Economic Affairs

Markets are staring at a failure of policy

While much ink has been spilt on the market turmoil at the start of the year, the response from some economists and policymakers has been dismissive.

"But nothing has fundamentally changed in the global economy over the past few weeks" has been the somewhat-disingenuous remark from some. This superficial response glosses over the tensions built up over years around a toxic combination of rising debt, slowing economic growth, disinflation, corporate earnings contraction and the threat of a currency war. In short, after years of zero interest rates and US$4 trillion (S$5.7 trillion) worth of quantitative easing globally, markets are now staring at a failure of policy.

To be fair, the panicked January sell-off was exaggerated and sharp rebounds are likely. Whatever the long-term structural economic flaws, there are still many in the markets who want to believe that policymakers and central bankers have a silver-bullet solution.

It was instructive that risk assets - from the Australian dollar to Japanese stocks - traded higher after European Central Bank president Mario Draghi said there were "no limits" to the bank's efforts to reflate the regional economy. This was classic Draghi - more of the "whatever it takes" rhetoric that made him "Super Mario".


But after five years of quantitative easing - basically conjuring electronic money out of thin air - economic growth has slowed. World gross domestic product (GDP) growth fell from 5.1 per cent in 2011 to an estimated 3.1 per cent last year. World manufacturing growth has fallen off sharply over recent years. Surveys indicate that manufacturing activity is declining in both the United States and China. The International Monetary Fund reckons global growth should pick up slightly to 3.4 per cent this year, but warns that the risks to its forecasts are to the downside.


Some economists are hoping that cheaper oil will boost US GDP growth. But they might be disappointed. Sharply lower oil prices have forced US energy firms to cut back on investments and workers. Further, a possible plateauing of US house prices and falling stock markets could result in more consumer caution via a negative "wealth effect".

The world continues to struggle with disinflation and deflation - disinflation being a slowing rate of inflation, while deflation shows an actual decrease in price levels. The world trade price index in US dollars has fallen almost 22 per cent since 2011. Mirroring this, China's producer price index - the indicator of what producers receive - has been in deep deflation since 2012.

We will probably avoid the global economic recession that the markets now fear. But this is profitless economic growth.

Global operating profit margins, measured using the MSCI All Country World Index companies' results, have already gone into a cyclical contraction, as they did during the Asian financial crisis of 1997-1999, the Nasdaq crash of 2000 and the global financial crisis of 2008-2009.

Emerging-market stocks have been in an earnings recession for two years now. Asia ex-Japan, including China, joined the earnings decline last year. S&P 500 companies, on aggregate, reported earnings contraction in the third quarter of last year.

And that contraction is likely to continue this year on a combination of a cyclical mean reversion in US corporate operating profit margins, the strong dollar and the severely diminished price for crude oil.


Meanwhile, China's struggle with structural economic change risks creating negative feedback loops - weakening other developing economies via lower commodity demand and prices, as well as diminishing emerging-market demand for the products of the developed world, hence further slowing economic growth in the big three developed economies of the US, euro zone and Japan.

And China's growth rate is unlikely to reverse any time soon simply because it is a deliberate long-term restructuring plan. Its credit-intensive, investment-driven economic expansion is unsustainable. According to a McKinsey Global Institute (MGI) report published last year, China's total debt to GDP could hit 400 per cent by 2018 if recent trends continue unchecked. It would then approach Japan's debt-to-GDP levels of today. And China also has to cut excess industrial capacity from sectors ranging from shipbuilding to steel to cement. These structural changes will take years to run their course.

Amid slowing growth, the world continues to pile up debts. The MGI report said global debt had grown by US$57 trillion since 2007, raising the debt-to-GDP ratio by 17 percentage points. After the global financial crisis, some economists argued that the global "debt super cycle" would shift from the developed economies to emerging markets, particularly China. The latter would leverage, spend big on infrastructure and the global economy would be the better for the "rebalancing" of debt from the West to the East.

