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The Bank of Japan does a U-turn…

The Bank of Japan does a U-turn, while the ECB stares into an empty unconventional tool box (for now!). Encouraging export growth in emerging markets

A Tale of Two Central Banks

Before the crisis, outgoing BoE Governor Mervyn King famously remarked that his ambition for monetary policy was to be boring. This is probably roughly the perception the public at large still entertains about central bankers. They think of them as dependable men in grey suits with a somewhat conservative outlook on life. In normal times, this is exactly how it should be. After all, no one wants a bunch of rogue traders with a penchant for experimenting in charge of the purchasing power of their life savings! Yet these are not normal times. More often than not politicians have failed to deal adequately and forcefully with the aftermath of the crisis. As a result, the burden of saving the global economy fell on the shoulders of these grey-suited central bankers who have been willing to embark on monetary policy experiments that would have been unthinkable before 2008. This has not always been easy for them as at least initially it went against their professional instincts and because they face all kinds of difficult questions about political, intellectual and mandate constraints.

The BoJ does a U-turn…

Nevertheless, each in their own way the Fed, the ECB and the BoE did what had to be done and their actions are an important driver behind the improvement in global growth we have seen since the summer. Until recently, the BoJ remained the laggard in G4 space with no real change in its reaction function from what was seen since the 1990’s. However, in a determined effort to finally overcome deflation the Japanese central bank outflanked its G4 peers by a wide margin last week.

At his first policy meeting incoming Governor Kuroda went into it full force by committing to a massive monetary expansion for the next two years. This will double the size of the BoJ balance sheet from around 30% of GDP currently to around 60% of GDP in late 2014. By comparison, on the assumption that QE3 will continue at the current pace until the end of this year, the Fed will have increased its balance sheet from 5% of GDP in 2008 to around 20% in late 2013. In addition to this, the BoJ increased the average maturity of its bond purchases from less than 3 years to 7 years and also took some decisions with less importance such as a small increase in its purchases of risk assets.

For central banks talking can at times be just as important as acting and Kuroda clearly made a point of making sure that his words and his deeds reinforced each other so at to reach maximum impact. He made a clear break with the policies of his predecessor Shirakawa by stating that Japan cannot escape deflation “with the incremental approach that has been taken until now”. Moreover, he expressed confidence that “all the policies we need to achieve 2% inflation in around two years are now in place”. The latter statement could hardly be more different from the previous defeatist BoJ thinking according to which deflation is a supply side phenomenon that should be solved by structural reforms. Finally, Kuroda also signalled that the BoJ is willing to accelerate the pace of easing if the current policy stance should not have the desired effect.

One very rarely sees real life policy experiments in macro-economics but this is certainly one of them. We have often explained our views on the effectiveness of monetary policy on these pages which can be summed up by the following two points:
- A central bank has an unlimited ability to print money because of which it can always increase the demand for assets, goods and services to whatever level its deems necessary in terms desired growth and inflation outcomes.
- Because the markets and the public understand this, a forceful and clear promise to do whatever it takes can help to create a self-fulfilling increase in private sector nominal growth expectations. The larger the degree of credibility in this respect, the less the central bank will actually have to do in equilibrium.

Mr. Kuroda just presented us with a very exciting opportunity to see whether or not this view of the world is actually correct. The proof of the pudding is in the eating as they say. In particular, the BoJ clearly did everything it could to maximise the effectiveness of the crucial expectations channel by signalling confidence in its ability to overcome deflation and by demonstrating his willingness to do whatever is necessary to achieve this. Importantly, the position of Mr. Kuroda and the credibility of the announced measures were significantly strengthened by the fact that this was a unanimous decision.

The willingness to act is not only expressed by the size of the program but also by the fact that asset purchases have moved further up the risk curve. For this reason, Kuroda dubbed his policy as Quantitative and Qualitative Easing (QQE). This Qualitative part should strengthen the portfolio balance channel of monetary policy: By removing risk and duration from private portfolios and replacing them with safe assets the central bank can induce private agents to substitute towards risky assets. The performance of the Japanese equity market over the past few months shows that they have already done so massively in anticipation.

