Almost a decade after the global financial crisis, the world economy is poised for a convincing recovery in 2018. The IMF’s World Economic Outlook (WEO) has started revising its growth projections upwards since 2017 after a series of downward revisions since 2008. The volume of world trade is also projected to grow by 4.6 per cent in 2018, higher than global GDP growth of 3.9 per cent. When there are clear signs of broad-based recovery, one would expect asset prices to accelerate upwards. However, contrary to the popular expectation, there has been a synchronised meltdown of stock prices globally since early February this year.
In their enthusiasm to stimulate growth, most of the systemically important central banks of the world pursued an ultra-accommodative monetary policy for a long time. Compression of yield was unprecedented in most parts of the world, which prevented/delayed deleveraging in the post-crisis period. While the response of the real sector to the ultra-loose monetary policy in major developed countries has been lacklustre, asset prices reached record levels around the world due to easy availability of liquidity through cross-border capital flows. In fact, asset prices, which were well above fundamentals of the global economy, were waiting for a trigger to correct.
The recent spike in the US 10-year yield unnerved the stock markets globally. A positive correlation between economic recovery and asset prices is more than offset by negative correlation between interest rate and asset prices. Is global recovery weak? Is there something behind the recent meltdown of asset prices which needs a better understanding of the current situation?
Global scenario
There has been a reversal in the global interest rate cycle for quite some time following normalisation of the monetary policy, led by the US Fed. Jobless claim in the US in February 2018 was the lowest since 1969. The fear of inflation looms large in the US, particularly in the context of an accommodative fiscal policy pursued by the US through massive tax cut. Speculation is rife about rapid normalisation of monetary policy to prevent overheating, at least in the US. The US Fed may increase Fed rate three times or more in 2018 itself.
The fall-out of the recent spike in the US yield rate is not limited to correction of global asset prices only. The debt flows to developing countries, which had increased significantly in the post-crisis period due to availability of low-cost funds in the developed countries, would be due for repayment. The emerging economies may face teething repayment problems going forward as most of the cross-border debts were negotiated variably over the LIBOR rate. Corporate balance sheets have also been weakened in most parts of the world due to over-leveraging. Even corporates, without having a natural hedge through their export earnings, borrowed funds from abroad to defray their local currency expenditures. The collateral damage done to the corporate balance-sheets due to imbalance in the debt-equity mix would unfold when their foreign liabilities have to be serviced at higher rates of interest in the near future.
Disruptive trend?
Is normalisation of the US monetary policy disruptive? The perception that the US Fed would do it in a gradual manner is changing. Countries which earlier reduced their interest rates progressively with the US Fed to promote growth, may be able to match the Fed rate hikes going forward and thereby maintain the interest rate differential that can prevent capital outflows.
Countries which have not done so may not have enough space to raise their policy rates quickly and may possibly face capital outflows due to the narrowing of yield spread. Although the fundamentals of an economy typically prevent capital outflows to some extent, debt flows are more sensitive to interest rate differentials and therefore may intermittently disrupt stock prices.
The current global recovery appears to be mostly policy and/or consumption-driven. While structural reforms hold the key to accelerating global recovery, such reforms are not distinctly visible globally. Unless there is a pick-up in investment and an improvement in productivity growth through structural reforms, it would be difficult to sustain global recovery in the medium-term.
Is India ready?
How is India positioned to face this eventuality? The Government has taken several initiatives for structural reforms in agriculture, industry, and the services sectors besides reforms in the fiscal and monetary policy frameworks. Structural reforms like GST, the Insolvency and Bankruptcy Code, etc, are still works-in-progress. Despite the fact that India’s medium-term fundamentals are reasonably sound, Indian stock prices tumbled during the recent global asset price meltdown. Domestic developments like the jewellery scam following the fraudulent issuance of the Letter of Undertaking (LoU) by Punjab National Bank, compounded the problem. The Government has moved swiftly to regulate auditors and confiscate assets through new legislation.
Currently, inflation in India is within the desirable range. Excluding the impact of house rent, the CPI inflation is expected to remain around 4 per cent, which the RBI is mandated to achieve in the medium-term. There is no threat to CPI inflation from the farm sector, given the record level of foodgrain production over the last two years. The Government has the option to reduce excise duties on petro/diesel if crude oil prices exceed $70 a barrel.
The benchmark yield rate in India is already high. A premature hike in the policy rate may push it further upwards. This may have a sobering impact on debt outflows, but hamper economic recovery. Better would be to pursue structural reforms to their logical end; this would attract foreign direct investment on an enduring basis. What is more important now is to resolve the twin balance-sheet problem once and for all. Cleaning the balance-sheets of commercial banks cannot be completed without taking to task wilful defaulters.
A missionary zeal is needed to punish them while nurturing startups and honest borrowers to steer the recovery forward.
The writer was principal adviser and head of the monetary policy department, RBI