Why central banks are at loggerheads

Lokeshwarri SK | | Updated on: Jul 31, 2019
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Emerging market economies are growing their forex reserves, but advanced nations want them to spend more

RBI Governor Shaktikanta Das’ recent hard-hitting speech at a book launch, sends a strong message to advanced economies (AEs) to stop the blame-game and admit the fact that the monetary policies adopted by them following the Global Financial Crisis in 2008 have failed to deliver the required results.

The immediate trigger for the RBI governor’s outburst appears to have been the speech delivered by the Bank of England Governor, Mark Carney, in June, in which he implied that policies of emerging economies are leading to low interest rates globally. The other incitement was the inclusion of India in the US Treasury’s currency manipulators’ watch-list last year.

While India has been was removed from this list (in May this year), such tactics by advanced economies are seen as amounting to arm-twisting, to make emerging market economies (EMEs) toe the line. Besides building a case for EMEs growing their forex reserves in the face of increasing uncertainties in global flows, Das also managed to set the alarm bells ringing on the increasingly challenging global environment caused by the growing pile of debt and ongoing trade tensions.

The blame game

Governor Carney had stated in his speech that due to the uncertainty over the sustainability of capital inflows, EMEs have defensively accumulated reserves and limited the opening of their capital accounts, including by resorting to overt capital flow management in some cases. He was also critical of the fact that EMEs had been slower in improving their financial openness compared to advanced economies since 1980.

According to him, this excess precautionary savings in EMEs are pushing down the equilibrium interest rates, increasing the risks of a global liquidity trap. It may be recalled that former RBI Governor Raghuram Rajan had also warned about such an eventuality in September 2014.

In a speech made in Chicago, he had said that “Any emerging market today is going to look at the currency volatility and say ‘whatever money comes in, I’m going to be careful about it, I’m going to build some reserves. That kind of policy will depress global demand.”

But despite being aware of the consequences, AEs continued their monetary easing over the last decade, unmindful of the consequent asset price inflation and debt-pile in other economies.

With higher liquidity in the global market, attention is now shifting towards the factors affecting consumption. The US treasury department’s semi-annual report on currency manipulation, is another effort to make EMEs consume more and save less.

It puts countries on the currency manipulators’ list if: a country has a bilateral trade surplus with the US of at least $20 billion; a material current account surplus of at least 2 per cent of GDP; and one-sided net purchases of foreign exchange in six out of 12 months adding to at least 2 per cent of an economy’s GDP over a 12-month period.

A country is put on the monitoring list even if two out of the three criteria are met.

The looming problems

Against this background, one cannot but agree with Das that the AEs are resorting to ‘bilateral hegemony’.

The stronger message sent by all these verbal exchanges is that the global conditions are getting extremely challenging and central banks might not have any immediate answers to these problems.

The IMF, in its WEO report in July, revised global growth forecast for 2019 to 3.2 per cent and for 2020 to 3.5 per cent, 0.1 percentage points lower than the April forecast.

According to the IMF, “GDP releases and softening inflation, point to weaker-than-anticipated global activity. Investment and demand for consumer durables have been subdued across advanced and emerging market economies as firms and households continue to hold back on long-range spending.”

The WTO has projected growth in merchandise trade is 2.6 per cent in 2019, down from 3 per cent in 2018. It is obvious that the trade-war along with demand compression is beginning to take a toll on global activity.”

At the global level, the total amount of bonds with negative yields has risen to nearly $13 trillion; implying that nearly a third of advanced economy government bonds trade at negative yields. Equity premium has crossed 4 per cent, which is one standard deviation higher than its long-term average.

Return to normalisation in AEs poses challenges as leverage has already built up across the globe. The turbulence in financial markets in the last quarter of 2018 shows the extent of pain that will ensue once monetary tightening begins.

The trouble is that much of the stimulus money has flown to companies in EMEs. Total credit to the non-financial sector in the EMEs went up from 107.2 per cent of GDP at the end of 2008 to 183.2 per cent at the end of 2018. Net private capital flows to EMEs in the form of direct and portfolio investments also nearly doubled in the post-crisis period.

Possibility of disruption to emerging market economies is very high as these flows grow volatile. As Governor Carney said in his speech, the typical emerging market economy receiving higher capital inflows will grow 0.3 percentage points faster, if all else was equal; but typical EMEs with higher capital flow volatility will grow 0.7 percentage points slower.

The way out

It is apparent that advanced economies have limited room to manoeuvre as general government debt of AEs as a group has surpassed 100 per cent of GDP.

The move towards de-globalisation, trade wars and geo-political tensions pose further problems to global growth. Also, as stated by the RBI governor, the financial safety nets, regional or multilateral, are insufficient to provide the necessary buffers against such turbulence. Swaps from systemically important central banks are also not available to the EME.

It is, therefore, up to each country to assess the likely impact of the unfolding global conditions. The RBI needs to keep building its forex reserves and it would be good to preserve the other reserves of the RBI, including its contingency reserve, as far as possible, given the increasing external risks.

As the push factors in global funds flows become weaker, the pull factors (increasing the depth of domestic financial markets, favourable regulations, tax policies, etc) need to be worked on. Foreign investors prefer stability in tax and regulation and it is best to avoid frequent tweaks, to enable sustainable flows.

Published on August 01, 2019

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