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BW Businessworld

The Panic Button

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The title code red refers to unconventional and, on hindsight, irregular practices followed by Col. Jessup in the movie, A Few Good Men, to keep his unit fighting fit. Mauldin and Tepper play Tom Cruise to Jack Nicholson’s memorable role allegedly being played out today by central bankers in the US, EU and Japan.

The charges are not new. The unprecedented expansion in balance sheets by western central banks may have been necessary in 2008 to stave off a prolonged recession, but has this played out far too long? Japan’s entry into the game will defer the retreat, as economies are forced to play a domino of loose monetary policy and low rates to keep their currencies and exports competitive. Meanwhile, retirees, who mostly hold bonds and deposits, are seriously impacted by the resulting low interest rates, as are pension funds which may be forced to renege on their commitments unless bailed out by the government. Paradoxically, the research quoted in the book suggests that even equity fails to generate meaningful real returns, since growth and employment generation continue to be sluggish with banks reluctant to lend as spreads remain narrow and asset quality suspect.

To compound the problem, central bankers are shown as not quite being on the ball when forecasting business cycles. This is partly due to an obsession with lagging indicators (unemployment, inflation) rather than leading indicators (building permits, growth in money supply, yield curve), as well as periodic revisions in historic data. The authors quote from a 2004 speech by Ben Bernanke: “…if making monetary policy is like driving a car, then the car is one that has an unreliable speedometer, a foggy windshield, and a tendency to respond unpredictably and with a delay to the accelerator or the brake.”
 Ananda Bhoumik
A more serious charge is fiscal dominance, which describes the situation “when a central bank is forced to buy government debt so that the government can spend freely”. The authors suggest that the Federal Reserve has a strong incentive to maintain status quo and push back the taper, as the mark-to-market loss resulting from a 2 percentage point increase in interest rates could render the Fed technically insolvent and also necessitate large bailout of banks.

So, what is the endgame in this lethal game of endless money printing and pliant central banks? The authors stop short of suggesting hyperinflation, but see bubbles in government bonds and agricultural farmlands in the US. They see the yen continuing to decline to 150 over the next 3-5 years (switch your debt to yen), which will threaten the export competitiveness of Germany, Korea, Taiwan and the rest of export-led Asia. The euro zone will continue to struggle with its fiscal crisis. The cooling of China will end the commodity supercycle (so commodities are no longer a hedge against inflation).

The authors are patriotically bullish on the dollar, driven by the US turning into a net-exporter of energy on the back of shale gas discovery as well as by the revival of manufacturing in the US as Chinese wages and cost of transportation between China and the US turn uncompetitive.

The book does not discuss India, but the subject is very relevant for this country. Volatility in all markets will remain elevated and cost of hedges and forward rates will therefore remain high.

Economic cycles may become shorter, making long-term investments even more challenging. RBI is rightly focused on managing inflation, but finds it difficult to deliver as monetary policies are rendered ‘blunt’ due to infrastructure bottlenecks.

The bubble in real estate price has driven up the cost of doing business and is pumping up leverage for retail consumers and small businesses on the back of a rising collateral value and easy credit. The economy remains prone to overheating as infrastructure growth continues to lag the demand being created by the demographic dividend.

India’s banking sector is right now under the lens, but the system has inherent resilience that comes from diversity in loans and deposits, thanks to India’s vast size and heterogeneity of GDP composition.

However, the banking system has run up large funding gaps as long-term infrastructure loans are funded out of short-term deposits. The imbalance is unsustainable and leads to a persistently flat-to-inverted yield curve, which disincentivises long-term savings. Infrastructure, therefore, needs to be funded by long-term senior bonds which banks should be allowed to issue.

One of the chapters in this book is titled ‘Economists Are Clueless’. The authors have perhaps been unduly harsh on their profession.

Bhoumik is Senior Director, India Ratings

(This story was published in BW | Businessworld Issue Dated 30-06-2014) ]]>