News } Tabak

Quantitative Easing, an uncertain future, and opportunities

TBK View Newsletter: November 2010

No lyrics and music video this issue but one of the funniest commentaries on the U.S. economy, and how nothing has really changed in the world of politics and high finance. It’s called Quantitative Easing explained.

This you must see. To do so click here

And to see the more sober – but not as funny - reply click here

It’s always interesting to look back and see what you wrote about one and two years ago. The November 2008 issue was entitled Putting out Fires with Gasoline and the November 2009 issue Confidence up, housing stable, credit down.

I read them again before writing this November issue and it’s amazing what has – and what hasn’t – changed since then.

One thing that hasn’t is the availability of credit. For all the work the international financial community and governments have made to ease the situation, it’s still hard to get money. Why?

Well as you’ll see below, not only have banks have cut back on their lending, many people do not want to borrow, and the money provided by government stimulus is going into unproductive assets.


If you look up QE2 in Wikapedia you will see it was an ocean liner that was operated by Cunard from 1969 to 2008. The liner retired from active Cunard service in November 2008, where it was planned for her to begin conversion to a floating hotel which would have seen her eventually moored at the Palm Jumeirah, Dubai. However she now remains mothballed at Port Rashid in Dubai awaiting an uncertain future.

The modern version of QE2, “quantitative easing”, has nothing to do with do with ocean liners but one thing they do seem to have in common is an uncertain future.

For a U.S. perspective on QE2 it’s good to read best selling economic commentator John Maudlin’s view in a piece entitled ”The Ride of the Keynesian Cowboys” in which he doubts its effectiveness and points out the unintended consequences that could arise. It’s quite long but in essence he questions whether the growing chorus of noted economists and analysts who openly question the need or wisdom of a QE2 can get the practice to stop. He doubts it. He says “The Keynesian Cowboys are saddling their QE horses and they intend to ride. They have no idea what the end result will be. This is all a guess based on pure theory and models (like the broken money multiplier). And I really question whether the result they hope for is worth the risk of the unintended consequences” To read the article click here.

Closer to home Tony Alexander in his BNZ weekly overview has written a couple of excellent articles about quantitative easing – what it is, why it’s not working, and how it’s affecting asset prices.

Initiated by the Federal Reserve in the U.S., quantitative easing is commonly called printing money. As Tony points out, their idea to get the economy going again is they need to give artificial support to buy time for the private sector to start spending again. All central banks can do when interest rates are so low they can’t reduce them any more, is to take the extreme measure of “printing money”.

The exercise does not actually involve printing any physical bank notes. The U.S. government is running a large deficit which they normally finance by borrowing money from the public. So the more money the government spends than it receives in tax revenue is taken out of circulation by investors who will be repaid with interest some time in the future – that is the government bonds issues bonds. The net cash effect is zero.

With quantitative easing the Federal Reserve actually buys some of the bonds it issues. But the money to buy its own bonds does not come from the private sector; they simply make a note in their accounts that they have an asset in the form of government bonds while the government notes a liability in its balance sheet. This means the money that was going to come from the private sector to buy the bonds stays put in other investments like shares and bank accounts. So as Tony says “that effectively is the money which is printed – the stuff that does not leave. By staying in the in bank accounts etc. there is a net addition to funds circulating in the economy caused by the over-spending of the government.

Extra money sloshing around means extra downward pressure on interest rates which in theory will help the economy. In practice however a key thing happening in the United States which is keeping the economy weak is unwillingness on the part of banks to lend more money, exceeded in many cases it seems by the unwillingness of consumers and businesses to borrow it. Therefore the low interest rates which will stay around for longer may not have much effect at all. It is not the price of money people are basing their borrowing decisions on at the moment but their confidence – which is lacking.

But the extra money sloshing around does not all simply sit in banks. Some goes into other assets like property, shares, and commodities. People are wary of property understandably given what has happened. There are many feeling the sharemarket is looking over-stretched when one considers the immediate prospects for growth outlook poor. That leaves other assets as potentially major beneficiaries of the Fed’s money printing exercise.

