The new and disturbing phases of market uncertainty in January have given way to outright routs, involving a broad-based fall in stock prices in the major developed markets, dragging some into bear territory. The latest phase, unfolding from early February, has presented a new dimension, with bank stock prices falling significantly more than those of non-financial companies.
Such is the concern in Washington that Janet Yellen, U.S. Federal Reserve chair, felt compelled to suggest in a statement to the House Financial Services Committee on Wednesday that a second interest rate rise had become unlikely. Pointing to increased risks from China's slowdown, its sliding currency and broader market turbulence, she warned -- - in a piece of vintage central bank understatement ---that financial conditions had become "less supportive" of U.S. growth.
The current turmoil started in China, which is grappling with a markedly slowing growth rate, and a simultaneous hangover from a vast expansion in bank and non-bank credit. But are these and other developments in China and emerging economies linked to events in developed economies? If so, does the causality run from East to West or the other way round, and why is it happening now, with a disproportionate focus on banks?
The crisis in the West is a story of various forces depressing demand and pushing down on the neutral interest rate, the central bank policy rate that is consistent with stable inflation. One part of this story, emphasized by economists Ricardo Caballero and coauthors, identifies the emergence of Asian economies as a culprit. This emergence generated new wealth. Partly for demographic reasons (including the recently reformed one-child policy in China), and partly due to uncertainty about state provision for health and old age, much more of this new wealth was squirreled away than would otherwise have been the case.
We would normally think of returns being higher in an emerging economy, causing capital to flow "downhill" from rich to poor. But in this case, the vagaries of property rights protection and political risk meant that the money flowed "uphill" to lower-return but safer destinations in the West. These flows drove up the price of safe assets like sovereign bonds.
History repeats
It is just possible that the latest market uncertainty, following the various waves stretching from 2015 into 2016 is, at least in part, a replay of some of those dynamics. Growing realization -- forcefully conveyed by Yellen -- of risks in the Chinese economy, and the saga of the authorities trying, unsuccessfully, to stabilize domestic stock prices, has driven a surge in capital outflows. Other emerging economies -- already historically prone to "sudden stops" where capital runs from markets -- are vulnerable because of the importance of China as a market for their exports.
These factors accentuate the demand for safe assets in the West, bearing down on real interest rates that are already reaching unprecedented lows. Following this, Western stocks have fallen for two main reasons. First, this is just the flipside of the increased demand for safety: stocks are risky, sovereigns are not. Second, observers know that Western central banks are, to all intents and purposes, out of ammunition.
As Japan demonstrated in early February, conventional interest rate policy is at its limit, with rates at either zero or a little below. Other instruments such as quantitative easing are also stretched, as seen in the bloated balance sheets of central banks in the U.K., U.S. and Japan, and the efficacy of these interventions is anyway dubious. The logical backstop, aggressive fiscal stimulus, is politically impossible in the U.S., U.K. and the eurozone, and perhaps no longer possible in Japan, given how much -- including earlier bouts of stimuli -- has already been done there.
Dark clouds over banks
Why the focus right now on banks, some of which are seeing their stock prices collapse? Western authorities have taken many steps to improve regulation and force or allow banks to repair their capital levels. But there are many clouds on the banks' horizons. It may be hard or impossible for them to adapt to a protracted period of low nominal rates, if they cannot develop acceptable ways of charging for their services. Negative rates, at some point, of encouraging people to withdraw deposits and hold cash.
The 2010 Dodd-Frank legislation, which revamped U.S. financial regulation, now inhibits the U.S. Federal Reserve from making emergency loans to a single institution, thus preventing a repeat of the assistance it offered to failing investment bank Bear Sterns in 2008. Further, markets may judge that after many years of significant deficits, fiscal authorities in the major economies are much less able now than they were in 2008 to make good on an implied promise to act as lender, (or at least, stimulator) of last resort.
There is always a danger of over-engineering economic rationales for market fluctuations. The recent rout could simply be a kind of self-fulfilling prophecy. An investor sells down stocks because he thinks others will, and vice versa. Dynamics like these resemble old-fashioned bank runs, as depositors pull out their cash due to sheer panic. If this is the reason behind recent market moves, there would be hope that the falls in stocks would reverse relatively quickly, and that they would not materially impair the recoveries in the West. There would also be more optimism that capital flows out of China and other emerging economies would halt -- and even reverse somewhat.
However, if the global economic fundamentals are what is really worrying investors, then the authorities may need to act more forcefully. Investors starved of safe assets need to be provided them, and Western and emerging economies starved of demand need stimuli; large-scale, debt-financed spending would kill both of these birds with one stone. Central banks, too, may have to revisit unconventional monetary tools that help take more risk onto their balance sheets. However, I am not terribly optimistic that they will do the right thing. And it may be precisely because markets share my pessimism that the panic was triggered in the first place.
Tony Yates is professor of economics at the University of Birmingham and was previously senior adviser at the Bank of England's monetary policy directorate.
