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insight

"Can Central Banks Save the World?"

(Adapted from the Speech by Norman Chan, Chief Executive, Hong Kong Monetary Authority, at the 19th Annual Hong Kong Business Summit on 25 November 2013)

Five years on since the Global Financial Crisis – which was followed three years later by the European Sovereign Debt Crisis – the big question lingers: have we learnt our lesson and come out of the crises wiser? Or, from the perspective of a central banker, can central banks save the world?

I would like to first raise a deliberately provocative question: Is the world worth saving?

“Is the World Worth Saving?”

Many factors led to the recent crises, but I believe the root cause of the current global predicament was the excessive leverage and indebtedness that had built up in the household, corporate and government sectors in the advanced economies over the past 20 to 30 years.

During that time, the indebtedness of many industrial economies, such as the US, the UK, France and Germany increased steadily from 160% of GDP to over 320%, and Japan to over 450%. In other words, the speed of the increase in debt doubled the pace of economic or income growth of those economies during the period.

Today, surprisingly, little has changed.  Many have still not learnt the lesson, and think the problem of excessive leveraging can be solved by further leveraging. The aggregate public and private sector indebtedness ratios in most advanced economies continued to increase after the Global Financial Crisis. In the US, for example, public debt increased by US$6 trillion from the end of 2008, with the public-debt-to-GDP ratio rising from about 74% to the current 100%.  Another striking example was Japan where the same ratio surged from a precarious 190% in 2008 to almost 240% in 2012.  In terms of private-sector debt, while the US and the UK underwent more significant private sector deleveraging, most European countries showed little improvement in this area. 

As most of the advanced economies are debt-ridden and only have little, if any, fiscal headroom to support post-crisis growth and job creation, the use of near zero interest rates and Quantitative Easing (QE), which leverages on central banks’ seemingly limitless ability to expand their balance sheets, appear to be “The Only Game in Town”.  Can central banks save the world with these unconventional monetary policies? 

At the individual, household or corporate level, most of us understand what happens when we live beyond our means through borrowings. However, the situation is a lot less clear for governments because the usual bankruptcy rules do not apply. Besides, there is the temptation for governments to continue to incur deficits as the market seems to be quite willing, at least for a while, to finance such deficits.  Furthermore, it is usually an easy way-out for governments to spend and borrow now, and worry about repayment later. Allowing or asking governments to spend beyond their means for an extended period of time is tantamount to society mortgaging the income and livelihood of our future generations. Such action is clearly irrational and irresponsible, but it is happening all over the world.  If this is the kind of world we are living in, is it really worth saving?  

Can Central Banks Save the World? “Yes and No”

Instead of seeking to find the answer to this metaphysical question of whether the world is worth saving, let me return to the original question: Can Central Banks Save the World? The short answer is “yes and no”.

When a financial system is facing imminent meltdown, as it happened in the wake of the collapse of Lehman Brothers in 2008, shockwaves normally follow in the form of a severe credit crunch, leading to the failure of not only illiquid or poorly managed firms, but healthy ones as well.  In their role as lender of the last resort, central banks can and should step in to inject the necessary liquidity to allow the financial system to continue to function. If not, illiquidity can quickly turn into insolvency on a systemic scale. With their ability to create money by expanding their balance sheets, the Fed and the world’s central banks intervened in the crisis and the action helped prevent a global financial system meltdown.  

Therefore, we can say that central banks can and do save the world during a financial crisis.

However, their ability to reflate the economy or boost employment during post-crisis recovery is not as clear cut. Pertinent analyses by renowned economists suggest that unconventional monetary policies by central banks are now in “uncharted waters” and may create unintended consequences and significant risks to the global financial system, including:

  1. Punishing the savers and pensioners: Millions of savers, many of whom have remained prudent and avoided falling into the excessive leverage trap, are being penalised as their deposits have been earning virtually no interest in the past four years under the “low-for-very-long” policies.  With a sharp drop in recurrent interest income, these savers may scale down consumption or investment, offsetting, at least partially, the potency of low interest rates and QEs.
  2. Creating moral hazard: The suppression of interest rates and injection of huge amounts of liquidity through QEs create incentives to delay the necessary process of deleveraging by households, corporates and governments. Although QEs can reduce the short-term pain brought by adjustments, the real risk stems from the resulting delay in the implementation of much-needed reforms in the private and public sectors. This problem is particularly acute in the fiscal positions of many advanced economies that have built up high levels of public debt.
  3. Misallocated resources and investments: In the near term, QE may have the effect of boosting the asset markets, especially the stock and housing markets, as evidenced in the US. In the Emerging Market Economies, we have also witnessed the inflow of capital at the initial stages of the QEs, which drove asset prices up and induced inflationary pressure. Apart from the question of the sustainability of such buoyancy in the asset markets, there is the problem of misallocation of resources as abnormally low interest rates distort investment decisions by allocating capital away from productive real investment into risky assets. The lack of real investment in turn reduces medium-term potential growth. The search for yield behaviour also leads to a mispricing of risks across a wide spectrum of asset classes. Buoyancy in the asset markets, coupled with the mispricing of risks, allow imbalances to build up in the financial system, posing a significant threat when the unconventional monetary policies eventually unwind.

What Lies Ahead?

With almost five years of QE in the US, the main issue now is not the extent to which QE has helped economic recovery since 2009, but what happens when the Fed needs to exit from these accommodative policies, and thereafter. We do not know the exact timing when the Fed will exit, as it depends on the actual pace of economic recovery and improvement in the job market. However, when the Fed spoke in May and June this year about a possible timeline for tapering, US and global asset markets took a beating, and triggered a sell-off in many emerging market economies, especially those with weak current account positions.  The markets have also exhibited some rather strange behaviour of late – dropping when economic and employment data showed signs of improving; and rising when jobs or employment data showed signs of softening.

This pattern highlights the uncertainty and risk that when asset markets have been supported by low interest rates and high liquidity for a prolonged period, the normalisation of the interest rate and liquidity conditions could create market dynamics that could destabilise the financial system and dislocate the recovery path of the real economy. We must remain vigilant against any possible spillover effects, particularly with the massive inflow of international capital that has entered Hong Kong in recent years.

On that front, the HKMA has taken, and will continue to take, proactive steps to contain the potential adverse impact of unprecedented monetary easing policies. Since 2009, the HKMA has undertaken six rounds of countercyclical prudential measures on mortgage lending as well as supervisory action on bank capital and liquidity to ensure the banking system is resilient to future shocks. We have also launched a series of measures to contain credit growth, and recently we have further required banks with relatively fast credit growth to ensure they have stable funding sources to support that growth.

As for individuals, as always, we must guard against this temptation to incur excessive debt simply because interest rates are currently at very low levels. We must exercise prudence on household, corporate and government levels and stand ready to face the shocks so that we can emerge from the next crisis relatively unscathed, as we have done in the past.      

 

Norman T.L. Chan
Chief Executive
Hong Kong Monetary Authority
25 November 2013

Last revision date: 25 November 2013
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