Global interest rates are falling, and will fall dramatically. Alan Greenspan has already cut rates by 0.5%, with one surprise cut in between meetings of the Federal Reserve. And the Fed is going to cut some more this month.
Germany’s Bundesbank has so far resisted calls from the new Social Democrat-led government and other centre-left European governments to cut rates to boost economic growth and jobs. But it is under growing pressure to act.
Japan’s interest rates are already near zero. But the Bank of Japan is dead set on pumping life into a comatose economy. The BoJ’s balance sheet has expanded by over 40% in the last two years. Reserve money is now growing at 12% year-on-year from a low of just 2% in the summer. And now the BoJ is to provide up £53 trillion ($340 billion) in loans to finance the huge injection of cash that the government plans in order to bail out Japan’s collapsing banking system.
All this is designed to help avoid a global financial crisis. As I have argued before in this column, the crisis that began in Asia and then spread to the rest of emerging markets was not primarily transmitted by a slowdown in world trade flows, although that is one result. The contagion was financially induced.
The emerging-market virus has mutated and spread to the rest of the world through the banking collapse in Asia, the withdrawal of Japanese lending worldwide and the deepening problems of hedge funds and banks in the OECD countries.
Non-performing loans on emerging-market debt will eat up a massive chunk of the capital of international banks, something like 40% of international banks’ core capital. To maintain the internationally approved minimum on bank capital, losses on emerging-market loans could require banks to contract lending globally by as much as $4 trillion. That’s the equivalent of Japan’s GDP.
The Japanese banks are bust and everybody knows it. European banks are easily the most exposed to emerging markets. They are lousily managed with hardly any risk control. And they were last into lending in emerging markets and so have the worst quality of assets backing their lending. US banks may be the best run in the world, and are less exposed, but they too were sucked into the Asian miracle. And they certainly swallowed the argument that the US growth story and bull market would last forever. As the credit crunch bites in the US, they will suffer too.
That’s why the recent rise in the yen against the US dollar does not reflect economic recovery in Japan. It really is a measure of the stress in the global financial system. Japanese banks have been fire-selling US bonds and scrambling to bring money home as survival finance. As a result, leveraged investors have closed out their yen borrowings and their US dollar longs in droves.
There’s more than $1 trillion in funds with leveraged investors. Even if the gearing on those funds is no more than four to five times (not all hedge funds have the collective stupidity of Long-Term Capital Management), that’s still two to three times the size of the US equity mutual fund industry.
This is all pretty close to becoming a global capital crisis. Now G7 central bankers have belatedly woken up. The task is now damage limitation, not to save Brazil, the last potential domino in the emerging-market crisis, but to save their own financial system.
So interest rates have been cut and the US Congress has finally agreed to release funds to refinance the IMF so it can help bail out the likes of Brazil, Romania, Pakistan and possibly even Russia again. And the Japanese government has finally passed legislation that, at least on paper, aims to recapitalize its banks and take the heavy burden of bad debts off their backs.
Easy money and lower interest rates have promoted a rally in world stock markets in recent weeks. The Dow has recovered by over 10% since its lows in July. But this is a fool’s rally.
While central banks may succeed in saving the financial system, lower interest rates won’t stop the global economy from going into recession. That’s because, instead of Japan becoming like the rest of us, the world has now become Japan. There is a liquidity trap on a global scale. Banks are going to shrink their balance sheets anyway. So cheap money will not become new lending. It will find its way into nice government bonds instead, with the spread being used to replenish margins. Consumers, hit by falling asset prices, won’t be borrowing to spend either. On the contrary, they’ll be saving. So easy money will not equal higher growth in the OECD and recovery in capital-starved emerging markets.
But the action of the Fed in cutting interest rates aggressively will change one thing the outlook for the dollar. The US will bail out the world by pricing its dollars low, while the German Bundesbank and the European Central Bank will do much less, more slowly. That will increase the global supply of dollars, while the US consumer goes on sucking in more cheap imports from emerging world. So the twin US deficits on trade and capital outflows will widen. That spells the end of the strong dollar.
Emerging markets will like a weaker, cheaper dollar. Their currencies usually ride with the greenback and it’s a lot easier to climb aboard when the dollar is behaving like a slow lumbering freight train than as an express.
But the rejoicing in emerging markets won’t last long. Demand for their exports in rich countries will be ghastly. And there will be no rich foreign banks knocking on the door to buy their defunct ones. They will suffer a dearth of capital. Lack of capital will drive a wedge between rich and poor countries again — like in the 1960s. And it will prove pretty deflationary for OECD economies too.
David Roche is president of Independent Strategy, a London based research firm.
