?
The effectiveness of QE in Australia is likely to be mixed. Firstly, compared to other countries that have implemented QE, the Australian corporate debt market is small. Furthermore, many Australian corporations borrow from overseas money markets. Therefore, the stimulative effect of QE on corporate borrowing and investment in Australia is likely to be limited. There is also concern regarding business appetite for borrowing in the current environment, even with record-low interest rates. In particular, the unclear outlook for the COVID-19 pandemic is likely to dissuade businesses from committing to large scale-investments.
Despite its drawbacks, QE may be an effective way to help banks to provide short-term bridge loans for small and medium enterprises (SMEs). To target this, the RBA has announced a new lending facility for banks to provide more than $90 billion of three-year loans to SMEs, at lower interest rates. The funding for this facility will come from new money supply printed by the RBA.
This policy is likely to provide significant relief to players in the National and Regional Commercial Banks industry. Record-low interest rates for lending have put strain on banks, which have struggled to lower the rates they pay on deposits they receive. Falling interest revenue from loans, in combination with steady deposit interest costs, has placed increasing pressure on banking profit margins. Furthermore, the rapid economic shutdown due to the COVID-19 pandemic has raised the risks of businesses failing to meet interest repayment obligations. This risk has lowered the value of bank loans, making it more difficult for banks to secure funding for themselves.
The new RBA facility will provide breathing space to Australian banks, by allowing them to borrow an equivalent of 3% of their existing outstanding credit to Australian businesses and households, with access to additional funds if they provide more support to SMEs.
In the current economic environment, the ability for households and businesses to borrow in order to survive a halt in normal economic activity for several months is crucial. By providing financial lifelines through QE, the RBA may be able to better position the economy for a quicker recovery when the COVID-19 pandemic passes.
Downsides to the silver bullet
Although QE may provide some short-term benefit to an economy rattled by escalating quarantine measures, the long-term efficacy of QE is limited. Flooding financial markets with new money may support stability in the short-term, but risks run-away inflationary pressure in future years. QE policies also tend to have an inequitable impact on the economy, supporting high-income earners through growth in property and equity prices, while having only a marginal benefit for lower-income earners.
The idea that QE is a short-term emergency policy is also questionable. Globally, both the United States and Japan have found it extremely difficult to wind down QE policies once financial markets had grown reliant upon them. The dramatic shifts in monetary policy made in recent weeks may return to haunt us further down the road.
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