The global economic situation is brimming with irony. The ultimate safe haven, where investors flee whenever there’s a turmoil in the global markets, is no longer so safe. The risk-free rate is no longer riskless. It has been downgraded by a rating agency that had no problem with issuing AAA ratings for dodgy mortgages that led to the financial crisis.
But where will investors go? To Europe? That’s in bigger trouble. To the Swiss franc and the yen? Their governments want their currencies to go down. To gold or emerging market bonds? Those markets have neither the size nor the depth of the US treasury market.
Will the US interest rates rise? The downgrade implies that risk should be repriced. But fears of a downgrade were already present and, yet, bonds rallied last week. Japan’s debt was downgraded to AA- last January, with hardly any impact on interest rates or its stock markets. Japan’s debt, however, is domestic. The US, on the contrary, depends on the kindness of the Chinese, who have been diversifying their reserves away from the dollar.
The mess would be amusing if it wasn’t so dangerous. Why dangerous? Because it’s clear that four years after the North Atlantic financial crisis broke out, their economies are still not recovering. Monetary policy—the first two rounds of quantitative easing in the US—has failed, because households want to pay down debt and nobody wants to borrow. Fiscal policy has reached its limits.
So what’s the alternative? Governments and policymakers seem clueless. Countries are trying to export their way out of the problem, which is why Japan intervened in its currency markets last week, why the US favours a weak dollar, and why China links the yuan to the dollar. The situation is tailor-made for conflict.
Of course, there could always be a third round of quantitative easing and the buying of Italian and Spanish bonds by the European central bank, which could lead to a bounce in the markets. But these are band-aids. The quick rebound in the US and the European economies that the markets were counting on is no longer on the cards, and a long period of low growth, perhaps, even a Japan-like lost decade, looms ahead.
That would also impact China’s export powerhouse, and this time they will be unable to fall back on a stimulus because they already have over-investment and inflation. It’s another irony, of course, that global investors appear to have more faith in the Chinese Communist Party than in Western central banks and democratic governments.
What about India? On the credit side, commodity prices could fall and we could have lower inflation. Lower growth and falling inflation may force the Reserve Bank of India to stop tightening. That hope pushed down government bond yields last Friday. There is also a lot of liquidity in global markets and some of it may come to our shores, attracted by our relatively high growth.
On the debit side, exports will falter and it may happen that the liquidity flows into commodities, instead of into emerging markets. Many of our big companies have sizable operations in the West. More importantly, the huge increase in uncertainty will have an impact on confidence and, therefore, on investment.
In any case, if the experience of 2008-09 is any guide, inflows will resume only once the immediate crisis is past, the uncertainty reduces and investors pick up the courage to venture out of their holes.
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