The world is still assessing the damage caused by the earthquake-tsunami that devastated parts of north-east Japan on Friday. Most of the immediate commentaries—and we have to remember that the noise-to-information ratio exceeds one in the early stages—have relied on the economic impact of the Kobe earthquake of 1995 as the basis to make predictions about the impact of this one. At one level, it is understandable but at another level, it is unreliable.
The Kobe earthquake was not accompanied by a tsunami and it did not affect power generation. Power is at the core of industrial production and hence the damage to industrial production this time around would come from the extent and the length of interruptions to power supply in Japan. It is too soon to assess that.
Second, when the Kobe earthquake happened, the world was not yet aware that Japan had embarked on a two- decade period of economic stagnation, conventionally measured. Nor did the Japanese know it. Hence, they had neither hesitation nor difficulty in pumping a lot of money into reconstruction efforts. This time around, the Japanese economy is already saddled with a huge mountain of debt and its annual budget deficits, too, are high. It does not have big headroom to expand government spending. If it tries to create one, we do not know what impact it would have on the cost of government debt in Japan. If it finally ends up waking the Japanese government debt market from a deep slumber and pushes yields higher, the contagion effect on other fiscally challenged developed countries is not to be ruled out. That would be a mirror image of what happened to emerging market sovereign debt in 1994. In the aftermath of the Kobe earthquake in 1995, the world was not grappling with near-bankruptcy situations in developed countries.
When the Kobe earthquake occurred, the world economy was just coming out of a series of mini-shocks to growth, starting from the disintegration of Soviet Union and the collapse of the Berlin Wall. Then, came the Savings & Loan crisis in the US, the invasion of Kuwait by Iraq, mortgage and banking crises in Scandinavia, the collapse of the mortgage boom in the UK, two mini-crises in the European Monetary System and the Mexican crisis. As a result, global commodities were in a coma after a slump in the early 1990s and so was the case specifically with crude oil prices. The all-commodities index began rising only in the second half of 1995 and took off towards the end of 1995 as signs of global recovery began to take hold. Crude oil prices were in a slump longer than that.
We have no such luck now. At least not yet. Prices of commodities are rising as they are boosted by demand and supply factors and by speculative demand too. Raghuram Rajan, former chief economist of the International Monetary Fund, wrote in his blog that the Federal Reserve monetary policies encourage excessive risk-taking (see http://blogs.chicagobooth.edu/n/blogs/blog.aspx?nav=main&webtag=faultlines&entry=31).
Now, the Bank of Japan would be adding to global liquidity with its injections. In its policy meeting compressed to a day from two, the Bank of Japan has injected record sums into the money market and expanded its asset purchase programme. Regardless of whether this leads to any improvement in real economic activity, its inflationary impact via the impact on the prices of commodities has to be taken into consideration.
Quite apart from these liquidity considerations, the impact on crude oil and conventional sources of energy would be positive in the medium-to-long-term since the world would reassess the safety and reliability of nuclear power. Already China and India have dropped hints to that effect. Regardless of the outcome, this would boost prices of crude oil, coal, etc., for some time to come.
In the final analysis, investors have to remember—and it has been stressed on numerous occasions in these pages—that the world economy has staged only a fragile recovery from the global financial crisis of 2008. That, too, has been only due to massive government stimulus and loose monetary policies that give rise to other significant and substantial costs. On top of that, the debt-funded growth model of the last decade or so has given rise to a boom in the prices of natural resources. Consequently, the growth-inflation trade-off for the world is a lot worse than most would like to believe.
Hence, providing for a higher margin of safety in our portfolios than is usual is the prudent course to take. Instead, if low interest rates were deemed an invitation to take on greater risk, then events such as the one that occurred on Friday will have failed to deliver their lessons to investors and such investors will then have to face the risk of even bigger lessons in the coming months.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at email@example.com
To read V. Anantha Nageswaran’s previous columns, go towww.livemint.com/baretalk