|When the tide goes out ...|
|Monday, 27 May 2013 00:00|
It’s mostly liquidity that’s driving markets
The US economy is likely to grow 3% in the June quarter, making it the second straight quarter of strong growth in the face of a large contraction in government expenditure, but the basic fragility of global growth was best brought out by last week’s flash crash across global markets. US Fed chairman Ben Bernanke made what everyone thought was a routine congressional testimony along familiar lines – the Fed will continue to buy $85 bn of bonds each month till US unemployment rates fall to under 6.5%, after which purchases would be calibrated downwards. Why markets read this as a statement that liquidity would be reduced is not clear, but Japanese bonds were the first to react and, coupled with a drop in Chinese PMI, this sent the Nikkei and other indices crashing. The obvious lesson from last week’s episode is that while big vulnerabilities persist in most economies, the global surge in liquidity has masked much of this – which is why, despite Europe’s periphery countries being in the shape they are in, bond yields remain unusually low; closer home, despite most physical indices still indicating the economy hasn’t bottomed out, the sensex has remained remarkably buoyant.
None of this is to say the liquidity surge, or Operation Twist in the US, hasn’t worked. It has, and wonderfully. While the rise in government expenditure helped provide a floor to the contraction when private sector demand collapsed post-Lehman, the increase in the Fed’s balance sheet by buying more bonds helped lower interest rates. According to the IMF’s paper on unconventional monetary policies of the type we’re seeing today, the cumulative effect has been to lower long term bond yields by 90-200 bps in the US, about 45-160 bps in the UK and by around 30 bps in Japan. In a situation where the economy is growing below potential, that’s a huge help and there’s little danger of inflation.
That, of course, is in the short run. In the medium- to long-run, this doesn’t diminish the need for structural reforms in most economies. Which is why, at the time of the massive stimulus, all experts, including in government, were of the view that the Fed’s exit strategy would be very important. Exit too fast, and the markets get spooked; indeed, last week’s crash showed that even the suggestion of an exit can spook investors. And with good reason. With debt levels so high in most economies, it is clear fiscal expansion needs to be rolled back, even if you don’t believe Reinhart-Rogoff got their danger-mark debt level estimates right. In the US, the IMF reckons, to get debt back to reasonable levels, the US needs to cut its primary deficit by 0.9% of GDP each year till 2020 – much of this, of course, will come from the economy growing, but government expenditure also needs pruning. Add to this the impact of the balance sheet loss of various central banks – which governments will have to make up – once bond purchases slow and interest rates rise, lowering the value of bonds they hold. The IMF’s report on exit strategies has a most-likely scenario where losses could be as high as 2-4% of GDP in the US in a rising interest rate scenario – this rises to 7.5% in a tail-risk scenario. The question is whether, by then, there will be enough structural changes to take the twin strains of lower government expenditure and balance sheet losses due to higher interest rates.
|Last Updated ( Saturday, 25 May 2013 18:28 )|