The end of cheap money?
Last week the European Central Bank (ECB) became the first major Western central bank to tighten monetary policy since the onset of the global economic crisis. Is the era of cheap financial capital–which has seen the West’s central banks keep interest rates close to zero percent–coming to an end? What do these developments mean for emerging market governments, many of whom are struggling to cope with massive inflows from abroad?
Let’s start with Europe. Like its counterparts in Japan and the US, for much of the crisis the European Central Bank made vast amounts of liquidity available to its banks. Interest rates were slashed and new funding facilities established. Central Banks even started to buy long-term assets, including government bonds. Expectations stabilised and that elusive commodity–financial market confidence–eventually returned . Along with large fiscal stimulus packages, it could be said that policymakers had learnt the lessons of the 1930s, averting an even worse downturn.
Repairing the balance sheets of financial institutions and ultimately weaning banks and governments off cheap money was, however, to prove far more difficult. Bad loans would have to be written off; new capital would have to be raised from financial markets with analysts and the press both prone to ask management hard questions. Sickly-looking loans would be called in, often causing the borrower to shut down operations and lay off staff. There are few votes, then, in serious bank clean-up programmes. Not surprisingly, denial was the preferred strategy of many bank CEOs, regulators, and politicians. Far better to wait for the economy to turn around and hope it leads to a decline in underperforming loans. In the meantime take the ECBs cheap cash and play for time.
Meanwhile the vast expansion in the money supply that the ECB engineered worried inflation hawks. Their nervousness has clearly spread to the ECB’s senior leadership that became concerned about its crisis-era measures undermining its anti-inflation credentials. If inflation expectations ratcheted up across the Eurozone squeezing them out of the system would require, on standard central bank practice, prolonged high interest rates and unemployment levels even larger than those seen during the crisis. Any stature that the ECB might have gained from its extraordinary crisis measures was to be called into question when laughably weak stress tests for banks were undertaken in 2010 and only a few European banks were found short of capital. Worse, it turned out that three of the largest Irish banks that had to be bailed out at great cost later in 2010 had passed these stress tests! If any ECB officials felt they were being taken for a ride then I wouldn’t be at all surprised.
The ECB laid the groundwork for its recent change of strategy from late 2010. Strong hints that interest rates would likely rise in April were given, preparing the financial markets for this move. While the recent ECB announcement of its interest rate increase sought not to scare the horses with threats of further rises, all the pointers are in fact in this direction. Progressive 25 basis point increases can be expected each quarter until well into 2012. Plus the ECB can be expected to wind down its credit facilities, forcing banks to raise capital on private markets and to call in more dodgy loans. Eurozone governments too will find it harder to borrow from their banks at low ECB-driven interest rates. Coupled with a botched reform of bondholders rights, that increases their exposure to debt write-downs after 2013, it is not hard to see how over-extended Eurozone governments will come under financing pressures in the coming months and years. All in all, the ECB’s interest rate rise presages far more painful economic restructuring than many politicians and business people care to admit.
Will the U.S. Federal Reserve Board (FRB) follow suit? Bank restructuring is, on most measures, more advanced in the U.S. Moreover, there appears to be a greater appreciation at the FRB of the macroeconomic risks created by the remaining substantial debt overhangs. While there are inflation hawks in the U.S., price inflation remains pretty subdued in the U.S. and inflation expectations appear under control. Differences in circumstances, then, are likely to delay–if not, outright discourage–the Federal Reserve Board from following the ECB. Growing divergence in interest rates across the Atlantic should be expected. Moreover, while they may be a lot of smoke and mirrors from Mr. Bernanke and colleagues, the second Quantitative Easing programme is unlikely to be abruptly halted in June 2011.
As to Japan, in response to the recent earthquake and tsunami, the Central Bank of Japan flooded its financial system with capital and made it clear it intends to continue to do so. This is all the more remarkable as Japanese interest rates were already very low before the recent tragedy. As will become clear below, perhaps more important for emerging market governments, was last month’s coordinated G7 intervention to stop the Yen from appreciating too much against the U.S. dollar and other leading currencies.
To conclude, the crisis-induced era of cheap money is far from over. For emerging markets this has proved to be a bind as financiers engaged in the carry trade (that is, borrowing at low interest rates in the West or Japan and buying emerging market financial assets that pay far higher returns) and potentially destabilising inflows of capital ensued. Japan, at least, will remain a low cost source of funds for such trades. Worse, the G7 intervention has effectively put a floor in the appreciation of the Yen, the consequence of which is to reduce the risk that an adverse Yen movement undermines the profitability of the carry trade. Together these circumstances present financiers with almost a one way bet. So expect the waves of foreign financial inflows to continue and more governments in emerging markets to take steps to delink their economies from world financial markets. For supporters of globalisation how cheap, then, is cheap money?