Monetary Policy and Liquidity Tightening
Brett Halsey, SVP, Credit & Surety and Mills Ramsay, VP Credit Risk Underwriting Manager
QBE North America
Monetary policy will continue to tighten on a global scale. This will likely be the stance of most, if not all, hard currency central banks as long as political or trade risks do not significantly disrupt the fundamentals such as those we have seen recently in the developed market. This will include both policy rate hikes as well as reductions in balance sheets, which will lead to an economic slowdown in the Eurozone (EZ) and a technical recession in the U.S. A crisis is not expected; however, changing credit conditions will put pressure on risky and leveraged entities. Close attention should be paid to liabilities, especially short-term debts and refinancing risks.
In the years following the Global Financial Crisis (GFC), central banks resorted to extremely accommodative monetary policy in the form of ultra-low interest rates and novel “quantitative easing” (QE) measures. QE programs, by which a central bank purchases large amounts of assets in order to inject currency into the economy, raise equity prices and kickstart both consumer and corporate spending. The goal of these programs is to create a period of expansion.
We have reached the zenith of this period ― developed economies have seen signs of mild overheating, unemployment rates are at historically low levels and inflation pressures are starting to build in certain markets. In response to such economic signs, central banks of most major economies have begun to either actively normalize monetary policy or have signaled normalization in the near term. This will have a significant effect on macroeconomic conditions worldwide, the general business climate and asset quality.
The U.S. Federal Reserve was one of the first of the major central banks to begin normalization, starting with the gradual sell off (or maturation) of their QE asset portfolio in 2017. This was followed in 2018 by an increase in Federal Funds target rate hikes with further hikes signaled in the near term. The European Central Bank followed suit with the announcement of the tapered sell off of its own QE portfolio, and cautious forward guidance of rate hikes. Many other major central banks have, in turn, raised or signaled rate changes, which is evidence of the recent convergence seen on monetary policy worldwide.
These normalization actions will begin to affect the domestic economic conditions for the countries undertaking them in both the short and long terms. The money previously spent on consumption and investment will now be reallocated to savings with higher interest rates than were given before in these currencies. This will initiate an economic slowdown in the medium term; a mild technical recession is expected in the United States in 2020 and a mild slowdown in the EZ region in 2019 as these regions adjust for slack in the labor market and get used to a more normalized monetary policy environment. The central banks of these and, in fact, all regions will have to balance a need for growth with a need for currency (especially inflationary) stability.
While rate hikes are great for savers, the borrowers on the other side of these transactions will be squeezed. Global debt levels have ballooned even further since the GFC to a massive 225% of global GDP. Ten years of cheap credit have led to a more leveraged economy than ever. Although China drives much of this debt, any debt crisis would hit all shores. Corporates who have loaded up on short term loans with variable rates may face refinancing risk and issues as debt becomes more expensive to maintain. Many corporates in the developed market regions are on solid footing with cash reserves, hedges and asset buffers, and are prepared for debt service costs to rise by a few percentage points. However, riskier, more illiquid, and highly leveraged firms will likely see a higher probability of default and will struggle to stay above water without continued access to cheap capital.
Similarly, emerging markets (EM) economies often rely on financing and investments denominated in hard currencies from larger, more stable economies. As rates rise and QE tapers off, investors will have more incentives to keep their hard currency safe domestically where they can now see greater returns. This will continue to lead to capital outflow from these EMs.
On top of this outflow, the hard currencies EMs borrow will appreciate against their local currencies, drying up liquidity and raising debt service costs due to forex changes. Emerging market central banks are then pressured to raise their own rates in response to try and keep their local currencies from faltering against stronger hard currencies. However, these central banks must weigh these tightening actions against their competing desire for economic growth. A series of rate hikes to protect the currency can send a fragile economy into a recession or downturn, especially in EMs where access to capital is important for growing industry.
While many EM economies have greatly improved and buffered themselves against the pending wave of policy tightening, there remain vulnerable countries that will likely feel a liquidity squeeze. This will affect their asset quality and ability to service debts on both a sovereign and corporate level. Countries that suffer weakening fundamentals, currency instability in the form of inflation and political risks are especially vulnerable. Strong monetary institutions and policies are important, and in countries where this is not the case, the risk of an external debt crisis is even greater.
Emerging markets will be hit by the spillover effects of these changing conditions. Levels of hard currency reserves and the currency denominations of emerging market entities’ debts will become ever more critical. We are not facing another near term financial crisis, but we are facing a shift in the economic and financial status quo as we move away from the era of recovery and into one of normalization. This will shock those entities that relied on accommodative credit conditions to stay afloat, but those with strong fundamentals and strong balance sheets will remain stable.