After two months of volatility in global financial markets, major equity indices in the United States have returned to their peaks. But bond markets and emerging economies remain deeply affected. Now, with major advanced-country central banks preparing to “taper” their quantitative-easing (QE) programs, the world must brace itself for additional bouts of financial turmoil in the next few years.
In fact, it took only the assertion by US Federal Reserve Chairman Ben Bernanke in May that, if the American economy continued to improve, the Fed would begin to reduce the pace of its securities purchases to unleash a short but significant financial-market sell-off. In order to ease global markets’ fears, which the Fed apparently assumes stem from a misunderstanding of Bernanke’s message, Fed officials have relied on various analogies in an effort to clarify their intentions.
For example, Bernanke explained that the Fed’s plan would be akin to a driver easing pressure on the gas pedal – not stepping on the brakes – as the car accelerates. Other officials liken their task to landing an airplane “stealthily” (that is, by powering down the motors and gliding steadily toward the ground). Still others are quitting smoking with the help of a nicotine patch.
Unfortunately, the Fed’s current quandary is more like riding the back of a tiger. It will be difficult for the Fed and other central banks to “dismount” from the QE programs without being devoured.
The unconventional monetary policies that major central banks adopted in the aftermath of the global financial crisis undoubtedly played an essential role in stabilizing financial markets, providing banks with needed liquidity and supporting overall economic recovery. But, because these policies entail moving an enormous volume of financial assets to central banks’ balance sheets, they have also generated significant distortions in financial markets by repressing risk premia for certain asset classes. That has led to misallocation of assets within investors’ portfolios, as well as creating moral hazard among commercial banks.
When central banks begin to taper their securities purchases and, eventually, sell their assets back to the markets, financial markets will inevitably re-price risks and rebalance investors’ portfolios. The hope is that banks, investors, and the economy will be recovering robustly enough by then to endure such an adjustment – and that the central banks are able to engineer a smooth exit from QE.
But recent bouts of financial turmoil have made it increasingly difficult to remain optimistic. While equity prices in the US have recovered, bond yields remain elevated. For example, yields on ten-year US Treasury bonds have soared by about 100 basis points, reaching their highest level since late 2011. This had led to huge losses for banks and other investors in the bond market, while raising the government’s debt-service costs.
In just two months, the markets have effectively nullified all of the Fed’s efforts – namely, its open-ended “QE3” – to constrain long-term interest rates, proving once again that no amount of QE can allow central banks to control such rates with any amount of precision. When expectations in capital markets change, long-term interest rates can rise rapidly, regardless of the amount of securities on central-bank balance sheets.
Likewise, central banks cannot control what becomes of the extra liquidity generated through QE – a fact clearly reflected in QE’s spillover effects in emerging economies. In 2008, the first round of QE directed capital flows away from emerging markets and primary commodities toward developed markets. In 2010, QE2 drove capital in the opposite direction. And QE3, launched in late 2012, has so far redirected liquidity from emerging economies back to the US.
Moreover, expectations of a possible early exit from QE have led to much larger losses in emerging markets than in developed countries, with emerging-market equity prices having plummeted by roughly 20% since May – a low from which they have recovered little. In the same period, risk premia, as measured by bond-yield spreads, increased by 30% on average, with some African countries experiencing surges of up to 60%. Such significant increases markedly hamper these countries’ ability to borrow.
Emerging markets, particularly those, like Brazil and India, with a relatively high degree of liquidity, were also the target of large capital-flow reversals, accompanied by sharp local-currency depreciation. While the shortage of inter-bank lending that China experienced in late June was rooted in problems within its own banking system, it was exacerbated by the turmoil in global financial markets. Such spillover effects could seriously undermine emerging economies’ efforts to confront the looming challenges of slowing GDP growth and narrowing room for policy maneuver, compounded in some countries by twin deficits and elevated inflation.
Recent market turmoil has provided a vivid and timely alert to policymakers worldwide of the risks associated with the impending effort to dismount from the QE tiger. If left unmitigated, the policy that major central banks rode out of the last crisis could drag the global economy back into the jungle.
The opinions expressed here are those of the author, not necessarily those of the World Economic Forum. Published in collaboration with Project Syndicate.
Author: Pingfan Hong is Chief of the Global Economic Monitoring Unit of the United Nations Department of Economic and Social Affairs.
Image: An office worker walks past the Australian Securities Exchange building in Sydney REUTERS/Daniel Munoz