He then talks about the affect this has on the U.S. exchange rate and how there is essentially nothing sensible our Reserve Bank will be able to do about halting the rise of the New Zealand dollar. To see that article check out page 13 of the 4 November Weekly Overview here.

His 11 November Weekly Overview discusses Asset Price Inflation. To read this article click here. In the article he says “In late 2007 and early 2008 we saw many asset prices (houses, the Kiwi dollar, equities) go excessively and unrealistically high as a result of the global credit boom. That is, lots of money was loosely floating around and finding its way into asset markets as opposed to new products, production processes etc – the stuff we really like to see. So what is happening at the moment? Is it that credit conditions are once again excessively loose? In the most commonly known way the answer is clearly no."

Banks have cut back on their lending (mainly offshore but also here in NZ to a much lesser extent), and perhaps more importantly in some instances people do not want to borrow money. They are concentrating their efforts on repaying debt. Yet some asset prices are rising strongly. What gives?

What gives is that because banks in the United States in particular don’t want to lend, and because people in the private sector do not want to borrow, the Federal Reserve has decided to add to the US$1.7tn it has already injected into the US money supply with another US$600bn to be added by the middle of next year.

Where is the money going? It is not expected that the funds will go toward productive business uses or be used by consumers to boost their spending on goods, services and housing. If those expectations were present one might conclude that some asset markets would still be rising as they are now. But if such expectations were there the quantitative easing would almost certainly not in fact be needed.

What’s happening is that because the extra cash is not expected to be utilised in a normal manner by a much larger economy it is going into financial assets. More money but not more production means more inflation. Normally as students of economics we analyse this in terms of inflation appearing in the normal sense – the consumer’s price index. But for that to happen the transmission mechanism for the extra money hitting the economy is consumers borrowing it and spending it. In this context however we are instead talking about investors being left with the money they were going to use to buy government bonds now taking their investment money and buying other assets.

Hence our currency goes up at the same time as our commodity prices rise so the net impact on most primary sector exporters here is minor. But if you are an exporter not producing a commodity the extra quantitative easing is an outright negative factor. This includes tourism operators, manufactures etc.

The interesting question however is this. What happens when the US economy is strong enough that the Fed starts taking the money back out again? Basically the opposite of what is happening now in perhaps a violent manner as investors look to quit clearly over-priced assets as rapidly as possible. Asset markets tend to go up the escalator and down the lift shaft as it were.

What this means is that at some stage the NZD is going to drop quite sharply yet at the same time commodity prices will be falling probably along with sharemarkets. At some stage exporters will want to pull back sharply on their hedging while importers put more in place. When will this happen? When US interest rates start rising and the Fed. implements quantitative tightening (QT). When will this happen? That is impossible to say. How high will commodity prices and the currency go before we reach this turning point? That also is impossible to say.

All one can safely say is that major uncertainty continues in world financial markets and those with currency and other asset price exposures would be wise to allow for high volatility over the next few years. In a year’s time the NZD could just as easily be at 85 cents as 70 depending upon your interpretation of where the world is heading.

So where is the world heading?

In my last newsletter I quoted Rodney Dickens Ravings about the U.S. economy – to see that click here.

Well he’s taking a more positive view now. In his latest Ravings is entitled “Could the US economy be starting to heal itself” he says there is much more to U.S. economic growth prospects especially from a medium term to longer term perspective than the housing market, the financial crisis or quantitative easing.

In essence his article concentrates on the fact that capitalism will ultimately play a major part in restoring economic growth.

He says ”There are already signs that the US economy is starting to heal itself, helped significantly at the moment by the low or competitive USD. The low USD may be partly a by-product of quantitative easing but more generally reflects the normal market response to an economy in trouble. The implications of the low USD are far larger and will ultimately be more positive than most commentators have contemplated.

Adam Smith’s “invisible hand” of capitalism will also already be at work in the US and will ultimately play a major part in restoring economic growth. Even from the ranks of the unemployed will come some new innovators and entrepreneurs who will play a part in driving the eventual return to sustained economic growth in the US.” To see the article click here.

