Washington D.C., March 7, 2013 - In its March edition of the Capital Markets Monitor (CMM), published today, the Institute of International Finance warns that "political and policy uncertainties have intensified" in the last month, strengthening the headwinds against the nascent global economic recovery. Central banks have committed themselves to do "˜whatever it takes' to stabilize financial markets and economies, but political deadlock represents a risk to this stabilization. The critical problem resulting from prolonged political stalemate is that essential policy reforms could be delayed - with the consequence that wider investor confidence may be undermined.
Much of the recovery so far has in any case been heavily reliant on "˜easy money' conditions fostered by central banks. These conditions - quantitative easing, very low interest rates - cannot last forever, but the risk is that financial markets have become addicted to them. The fact that the Dow Jones Industrial Average rose to a record high this week is more a reflection of these relaxed international monetary conditions than a signal of strong recovery in the "˜real' economy. The report points out: "The longer central bank liquidity is relied on to hold things together, the more excesses and distortions are being accumulated in the financial system. An eventual unwinding of these excesses will become a destabilizing risk event."
Presenting the March CMM at a press briefing today,Hung Tran, First Deputy Managing Director of the IIF, said: "Policymakers need to be more attuned to the unintended consequences of their actions and must communicate clearly their long-term intentions with regard to monetary conditions. This would help lessen the risk of large swings in financial markets."
The CMM this month identifies four major uncertainties: the difficulties posed by thehung parliament in Italy, following that country's recent elections; the ramifications ofthe U.S. "˜sequester'and the sharp divisions within the FOMC over whether or not to sustain QE3;Japan'sefforts to overcome 15 years of deflation; and the subterranean risks toChina'sapparently successful "˜soft landing'.
Italy'sinconclusive elections have added uncertainty to the Euro Area crisis resolution effort. One clear message can be detected: about 55% of the electorate rejected austerity and structural reform. It raises the question of Italy being able to mobilize sufficient public support to meet the conditionality that would be required in order to activate the ECB's Outright Monetary Transactions, if needed. Sovereign bond yields in the Euro Area "˜problem' countries have declined - but this hasn't yet translated into better lending conditions, or lower costs to businesses and households. The strong rise in the Euro - up more than 20% versus the U.S. dollar in the past nine months - is aggravating the difficulties for those Euro Area members that are struggling to reinvigorate growth.
In the U.S,the consequences of the "˜sequester' may have been less than expected - the actual impact of the budget outlay reductions could be less than 0.6% of U.S. GDP in 2013. But the underlying cause of the "˜sequester' (political polarization and failure to achieve compromise) means the spending cuts arbitrarily hit hardest some areas where the long-term damage to future growth is least affordable, notably infrastructure and research. Of possible greater consequence to financial markets' stability is the division within the FOMC over the Fed's bond-buying program. The risk here is uncertainty: an open-ended QE3 cannot be taken for granted.
Japan'sdecisive action to try to end its long period of deflation is to be welcomed - a strong Japanese economy will benefit the global economy, after all. The newly-appointed BoJ governor, Hirohito Kuroda, has stated publicly that his policy will be to do "whatever is needed"; this is likely to translate into an open-ended asset purchase program. "˜Abeconomics' has been accompanied by an almost 35% rise in Japan's equity markets since November 2012, while the Yen has dropped by more than 13% (on a trade-weighted basis). Sentiment has clearly improved. But Japan's turn towards aggressive monetary easing needs explicit international policy coordination, particularly in commitment not to target exchange rates. Otherwise the risk is obvious - an inadvertent stumble into "˜currency wars' - acknowledged or otherwise. The bigger question for Japan is its declining labor force, which since peaking in 1998 has dropped by an average 0.5% a year, while its productivity is currently increasing by 0.5%; so its trend growth rate is currently nil. Structural reforms are needed - otherwise continued stagnation is likely.
Finally,China.Here inflationary pressures have diminished, reducing the need for tight monetary policy. This should enable GDP growth to settle around the 7.5% official target. However, price rises in some of China's real estate markets remain frothily elevated. New measures - including increased down payments for house purchases and a 20% capital gains tax on property - will help cut some of the speculative froth. Of greater concern is the rapid expansion of total social financing, driven by credit extension through non-bank channels and growing by 50% (on a year-on-year basis) to more than RMB1.7 trillion at the start of 2013. This kind of rapid credit growth has in the past normally presaged a future rise in non-performing loans.