Friday 29 Mar 2024
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This article first appeared in Personal Wealth, The Edge Malaysia Weekly on August 12, 2019 - August 18, 2019

The global economy is in for some turbulent times. Interest rates, already at very low levels for more than a decade, are on their way down again. Yet, since the 2008 global financial crisis, interest rates have not really normalised to pre-crisis levels despite several tightening attempts in 2017 and 2018.

Now, another round of rate cuts is happening. The US Federal Reserve cut its policy rate mid cycle by 25 basis points to put the target range at between 2% and 2.25% on July 31, a move referred to as an “insurance cut” amid emerging signs of economic weakness and uncertainty, caused by escalating trade war fears.

Expectations are that the Fed will cut its policy rate again before the end of the year. The prevailing view is that more central banks may go down the same path in the coming weeks, including the European Central Bank (ECB) and the Bank of Japan.

Central banks in major economies seem to be stuck in a loose monetary policy stance as the global economy faces strong headwinds and is headed for a slowdown.

In June, the International Monetary Fund revised down its growth projection for the world economy to 3.3% from its earlier forecast of 3.5%. A key risk to growth, it said, is the escalating US-China trade war and rising tariffs that could disrupt supply chains and impact investments. The World Bank, on the other hand, is looking at an even lower growth rate of 2.6% for 2019.

Against this backdrop, it would appear that interest rates at profoundly low levels — in the negative territory in the eurozone — are going to stay that way longer, at least for the next year or so. The fact that inflation has remained subdued has given room for more rate cuts in the near future. June inflation in developed economies stood at 2.1%, down from 2.3% in May.

While a low-rate regime may be the new normal, it is not a tenable situation when it is extended for too long. A loose monetary policy can be a double-edged sword. Indeed, a growing worry is that the global economy is now trapped in a low interest rate regime and the consequences may not be pretty.

Monetary easing is a quick fix that gives governments a window to implement reforms to put the economy back on the growth track. When interest rates are very low for too long, monetary policy may no longer be an effective option when the next recession comes. And as surely as there are upturns, the downturns will come.

A case in point. Some market observers believe that the recent cut by the Fed, at a time when employment is still strong and asset valuations high, may not provide much room for the US central bank to manoeuvre should the global economy be dealt with a major shock in the coming months.

The concensus view for now, though, is that the global economy, supported by cheap liquidity, will still grow, albeit at a slower clip. A recession is seen as unlikely until past 2021. What will happen when the next recession hits?

The problem with low interest rates is that it encourages excessive leveraging. We have begun to see a huge build-up of global debt, fed by more than a decade of cheap money and the spate of quantitative easing exercises implemented in the US, eurozone and Japan since 2008.

History, as we know it, has shown that many a crisis in the past have been triggered by excessive debt. And the latest statistics are not looking good.

According to the Institute of International Finance, global debt has risen by US$3 trillion to US$246.5 trillion, almost 320% of global output, as at the end of the first quarter of this year. In 2017, it was 225% of output. Excessive debt is a time bomb, and if cheap money continues to be abundant, debt may continue to snowball. How much longer can the debt binge continue? Growth that relies on debt alone is not sustainable and sooner or later, things will come to a head.

Low interest rates that persist for an extended period of time also tend to result in the misallocation and inefficient use of resources because the funds are cheap. In such an environment, investors may chase riskier assets.

Companies kept afloat by debt become less efficient, less productive and uncompetitive in the long run, adversely impacting real economic growth. Japan is a case in point — more than a decade of low interest rates have not resulted in any significant leap in its GDP growth.

Excessive leveraging may eventually lead to loan defaults, posing a systemic risk to the banking sector.

The problem with low interest rates and sluggish growth is that it can lead to currency wars, something that is happening now. Central banks will not want to see a big divergence in interest rates. Investors will put their money in currencies that have higher yields, thus chasing up their strength.

At a time when trade wars are escalating (US-China, Japan-South Korea), a strong currency is not exactly the best option to have.

In fact, a currency war is already going on. When the US cut its policy rate on July 31, the ECB reacted by saying it may also do the same. In early August, China allowed the yuan to break the 7.00 mark against the US dollar — in the midst of rising trade tensions between the two countries. In retaliation, the US has named China a currency manipulator, which means it could slap more tariffs on Chinese imports.

So, this is the state of the global economy today. The rough weather can be expected to get rougher. Monetary easing and fiscal expansion can stem the tide for a while. But in the end, the answer is still structural reforms to build economic resilience. And this is the hardest part.

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