The world economy is in transition. Economic growth is picking up, but the change means elevated risks and volatility in financial markets. All eyes are on the US and China – the world’s largest economies – as what happens here will have global implications.
In the US, the Federal Reserve (Fed) is moving to normalise monetary policy. This will mean tighter monetary conditions, not just in the US but globally.
Meanwhile, China is determined to rebalance its economy, and rely more on domestic consumption and services to drive economic activity rather than remain heavily dependent on investment. Credit conditions will have to tighten, raising the risks of higher non-performing loans and possible defaults of trust products and bonds.
Although markets have been fully prepared for the end of QE, volatility could increase further
The end of quantitative easing (QE) this year together with interest rates moving higher in 2015 should tighten global liquidity. Although markets have been fully prepared for the end of QE, volatility could increase further.
Perhaps the main advantage of QE was that it anchored long-term interest rates. With the Fed engaging in QE, expectations for interest-rate hikes were pushed back well into the future. In the absence of QE, forward guidance cannot provide the same commitment to keeping policy rates low, especially if inflation slowly begins to rise. Guidance is not a promise.
Asset markets have become accustomed to low US yields. 10-year US Treasury yields have stayed below 3.5 per cent since spring 2010, but we expect them to reach 3.5 per cent by the end of this year. Market behaviour at the moment is not reflective of this change.
Managing interest-rate expectations may prove hard
There is an additional complication. At the moment US inflation is low, and core inflation, which is usually the best predictor of future headline inflation, does not suggest significantly higher inflation soon. But at the same time, a recession and years of sub-trend growth and high unemployment have pushed many Americans out of the job market. As a result, potential growth in the US has likely dropped.
We should therefore not be surprised if inflation in the US begins to rise at lower levels of growth than was previously the case. The Fed could find itself in a situation in the future where it faces higher inflation at a time when growth is relatively low and a significant number of people are out of the job market. Managing interest-rate expectations and consequently market interest rates through forward guidance might prove hard.
Just like the US, China’s performance has an impact globally. Credit conditions will remain tight this year as China moves to resolve over-capacity issues in a few industries. There could be greater pressure on over-leveraged companies with poor cash flow, and as result we would not be surprised to see some bankruptcies as China’s transition gains momentum.
But China can cope, and these situations need to be seen in context. China’s transition and rebalancing are absolutely necessary to ensure longer-term sustainability; China is right to be willing to take some short-term pain. But at the same time the authorities are very pragmatic when it comes to keeping real growth above 7 per cent.
Policy stimulus likely later this year
Policy stimulus to ensure that growth remains adequate is therefore likely later this year. It has been the mantra of Chinese policy makers to cross the river by feeling the stones. It should not be any different this time around.
Last year some emerging market economies showed their vulnerability to changes in Fed policy. Changes in sentiment and global-liquidity conditions leave economies with large current account deficits – which make them dependent on foreign inflows – vulnerable. The combination of fixed exchange rates, current account deficits and declining reserves are usually worrisome.
Emerging markets are in a better position in 2014 than last year
But it is important to highlight the significant adjustment several emerging economies have made since last year. The first thing to note is that many emerging markets have relatively flexible exchange rates. In 2013 exchange rates in South Africa, India, Brazil, Indonesia and Turkey moved sharply and absorbed several shocks.
This is exactly what flexible exchange rates are meant to do. We have also seen central banks hiking interest rates (with possibly more interest-rate hikes to take place in South Africa and Turkey) and current account deficits decreasing substantially.
Short-term risks are a price worth paying
Vulnerabilities remain and more is needed in terms of structural reforms in emerging markets. But the starting position of these economies in 2013 was much healthier than in the 1990s, and emerging markets are in a better position in 2014 than last year.
The fact that big economies are going through a synchronized transition raises the risks. But ultimately transition is necessary to ensure sustainable growth, especially in China. And in that sense, short-term risks are a price worth paying.
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