Monetary policies may be risking the world, yet again

pic by TMR FILE

THE much hyped expectation of a ‘V’ shaped recovery globally appears to be fast evaporating.

Singapore, often seen as a barometer for global trade trends, reported a quarter-on-quarter reduction in GDP of 41.2%.

With the US GDP expected to shrink 6% this year, President Donald Trump and his economic team have backtracked from earlier claims of a ‘V’ shaped recovery to an expected ‘U’ shaped one.

Going by the International Monetary Fund’s numbers, Europe, the Gulf Cooperation Council and much of the developing world’s GDPs are expected to shrink on average by about 7% this year. Japan continues to be both in a recession and deflation.

China, once the locomotive that had kept Asia growing during the 2008 global financial crisis, is itself limping. Global economic conditions and outlook are certainly not pretty.

The Covid-19 pandemic is not really abating as many countries are still battling second and third waves with more lockdowns. Yet, none of these gloom and doom is apparent in financial markets.

All three US stock indices have risen some 40% since mid-March. So too have emerging-market (EM) indices such as Malaysia’s FTSE Bursa Malaysia KLCI (up 30%) and Turkey’s Borsa Istanbul (at 40%).

This obvious disconnect between the real sector and financial markets hinges squarely on the “unconventional monetary policy” of developed world central banks, led by the actions of the US Federal Reserve (Fed).

There is little that is really innovative in this “unconventional policy” — just super large doses of the same old tactics, cut interest rates, print money and outright market support.

This time, it includes the purchase of corporate bonds. Financial markets are supposed to fund real sector production of goods and services, but years of monetary looseness have not only diminished the impact on the real sector, it now appears to have little if any traction.

In fact, studies show the real result has been “financialisation”, that is, instead of funding real sector expansion, prolonged monetary stimulus has led to financial markets taking a life of its own.

For example, a single real sector funding transaction can lead first, to the creation of CDOs (collateralised debt obligations), the trading of which may require yet other financial instruments like CDS (credit default swaps) to hedge the resulting risk.

The focus of financial markets soon moves away from the underlying real sector transaction to the short-term returns from trading the many derivative instruments.

This is inevitable when the focus of monetary policy itself is on quick gains from stimulus rather than longer term structural reforms. The pandemic may have laid bare the inherent inconsistency of several business models, but when policy itself is short-term in orientation, the needed structural cleansing cannot happen.

The trillions the Fed, the Bank of England and European Central Bank have injected into financial markets is clearly not sustainable, but they serve to pump up stock and bond prices, avoid needed corrections and provide the illusion of normality.

This, however, comes with longer term costs arising from the distortions induced. The distortions are both domestic and global. Of the many, a key domestic distortion would be the disincentive to save and invest in real sector activities, but to channel funds into speculative assets.

Thus, even near-bankrupt firms see their stocks rise and forward valuations jump several-fold. Market support activities by providing an implicit floor to financial asset prices effectively provide speculators with a one-way option.

Repeated rate cuts make debt and leveraged speculation cheap. Bubbles inevitably form. When policy incentivises speculation instead of real sector investment, the key allocative function of financial markets fails.

While there is no doubting that policy has to be accommodative given a pandemic, reliance on the very blunt instrument that is monetary policy is risky.

The use of more precise, target specific instruments would be better. For example, instead of blanket rate cuts, directed rate reductions to specific industries and targeted asset purchases would not only be less distortionary, but much more impactful.

Restructuring affected SME (small and medium enterprise) loans through securitisation and the electronic trading of such instruments dissipates risks and helps banks clean up their balance sheets.

Blunt tools like rate cuts and reserve ratio reductions are not only indiscriminate, but enhance moral hazards and induce systemic risks.

Developed world monetary looseness can translate into global distortions putting EM countries at risk.

Since their monetary policy dictates which way capital flows, EM interest rates, commodity prices and exchange rates will experience heightened volatility.

Sudden stops and balance-of-payments become more frequent. Unfortunately, EM central bankers appear to be afflicted with the same groupthink. There appears to be little innovative thinking among them to side step these issues.

Islamic finance alternatives for risk-sharing modes can get them off this roller coaster. Every financial crisis has been preceded by monetary looseness, yet the lessons do not seem to have been learnt.


Prof Dr Obiyathulla Ismath Bacha is the professor of finance at the International Centre for Education in Islamic Finance. The views expressed are of the writer and do not necessarily reflect the stand of the newspaper’s owners and editorial board.