And where is NZ heading?

But, as discussed above, bank lending to business continues to fall. This is confirmed by the recently released Reserve bank’s Financial Stability Report. If you’d like to read the 56 page report click here

Commenting on the report, Bernard Hickey from wrote an article entitled “How the Fed and deleveraging are shredding John Key's grand plan to turn around the economy”. He says “the report shows that bank lending to businesses continues to fall, despite better business confidence and the beginning of a recovery from the 2008 recession. Bank lending figures show that business lending has fallen NZ$9.3 billion since November 2008 to NZ$71.5 billion, while farm lending has risen NZ$4.9 billion to NZ$48.3 billion and housing lending is up NZ$8.8 billion to NZ$170.8 billion.

That means New Zealanders and the banks have actually increased their exposure to property by NZ$13.7 billion since the crisis while business lending has fallen by almost as much. That’s not much of a rebalancing. Banks are even more reluctant to lend to businesses and are falling back on the tried and tested method of lending against land.

How can New Zealand possibly rebalance our economy when our high value export sector is being demolished and businesses are not borrowing and investing?” To read Bernard’s commentary click here.

According to our Reserve Bank Governor Alan Bollard, we face a long, slow recovery. He says the recovery is progressing very slowly and could be a prolonged process.

Maybe it will be, but I see some great opportunities in front of us now. And Alan Bollard has hinted at that in his recent speech to the Deloitte tax conference in Auckland. To see this - it’s actually very good even if quite dry - click here.

In particular he talks about New Zealand’s role in providing food to the emerging economies. To quote “Post-war evidence shows that as emerging markets develop significant middle classes, there is a commensurate increase in demand for protein, increasingly animal-based. That has been the pattern across a number of countries with different cultures in different geographies. Many of these countries are limited in expanding their own food production, by lack of suitable land, lack of water, increasing climatic volatility, and high oil prices. A recent Nomura report argues that real food prices will need to rise significantly.

New Zealand is not a huge food producer (not being among the top half dozen producers of any of the world’s key food product groups). However our food exports (as a % of GDP) top the world, and we are the best placed in competitive terms in Nomura’s food vulnerability index.” To see the Nomura report click here.

Opportunities abound

The ASB quarterly investor confidence survey, which came out this month, showed as investors look to security and predictability, the popularity of Term Deposits has risen to near record highs with 20% of respondents saying they offer the best return. Term Deposits are now ahead of the previous favorite rental property, which is now equal with bank savings at 14%. Managed investments increased one point to 11%, Kiwisaver remains the same at 9%, and shares in public companies have dropped 3 points to 5%. To read the Scoop article click here.

Of course this is the time to take advantage of opportunities while others remain reluctant to take on risk. And we’re starting to see this now.

Commercial property here experienced only a mild downturn compared with property markets offshore like those in the U.K. and U.S. and is now improving. The property index, which broadly measures commercial property market performance, showed an overall total return of 6.2% for the 12 months ended September 30, based on 367 properties with a value of $8.5 billion.

The return was made up of an 8.1% income return and a -1.8% capital return, the latter figure reflecting a slight downward adjustment to asset values over the previous year. Annualised total returns for the latest year for the office, industrial and retail sector indices stood at 4.6%, 7.1% and 7.7% respectively.

Bank funding is hard to get, and especially for property developments. See Herald article here. But new second tier funders are emerging which are a mixture of high net worth individuals in their own right, finance companies funded by a mix of high net worth individuals and credit lines, plus nominee and trustee lenders.

So there is loan money around to take up these opportunities.

I’m also seeing a surprisingly large number of investors responding to the joint venture and private equity participation offers we’ve structured. These generally involve larger amounts and are often restricted to “Eligible persons” in terms of the Securities Act.

None of these opportunities are advertised. So if you’d like to get on the potential investor list, give me a call or email me



John Paine
TBK Capital Limited


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