But there has been no "happy ever after" to this elegant little story. The developed world did not deleverage. But yes, emerging markets, particularly China, did leverage up, producing for a while a "sugar hit" for economic growth and market sentiment.

One argument some years ago was that it was natural and beneficial for China, as a high-saving nation, to have high investment and credit growth. But the theory fell apart on the inefficiency of China's credit allocation process - hence the mountain of non-performing loans now weighing on China's economic performance.

In developing economies without China's high savings and current account surpluses, the build-up of debt has exposed them to the fickle ebb and flow of global capital.

In 2010, amid zero interest rates and quantitative easing in the US, US$544 billion (net capital flow, excluding reserves) poured into the emerging markets. Last year, in the aftermath of the end of quantitative easing and anticipating higher US rates, an equivalent amount flowed out.

And as the funds flowed out, emerging-market economies found themselves struggling with the vicious circle of falling currencies exacerbating fund outflows and falling economic growth rates. The Institute of International Finance last year forecast a further net capital outflow of US$300 billion from emerging markets this year.

Quantitative easing has been instrumental in boosting asset inflation. In Japan and the euro zone, it might have helped ease consumer-price deflationary pressures, but largely through the currency depreciation that follows the debasement of paper money. But despite the world's big four central banks (the US Federal Reserve, European Central Bank, Bank of Japan and People's Bank of China) expanding their collective balance sheet by US$4 trillion since 2011, the goal of generating self-sustaining economic growth remains elusive.

Worse, what do policymakers and central bankers do for an encore in competing "beggar-thy-neighbour" policies?

If US corporate earnings continue to shrink this year, the limits to US policymakers' tolerance of Japan's turbo-charged quantitative easing may not be far away. Indeed, fear of competitive devaluation - yes, a "currency war" - contributed considerably to the start-of-year market funk.


Now, if the global economy weakens further this year, what can governments and central banks do? The US Federal Reserve has only a miserable 25 basis points to cut off its policy rate. The European and the Japanese central banks have next to nothing to offer, except possibly deeper negative deposit rates and the zero-sum game of more competitive currency devaluations.

Last year, an argument emerged that the answer was the ultimate bazooka of simultaneous fiscal expansion and quantitative easing. That is, fiscal restraint had diminished the efficacy of quantitative easing. So governments should abandon fiscal restraint, spend big, run up further government debts and finance the deficits through quantitative easing.

The first problem is that the US government will likely be constrained by fiscal conservatives in the Congress. Meanwhile, the governments in euro zone countries that most need policy stimuli are already running Budget deficits in excess of the Maastricht Treaty's maximum 3 per cent of GDP.

Second, Japan has been doing this for years - to not much good, it would seem.

Finally, it is true that central banks are in theory unlikely to go bankrupt as long as their debts are in their own currency. That is, the taxing powers of a sovereign government can be used to recapitalise in the event of balance-sheet insolvency or inability to meet obligations when due. But the limit of quantitative easing is the risk of the destruction of price stability and public confidence in government debt. And the limit of government bailouts of central banks is the political tolerance of the taxpayer.

There are many complex factors behind the sluggishness of the world economy, post-global financial crisis. Among them, high levels of indebtedness, over-investment in commodities, developed economies' unwillingness to endure the pain of structural reforms, China's reluctance to destroy excess industrial capacity, low global productivity rates and ageing demographics. None of these will be solved by printing more cheap money and racking up more debts.

It is worth repeating a line from the MGI report: "High debt levels, whether in the public or private sector, have historically placed a drag on growth and raised the risk of financial crises that spark deep economic recessions."

  • The writer is the chief investmentofficer for DBS Bank's Consumer Banking Group and Wealth Management.
A version of this article appeared in the print edition of The Straits Times on January 27, 2016, with the headline 'Markets are staring at a failure of policy'. Print Edition | Subscribe