For Quantitative Easing to Succeed Against COVID-19

It Is Crucial to Cut Off Early the Amplification Mechanism of Economic Contraction

Funds for Corporate Bond Purchases Must Be Supplied in a Timely Manner to Firms That Need Them

Coronavirus disease (COVID-19) has infected more than 7.4 million people and caused over 410,000 deaths in 216 countries around the world, while shaking the foundations of the economy through shrinking consumption, collapsing sales, and disruptions to global supply chains. In April, exports plunged 25% from the same month a year earlier, and the number of employed persons fell by 476,000.

In the early stage of the crisis, self-employed people, particularly small business owners, were hit directly by the contraction in consumption, and now major firms in sectors including aviation and shipping, as well as petrochemicals, automobiles and auto parts, and wireless communications equipment, are also reeling. The International Monetary Fund (IMF) sharply lowered its forecast for Korea’s economic growth from 2.2% to –1.2%. If this decline in exports and the collapse of manufacturing continue, the Korean economy faces the risk of devastation.

To respond aggressively to the COVID-19 crisis, the government and the Bank of Korea pursued coordinated domestic macroeconomic policy measures, including swift fiscal support and broad-based liquidity provision. The government prepared the 1st and 2nd supplementary budgets totaling KRW 11.7 trillion and KRW 12.2 trillion, respectively, to support epidemic prevention, assistance for small business owners and SMEs, livelihood stabilization for affected and vulnerable groups, and the revival of domestic demand through emergency disaster relief payments to all citizens. With this year’s economic growth projected to fall into negative territory, the government has also drawn up and submitted to the National Assembly a 3rd supplementary budget worth KRW 35.3 trillion, the largest ever, to overcome the economic crisis.

However, despite the government’s active fiscal support, domestic and external economic conditions remain difficult. In May, exports fell 23.7% year-on-year, led by general machinery, petrochemicals, automobiles, and steel, marking a decline of more than 20% for a second consecutive month, deepening uncertainty in export markets and clouding the outlook for a manufacturing recovery. The unemployment rate rose from 4.2% in April to 4.5% in May, while the number of temporarily laid-off workers reached 1.02 million in May. The spread of COVID-19 has not subsided in major trading partners, including the United States, and as a result the global slowdown and decline in demand continue. To make matters worse, U.S.-China trade tensions are severe.

The Bank of Korea, seeking to preemptively provide liquidity needed to stabilize the financial markets in the early phase, swiftly cut its policy rate from 1.25% to 0.75%, and soon afterward lowered it again to 0.5%. It also signed a $60 billion currency swap with the U.S. Federal Reserve to do everything possible to stabilize Korea’s financial markets. In particular, to provide broad and preemptive liquidity, the Bank introduced from April through June a “full-allotment liquidity support facility,” under which it purchased repurchase agreements (RPs) from financial institutions without limit at interest rates of 0.85% or lower. In addition, in cooperation with the government, the Bank decided to commit KRW 8 trillion to operate a special purpose vehicle (SPV) for purchasing corporate bonds and commercial paper (CP), actively supporting purchases of corporate bonds down to the BB rating. This was, in effect, the first-ever implementation of “Korean-style quantitative easing.”

Quantitative easing (QE) is an unconventional monetary policy under which a central bank directly supplies liquidity to the market by purchasing assets such as government bonds when it can no longer easily cut the policy interest rate further. It stands in contrast to traditional monetary policy conducted through interest-rate adjustments.

In response to the 2008 global financial crisis, the U.S. Federal Reserve lowered its federal funds rate target to 0–0.25%, reaching the zero lower bound, yet as credit markets contracted and financial instability intensified, it carried out three rounds of large-scale asset purchases (LSAPs). Under the first round of quantitative easing (QE1), between November 2008 and March 2010, it purchased $175 billion in agency debt, $1.025 trillion in agency mortgage-backed securities (MBS), and $300 billion in Treasury securities. Under QE2, between November 2010 and June 2011, it purchased $600 billion in long-term Treasury securities. Under QE3, between September 2012 and December 2013, it purchased $790 billion in Treasury securities and $823 billion in agency MBS. Former Federal Reserve Chair Ben Bernanke noted that these quantitative easing measures promoted the productive functioning of markets by supplying liquidity to specific credit markets, contributed to stabilizing long-term interest rates at lower levels, supported the mortgage market, eased broad financial conditions, and ultimately proved effective in stimulating the economy.

However, there is also a critical view that although the monetary base increased sharply as a result of the Federal Reserve’s large-scale asset purchases, banks held excessive excess reserves, so the money supply did not rise substantially in practice, meaning that the economic stimulus effects of quantitative easing were smaller than expected.

Debate over the effectiveness of quantitative easing continues, but it is generally assessed to have contributed to financial market stability and to private borrowers’ ability to raise capital. In this context, the Federal Reserve also implemented quantitative easing during the COVID-19 crisis by purchasing $700 billion in Treasury securities and MBS to respond aggressively to the recession and ease anxiety in the financial markets, and it even went so far as to declare unlimited asset purchases.

As the COVID-19 crisis is still ongoing, it is difficult to make an explicit assessment of the effects of the Korean-style quantitative easing policy that the Bank of Korea is attempting for the first time. Nevertheless, as the global recession accelerates and domestic demand contracts sharply, firms—especially in key national industries such as aviation, shipping, and automobiles—are facing severe funding difficulties, and even blue-chip companies are seeing financing conditions tighten rapidly. In particular, with the base rate target at 0.5%, close to the zero lower bound, the Bank of Korea no longer has much room to pursue financial stability and economic stimulus through further rate cuts.

Under these conditions, the Bank of Korea’s quantitative easing policy appears, at the very least, to have contributed to early financial market stabilization and improved liquidity. In particular, if the contraction in the real economy caused by COVID-19 fully spills over into the financial markets, it could trigger a credit crunch and financial instability, which in turn would further accelerate the economic downturn. It is therefore extremely important to cut off at an early stage the amplification mechanism of economic contraction arising from the interaction between real-sector contraction and financial market instability. Moreover, the Bank of Korea’s willingness to consider purchasing even lower-rated corporate bonds not only helps prevent otherwise viable firms hit by a sudden collapse in sales due to COVID-19 from going bankrupt, but also eases investor anxiety and gives firms more breathing room in raising funds.

Even so, it remains uncertain whether the Bank of Korea’s quantitative easing policy will soon stimulate the economy and eventually generate inflation. That is because the COVID-19 crisis that triggered the current economic crisis is still continuing worldwide, concerns are growing that a second wave of infections could spread in the second half of this year, and the development of treatments or vaccines capable of ending the pandemic does not appear imminent. Still, if the funds raised by the Bank of Korea through RP purchases from financial institutions and the funds for corporate bond purchases do not remain within the financial institutions but are instead properly supplied to the firms that need them—thereby preventing corporate failures caused by financial market tightening and effectively contributing to corporate restructuring and economic stimulus—then this “Korean-style quantitative easing policy” can be expected to produce meaningful results.

Dongheon Kim

Professor, Department of Economics, Korea University

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Original title: 코로나19 대응 양적완화 정책 성공하려면

Author: Dong-heon Kim

Date: 2020-06-17

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=press&pn=20&idx=22847