Ever since Mario Draghi, the president of the European Central Bank, dropped his bombshell in late-July on doing whatever it took to save the euro, stock markets, commodities and other myriad risk assets have not looked back. The S&P 500 stock index in the US is not too far away from its all-time high. Another bellwether of the market’s risk-love is the Australian dollar. The currency has not looked back since the Draghi announcement. The currency has traded mostly above 1.05 compared with the US dollar.

On top of the half-decent domestic economic data, international factors have also worked in favour of the Australian dollar. Many central banks from Switzerland to the Czech Republic to Russia to China have been adding to their holdings of Australian dollars. Whether justified or not, it has become a safe-haven currency. Further, there are sporadic reports of Chinese local governments and towns launching their economic stimulus plans. Investors in Australian dollars are hoping that China would place huge orders for Australian iron ore, coal and other metals. This is delusional on the part of both China and Aussie bulls.

A file photo of people walking down an overline bridge under a real estate project in construction in Beijing, China. Photo: Getty Images

“In China, much of the slowing to date reflects domestic policy actions and, accordingly, growth is expected to pick up slightly in the second half of the year as recent easings in fiscal and monetary policies start to take effect. Global growth is expected to be around 3.5% in 2012, which is close to its long-run average. Growth is then expected to pick up to be close to 4% in 2013, broadly in line with the latest forecasts from the International Monetary Fund (IMF)."

“A key risk for Australia is the rate of growth in China, which currently appears to have stabilized, but could be higher or lower than expected, given the challenges the authorities face in keeping growth at a more sustainable rate in a rapidly changing economy. The more benign inflation environment, with commodity prices having trended down, enables the Chinese authorities to ease policy more aggressively in any marked slowdown."

RBA has committed the error that many analysts have committed on the prospect of further monetary easing in China. The country’s inflation is not the real constraint on easing. The constraint is the extent of credit that is sloshing around in the country already. However, China’s inflation data is no bellwether for China’s economic stimulus. The country has excess capacity and its banking woes are due to lending for excess investment in the years gone by. Hence, the keys to further economic stimulus are whether the banking system can bear it—is it safe for the banks to lend further—and whether China is in need of capacity in any area.

Fitch, the credit rating agency, has tracked the sale of wealth management products (WMPs) by Chinese banks. It is only about wealth management in name. It is a proxy for banks to generate liquidity. It is supposedly backed up by interbank claims. But, there are layers behind it. The interbank claims are, in turn, proxies for corporate loans—companies that cannot receive loans from large banks. These WMPs are marked by poor disclosure: “Banks face no public reporting requirements, there is no centralized catalogue of issuance, and WMPs still lack unique identifiers to trace them. For these reasons, any disruption in activity requiring an unwinding of products could be messy, and it is unclear to what extent banks could truly impose losses on investors."—Chinese Banks: Wealth Management Risks Climb as Small Banks Accelerate Issuance, 27 July 2012, by Fitch Ratings.

With the European Central Bank having received the German nod to print money to buy European government bonds, China stimulating on the sly and the US Federal Reserve having its hand on the button ready to be pushed after the Presidential elections, if not earlier, the world will squarely have to confront economic stagflation in 2013. Widespread drought has struck at least three continents. Under the weight of the onslaught of combined monetary stimulus, the rise in the relative price of food will spill over to other costs and prices in 2013. Developing countries will be badly hit. In particular, India will be worst hit as these external factors compound domestic woes.

Usain Bolt claims that he has become a legend. In the eyes of investors, complacent and inebriated with liquidity (not of the intoxicating variety), Draghi is on his way to becoming one. A rude awakening awaits.

V. Anantha Nageswaran is an independent financial consultant based in Singapore. Comments are welcome at baretalk@livemint.com

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