Global investors have been in thrall to the central banks ever since quantitative easing (QE) started in 2009 and, of course, all eyes are on the Federal Reserve this week. The Fed has now frozen its QE programme, and may raise rates sometime this year, though perhaps not as early as next Thursday. Nevertheless, global investors have been comforted by the extremely large increases in balance sheets proposed by the Bank of Japan (BoJ) and the ECB, and the overall scale of worldwide QE has seemed likely to remain sizeable for the foreseeable future.

However, in recent months, an ominous new factor has arisen. Capital outflows from the emerging market economies (EMs) have surged, and have resulted in large declines in foreign exchange reserves as EM central banks have intervened to support their exchange rates.

Since these reserves are typically held in government bonds in the developed market economies (DMs), this process has resulted in bond sales by EM central banks. In August, this new factor has more than offset the entire QE undertaken by the ECB and the BoJ, leaving global QE substantially in negative territory.

Some commentators have become concerned that this new form of “quantitative tightening” will result in a significant reversal of total central bank support for global asset prices, especially if the EM crisis gets worse. This blog examines the quantities involved, and discusses the analytical debate about whether any of this matters at all for asset prices.

The conclusion is that the EM factor is likely to offset part, but perhaps not quite all, of the QE planned by the ECB and the BoJ in the next year. Overall, global QE will provide much less stimulus than it has since 2006.

The major sources of central bank balance sheet expansion at present are of course the bond purchase programmes announced by the BoJ and the ECB. Together these programmes are running at an average of about $130 billion a month. The average maturity of the bonds purchased is probably around 7 years, so an enormous amount of “bond duration” is still being removed from private sector hands in the developed economies.

The question is how much of this stimulus is likely to be offset by the sale of EM bond holdings as a result of the foreign exchange intervention by EM central banks. Fulcrum estimates that total EM central bank balance sheets may have declined by about $450 billion in the 3 months since the crisis worsened in the summer, of which about $170 billion has come from China alone.

Consequently, global QE, measured by this metric, has probably turned substantially negative [1]. Nomura (and others) estimate that foreign exchange intervention by the EMs was probably around $160 billion in August alone, and this would have directly triggered bond sales in the US and Europe.

Of course, no-one can prove that this drain of central bank liquidity caused the rise in global bond yields and the drop in risk assets last month; market interpretations of Fed policy have probably been just as important. Nevertheless, it is an interesting fact that has grabbed the attention of macro investors. The release of China’s foreign exchange reserve figures has suddenly become one of the most watched global data releases each month.

What is the outlook for this measure of global liquidity over the next year or so? The BoJ and the ECB are, if anything, considering further extensions of their bond purchase programmes. Consequently, global QE will return to positive territory unless the large drain on EM foreign exchange reserves continues.

But this drain is likely to be maintained for a while. A recent detailed analysis of global reserve holdings by Deutsche Bank economists [2] suggests that total global reserves could fall by $1,500 billion during the current drawdown, about a third of which has already happened. This might take EM central bank balance sheets roughly back to where they were just before the 2008 financial crash as a share of EM GDP – a pessimistic but not extreme outcome.

On this and other assumptions, Fulcrum estimates that the total increase in global central bank balance sheets as a percentage of world GDP, which is one indicator of the stimulus from global QE, would be fairly close to zero next year, compared to an average injection of about 2 per cent of global GDP in recent years. Apart from a short period at the end of 2009, this would be the lowest rate of expansion since 2006:

There is huge uncertainty here. If China and other EMs stop intervening in the foreign exchange markets, then the drain on reserves and on global liquidity would soon end as EM exchange rates fall towards their equilibrium levels. Alternatively, private sector EM capital outflows might end spontaneously, as they did after the “taper tantrum” in 2013. But the deterioration in economic fundamentals in the EMs looks more serious than in 2013, so the current shock could be long lasting.

What then? Some economists, like Matthew Klein at FT Alphaville, and Paul Krugman, argue that sales of bond holdings by foreign central banks do not matter anyway. Krugman argues that they hold bonds of very short maturity, which are close to cash, and he points out that sales of these bonds can always be easily offset by Fed action to hold short rates down. But the average maturity of US bond holdings by foreign central banks, at 3.95 years, is not negligible. Furthermore, since the Fed is thinking about raising rates, it may not want to offset the impact of foreign bond sales on US medium dated bond yields.

In my opinion, one of the few analytical lapses made by the Keynesian camp after 2010 has been a reluctance to believe that QE – or bond buying by foreign central banks – could impact asset prices and economic activity, except through a signalling effect about the future path of Fed short rates. Yet studies by the Fed [3] and the ECB [4] suggest that these bond purchasing programmes have had important effects on yields through “portfolio balance” effects, as private investors are induced to extend bond duration and hold riskier assets.

Surely, the same could now happen in reverse when EM central banks trim their bond holdings. If so, the EM reserve drain is another item to add to investors’ long list of concerns at the moment.