Rate hike fuels fear
With businesses and consumers used to low rates and cheap funding, many believe that the party will end with higher borrowing costs. Will this trigger the next crisis?
IMAGINE a situation where whenever you needed it, you could always dip into the kitty and come up with a fistful of dollars. This is what it was like for the past decade when central banks around the world, including the United States Federal Reserve (Fed) and the European Central Bank (ECB), created money by buying up bonds in the market, what is known as quantitative easing (QE).
Mopping up these bonds had the effect of making long-term interest rates lower, while at the same time, policymakers in these developed economies such as the US, the European Union and Japan also held down short-term rates by keeping key interest rates low.
At that time, the move to keep interest rates low was done in order to revive the economy. The short-term rates are the rates that commercial banks refer to when they set their rates for property loans, hire-purchase and personal financing loans.
Now that global economic growth is revving up, policymakers are mulling raising benchmark interest rates again, while those central banks that had created money in order to support growth are either starting to shrink their balance sheet or are planning to do so soon.
Most will focus on what the Fed will do or what the members of the Federal Open Market Committee will say, as these are the people who can vote to raise or cut interest rates. And the Fed is eager to shrink its balance sheet, incurred through buying US government bonds and mortgage-backed securities, because it has ballooned to US$4.52 trillion.
The problem with shrinking the balance sheet, which the Fed has begun from this month, will mean that long-term interest rates will start to go up. The Fed has also raised short-term interest rates twice this year after raising it last December. The benchmark federal funds rate now stands at a range of between 1% and 1.25%. There is at least one more rate hike this year.
Faced with the prospect of higher interest rates, meaning higher borrowing costs, how will businesses and consumers react? What about those who have borrowed at cheaper rates but are now faced with higher rates? Will this trigger the next economic crisis?
But economists are cautioning against jumping to conclusions. They do not deny that there will be volatility in the financial markets that will have a spillover effect on the real economy. But they argue that any rate hike or “tapering”, that is a reduction in the bond-buying programme used to stimulate economic growth, will be more nuanced.
UOB KayHian Malaysia Research economist Julia Goh tells
StarBizWeek that as far as the markets are concerned, the Fed will take the gradual approach for rate hikes. “It’s going to be modest and moderate, not likely to disrupt the markets. After all, it took them many years to get out of the recession (the 2008/2009 global financial crisis). I think they wouldn’t want to hike aggressively and cause a pullback in the economy,” she says.
Goh points out that the reduction of the balance sheet has also not been aggressive. “The Fed is just letting the bonds mature and not reinvesting,” she says, adding that this will be easier for the markets to absorb versus the Fed aggressively selling down.
Goh says what could cause the markets to be more volatile is when all the central banks reduce their stimulus programmes at the same time. “It doesn’t appear that this is the case,” she says. The ECB will be giving more guidance on when it will start tapering at the Oct 26 meeting. There are various estimates of how much the ECB will reduce its bond-buying programme for next year, which stands at €
60bil per month this year. Some € have estimated a low of 15bil to € €
20bil to a high of up to 40bil. A revision of the eurozone growth rate to 2.2% from 1.9% does support a reduction in the bond-buying programme, but a steadily strenghening euro has stayed the hand of policymakers.
Goh does not believe that the Bank of Japan (BoJ) will raise its key rate soon, as inflation in Japan continues to be low. “The Japanese economy is doing well but inflation is still nowhere near the target,” she says. The BoJ has a 2% inflation target. At the end of January last year, the BoJ also introduced nega- tive interest rates in the hope it would spur commercial banks to lend more and consumers to spend instead of save.
Volatility
It cannot be denied that the global economy has become addicted to the cheap money created by the QE and low interest rates. Because growth was slower in the advanced economies, corporate earnings took some time to recover while the QE meant lower bond yields. In search of growth and yields, investors took their money to emerging markets.
This had the result of inflating asset prices – from bonds to properties – in the emerging markets. A measure of how disruptive any tapering can be came in 2013, during the “taper tantrum” when thethen Fed chair Ben Bernanke said the Fed would start to “taper” the bond-buying programme. That had a disruptive effect on markets worldwide and particularly for emerging markets.
Citigroup Inc managing director for global strategy Mark Schofield says in a report from last month that it is not certain that tapering will bring the big increase in volatility that many commentators anticipate. “The reality is that it isn’t really possible to create a onesize-fits-all scenario for tapering. Each country will have its own response and each asset class will likely see a different reaction,” he says.
Schofield says based on a survey, the consensus seems to be somewhere in the middle as to the impact of tapering on the financial markets. “There is a great deal of debate as to how significant the impact of tapering is likely to be. Some see tapering as an integral part of the new phase in the cycle and as such think it will have no real impact on the global economy, while others think that it could be the event that finally bursts the bubble, leading to a downward spiral of asset prices and a brutal tightening of financial conditions
that could tip the economy back into recession,” he notes.
How will this impact emerging markets, especially the exports-reliant Asean economies already threatened by disruption of trade flows from protectionism? There is the very real fear that the QE and interest rate hikes will have a negative impact on the financial mar- kets of this region and other emerging markets, and this will eventually have knock-on effects on the real economy. Emerging-market currencies will bear the brunt of the market volatility.
AmBank Group chief economist Anthony Dass expects some capital outflows from the emerging markets of this region with the tapering and the rate hikes. “There could be some pressure, but I expect some of the countries in this region to eventually start pushing up rates. In the case of Malaysia, should inflation stay around 3% next year, then we may see Bank Negara raising the overnight policy rate by 25 basis points,” he says. This will bring it to 3.25%.
Dass says there is some breathing space for monetary policy in the region as it remains low. “The hikes for emerging markets in this region will be marginal, so raising by 25 basis points is not going to be disruptive. This is done so that the interest rate differential (between emerging markets and advanced markets) will not be so wide,” he says. Wide interest rate differentials will cause volatile capital flows, in this case, fund flows increase over time back to the advanced economies.
Based on the real effective exchange rate, the ringgit has been undervalued since November 2014. This means that borrowing costs have been more expensive, but Dass expects a stronger ringgit next year relative to this year. The house view is for the ringgit to average between 4.22 and 4.25 against the US dollar versus this year’s 4.31 to 4.33.
“If the ringgit appreciates a bit more, then borrowing costs will be relatively cheaper than this year,” Dass says, adding that in Malaysia’s case, fundamentals have improved with international reserves above US$100bil, cumulative inflows into local equities at RM9.53bil while foreign shareholding of Malaysian Government Securities is holding steady at 42% (from a low of 38%).
“When you look at this kind of liquidity numbers, there is some appetite. We’re not off the radar screen, we’re back on the radar screen and give some support to the ringgit, which will help in the borrowing cost pressures,” he says.