One of the reasons for the pause in the recent market rally has been the dawning realization, prodded by a World Bank report, that a recovery in the devastated economies of the West is likely to take years. It’s now the turn of the Bank for International Settlements (BIS) to underline that note of caution.
In its annual report, published on Monday, BIS warns that small is the gate and narrow the path that leads out of the financial crisis. It calls for reforming financial institutions, markets and institutions. It flags the risks emanating from the unprecedented monetary easing and says that an exit strategy must be put in place so that inflation is controlled as recovery occurs.
The report says: “Recovery will come at some point, but there are major risks. First and foremost, policies must aid adjustment, not hinder it. That means moving away from leverage-led growth in industrial economies and export-led growth in emerging market economies.” Strong words for governments intent on reviving the bubble. And strong medicine for a system that has been become addicted to leverage.
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It also raises the question of global financial flows. One of the ways in which the system worked was through “global imbalances”, or the building up of export surpluses in countries such as China which then reinvested the money in the US, allowing US consumers to live far beyond their means. If these surpluses start coming down, if US citizens start saving instead of consuming, if the leverage winds down, what will happen to all the liquidity that propped up asset prices? From the point of view of the market, the worry is the winding down of leverage will mean that the extraordinary gains in the stock market made during the last boom will no longer be possible. In short, once the recovery comes, it will no longer be “business as usual”.
For the emerging markets, the more important part of the World Bank report was its forecast that capital inflows to their economies would be even lower this year than in 2008. It’s now the turn of BIS to underline the fragility of financial flows.
In its annual report, BIS says, “Since the current crisis is associated with an unprecedented contraction in global economic activity, it is extremely uncertain when and how far private capital inflows to emerging markets might recover.” Even FDI inflows, usually supposed to be resilient during downturns, may be at risk. BIS warns that roughly one-third of recent FDI inflows were related to mergers and acquisitions, typically financed by international bank loans.
But what about the rally in the markets since March and the return of risk appetite? BIS does take that into account, but it’s not convinced about the strength of the recovery. Interestingly, for those of us waiting for funds to flow into India once the Union budget outlines a road map for reforms, BIS says, “because the crisis originated in the financial systems of advanced economies, the standard remedy in the past—reforming policies in emerging market economies—is not likely to restart the flow of capital to EMEs (emerging market economies) on its own.”
The report points out that it is not clear how global current account imbalances—which were an important factor in the surge of capital flows to and from emerging markets in the period before the crisis—will eventually be resolved. It says that the recovery is likely to require a rebound in trade with reduced global imbalances; but bringing about the needed adjustments in both EMEs and advanced economies could take time.
And finally it warns of the “risk of a destabilizing negative feedback loop: the severity of the downturn could deter a recovery in capital flows to EMEs, which could in turn further impair growth”.
But won’t the expansion of their balance sheets by central banks around the world unleash enough liquidity to support asset prices? It certainly looked that way in April and May.
A recent research report from BNP Paribas throws some light on global liquidity. It argues that the surge in liquidity has come, not from central banks in the advanced economies, but by the huge amount of lending taking place in China. It says: “The surge in money growth in China arguably represents a more pressing development than the surge in advanced economy narrow liquidity. Policymakers have sought to push lending higher directly, rather than passively via a rise in bank reserves.
In the first three months of the year, loans rose by virtually the same amount as over the whole of 2008. This has been done on a large enough scale to offset the deceleration in broad money growth in the advanced economies in recent months.”
In other words, because banks in the advanced economies aren’t lending, the money created by central banks is not leading to growth in broad money measures there. But Chinese banks have been lending hand over fist and that is why global liquidity has surged.
This kind of loan growth in China is plainly unsustainable and reports have already come in of the money being diverted to the stock market. So if the BNP report is right, it considerably clouds the outlook for liquidity in the immediate future. And if the World Bank and BIS are correct, then the outlook for a rush of money flowing to our shores is also doubtful.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org