FOMC,BOIandTreatyofVersailles

Bank of Indonesia announced yesterday that the central bank is going to directly finance the deficit of the Indonesian government. The news comes close on the heels of the BOJ announcement on Monday to buy an unlimited quantity of JGB’s. US Fed had announced similar measures last month. As the Fed’s two day meet comes to close today and as the world waits to hear Mr Powell in the press conference, the Indonesian news allows us to take a  closer look at the concept of money printing.

Whenever any government is running a deficit, either on account of profligate spending or on account of building up capital infrastructure, it needs to approach the markets to fund this deficit. The lenders in that hour of need can be domestic or foreign and the cost of capital is decided by the lender’s assessment of the sovereign’s ability to repay, adjusted to their own risk appetite. Few countries lacking the domestic demand have to resort to raising money in foreign currency. This we see happening in many countries in Africa where frequent euro bond issuances happen. Many countries, though, raise money in their own currency which then is subscribed to by foreign investors. Foreign investors hence run the dual risk of credit as well as currency on such investments.

However when the central bank decides to fund the government directly (even if we use the euphemisms like QE, W&M Advances, it is all the same) it circumvents the market mechanism of pricing the debt appropriately. Theoretically existing debt holders should be penalized through rising yields and inflation. A second order consequence should be in terms of currency devaluation because of capital flight. Let us now give a 100 year old historical context to this theory.

We are talking here about the Treaty of Versailles which came into effect post World War I in 1920. The treaty laid heavy reparation costs on Germany. Reichsbank, Germany’s central bank at the time, then embarked on a policy of monetising of government debt (due to the allied victors) through extensive money printing. The effect was two-fold - hyperinflation and a rise in exports through currency devaluation. But if we see the recent examples of money printing post the GFC, the DM countries (US,Euro, Japan) have not experienced high inflation. So theory aside, as per the inductive logic, we can’t make a definitive cause and effect statement. It remains to be seen how the current bout of debt monetisation will play out.

In the market round up, Dow Jones ended in a slight negative yesterday. US Dollar index is trading below 100 near the 99.70 levels continuing the downward trend for the week. Japanese yen has appreciated against the dollar and crude oil prices have shown an uptrend. Indian rupee has breached the 76 level and trades at 75.90 now. The 10 year government bond trades at 6.13 mostly unchanged from yesterday’s levels. Gold prices show a slight uptick at 1711$/oz. As the market signals remain mixed it is difficult to classify them in the dichotomy of “risk on” or “risk off”. Better to wait for the FOMC statement to be out later day before taking a definite call.