This article first appeared in Forum, The Edge Malaysia Weekly on February 26, 2018 - March 4, 2018

The whole world is going through the normalisation of a prolonged period of very accommodative monetary policies, the main antidote to the 2008 global financial crisis. The idea was to inject massive amounts of liquidity into the system to keep interest rates low and prevent a credit crunch that could have deleterious consequences for the real economy — a lesson learnt from the 1997/98 Asian financial crisis, when the reverse was done.

For the first time since the onset of the global financial crisis, we have a synchronised recovery in the developed and emerging markets, and between the real and monetary sides of the economy. The world’s major economies are humming now. Gone are the decoupling thesis, the developed economies and emerging economies dichotomy and multi-speed recoveries.

Demand is back and it is reflating asset prices, which is what the injection of liquidity into the economy — quantitative easing — is supposed to achieve. The US economy, for example, is almost at full employment and even the tepid Japanese economy, while still below its inflation target, has been registering continuous growth for more than two years. Recovery has also meant that supply-side capacities are reaching their limits, which calls for investments in new capacity.

So, why are the stock markets reacting the way they are at this good news on the real side of the economy? Major stock markets fell more than 10% at the beginning of this month. Although most markets have since rebounded from this “correction”, many are still left wondering how it happened and what it all says about the future.

There should be some context to this correction. The Dow Jones, even with this correction, is at 25,000 points — almost three times what it was at the trough in 2009. The local bourse is much less buoyant but it too followed the same trend. So, while the real side of the economy was recovering the last 10 years, the liquidity that was injected went into equities in a big way, perhaps even in a bubbly way. A part of the correction that we saw had to do quite simply with investors and speculators who exited because others were exiting and the market was going down — the herd effect.

There are, however, more fundamental reasons. The concern when massive amounts of liquidity were injected into the economy 10 years ago was the spectre of inflation, of hyperinflation. If there is an increase in money supply that is not matched with corresponding economic growth, inflation can set in quite quickly and spiral out of control. The very signs of recovery of the economy are the same signs that suggest inflation, which signals the end of the overly accommodative monetary policy. As far as the stock market is concerned, that is the beginning of the end of the availability of cheap money. Interest rates will rise.

There was a similar market reaction and correction on the same expectations when the US Federal Reserve first raised interest rates from 0% to 0.5% in December 2015. As further interest rate rises did not happen, the stock markets rallied until recently.

Central banks have been very careful about the speed at which they normalise rates and withdraw liquidity. Raising interest rates is not just about raising the cost of credit and all that comes with it, it changes overall relative prices and therefore the opportunity costs of holding different assets. Rate change therefore affects allocation decisions by households and firms, and central banks are mindful of how these decisions affect macro variables such as inflation and unemployment.

After a respite in 2016, perhaps in response to the stock market reaction to the initial normalisation, the Fed began to slowly raise rates last year. It raised the rate to 1.5% in December, which precipitated Bank Negara Malaysia’s raising its rate to 3.25% last month. The days of easy and cheap money have come to an end. The Fed has signalled further increases in rates while also unwinding its holdings of US Treasury paper as part of the quantitative easing. This will increase long-term cost of borrowing for firms as well as the US Treasury.

Bank Negara too will have to keep up. In many ways, the synchronous recovery between developed and emerging markets calls for some sort of synchronous policy response. The inflation rate in 2017 was 3.7%, which is higher than the current overnight policy rate of 3.25%.

A widening USD/RM interest rate spread will hasten the reverse flow of funds, which will put downward pressure on the exchange rate and increase inflationary pressure in an already negative interest rate environment. The selling of Malaysian Government Securities (MGS) and other sovereign debt instruments will increase yields, and therefore the cost of future borrowing. There will be pressure on Bank Negara to also tighten monetary policy if there are similar decisions made elsewhere, especially the US.

While there are arguments for some synchronised policy response, it is also true that the good economic news and monetary policy normalisation will impact an economy like Malaysia’s in different ways. The part of the economy that depends on external demand, the tradable sectors of the economy — resource-based such as palm oil and oil and gas — will benefit from this recovery, as will the manufacturing sector. But the Malaysian economy has begun to domesticate where the contribution of external demand to aggregate demand has been declining, especially since the global financial crisis. We are not the trading economy we once were and the linkage between recovery of global trade to the economy is weaker now than before.

The worrying prospect is that while the contribution of domestic demand to the economy has increased, it is the domestic sectors — distributive trade, construction and property — that will be negatively impacted by the normalisation of monetary policy. Consumption, both private and public, has been driving the growth of the economy.

Household indebtedness, which has risen since the global financial crisis because of the increased liquidity in the economy, has not improved. It has, in fact, worsened. In 2008, total household debt was 60.4% of GDP. At the end of 2016, it was 88.3%. The absolute amount and the rate at which it has grown is worrying.

Public debt has grown at an even faster pace, fuelled in no small measure by global liquidity injected throughout the crisis, which also went into the debt market. For Malaysia, the foreign flows into debts have been much more than that into equities. It is likely that the adjustments in the domestic debt market will be more pronounced than in equities.

Given that the government’s budget remains in deficit, it has to borrow to refinance debts that will come due, in addition to financing current deficits. There has been a reliance on external liquidity to finance borrowing. At its peak, foreign holdings of Malaysian government debt were in excess of 35% of outstanding debts. It has since declined, which is not unexpected as US rates have increased and there have been outflows of funds. If this continues, future cost of debt will rise.

To sustain the levels of debt at the anticipated increased costs, the economy must grow. It must not only grow, but the growth rate must match or outpace the increase in cost of debt. The economic imperative for the Malaysian economy is still about economic transformation. Its ability to sustain growth of aggregate demand in the face of rising costs of credit depends on its ability to create more value and generate more income.

The softening unemployment numbers (3.5% in 2016) coupled with low levels of gross fixed capital formation growth (2.7% in 2016) are worrying as they suggest that there are not enough investments in new production in the economy. While there is growth, it has been coming mainly from consumption, and a sizable portion of that has been financed by credit.

The economic transformation agenda and the aspiration for a New Economic Model has to regain its momentum. That agenda has stalled and its

neglect will not only affect the long-term trajectory of the economy but also the resilience of the economy in adapting to external shocks.

Dr Nungsari Radhi is an economist and managing director of Prokhas Sdn Bhd, a Ministry of Finance advisory company. The views expressed here are his own.

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