…while the ECB stares into an empty unconventional tool box (for now!)

Meanwhile, the other central bank in our Tale, the ECB, certainly took some bold and unprecedented action in the past though the implementation of the LTRO’s and especially the OMT. The first one is an unconditional liquidity backstop for banks while the other one performs this function in a conditional way for sovereigns. This has changed the nature of the EMU crisis fundamentally and for the better.

Nevertheless, this time around Draghi disappointed by remaining on hold and striking a defeatist tone which reminds us a bit of the tone often struck by the old-school BoJ. The main reason for this is that the ECB clearly feels that further action is being prevented by binding political and mandate constraints. Broadly speaking the ECB has two sorts of instruments at its disposal. The policy rate is used to preserve price stability for the region as a whole while unconventional measures are employed to counter financial fragmentation and thus ensure the transmission of the policy stance to all parts of the monetary union.

There are no constraints on the use of the policy rate except for the fact that it cannot be pushed below zero. So far the ECB has been reluctant to cut further because it expects the economy to gradually recover from H2’13 onwards, partly driven by improved credit flows in the periphery. To a first approximation one can thus say that the refi rate will only be cut if the risks to EMU-wide inflation shift to the downside. The ECB is clearly not yet willing to admit to this, even though their own 2014 inflation forecast stands at 1.3%.

Draghi maintains that the risks for inflation remain balanced as upside risks from rises in administrative prices and the oil price are roughly cancelled out by downside growth risks. We have been unable to understand this line of reasoning for six months now. What’s more, this view is becoming more difficult to maintain if one considers the recent fall in the oil price and especially in view of the increased downside risks to growth which were explicitly acknowledged by Draghi. The ECB indeed seems worried that the weakness is spreading to the core countries. While our base is that the refi rate will be kept on hold, the chances of a cut have clearly risen.
As for unconventional measures the ECB has done a lot to repair regional divergences in the degree of monetary transmission. However, this has not been enough to get credit flowing again in the peripherals. The question how to achieve this is a very complicated one. Further credit easing measures involve coordination with fiscal and regulatory authorities which is pretty difficult to achieve given fiscal and regulatory fragmentation which characterises the Eurozone.

The most obvious step seems to be a loosening of the collateral rules for private sector loans. This would actually amount to a policy of increasing monetary fragmentation with the hope of reducing financial fragmentation. Many people probably think that monetary fragmentation – where different monetary policy rules apply to different countries – started with the Cyprus capital controls. In reality it already started last year with the Governing Council’s decision that peripheral national central banks (NCB’s) can accept private sector loans as collateral while core central banks do not accept them. Unlike the normal repo operations, where risks are shared within the entire system, the credit risk is borne entirely by the NCB’s and thus ultimately the sovereign in question. If the loosening of collateral standards is successful in reviving credit growth this means that the riskiness of peripheral sovereign debt will increase. This could lead to problems unless market participants were assured that the region will make further progress in the area of burden and risk sharing. However, during the Cyprus crisis it became clear that, if anything, the core countries may be backtracking a bit in this vital area.

Nevertheless, it is not even entirely sure that looser collateral rules would entice peripheral banks to lend more. Even though the credit risks would ultimately be borne by the sovereign if things go wrong, these banks of course want to prevent this from happening in the first place. More private sector lending in a recession which may last for an unknown period worsens their (prospective) capital position at a time when regulators demand an improvement. The only way around this is to take the credit risk of their balance sheets. In this respect, the ECB could start to buy SME related ABS. But of course this is also a decision with fiscal implications as the increased credit risk on the central bank balance sheet ultimately falls on the national Treasuries (via the possibility of lower central bank dividends in the future or if things really go bad the need to recapitalise the central bank).

For now, it thus seems that Draghi is looking at an empty unconventional tool box. This is not to say that effective tools will not be put in that box in the future, they probably will. Looking back the ECB has been in this situation before and has always managed to take everyone by surprise. The only problem in Europe is that this always takes a while and sometimes only happens after a severe deterioration in market sentiment or the economic environment.

Encouraging export growth in emerging markets

We are getting a better picture of the state of global trade growth after the Chinese new year distortions in January and February. So far, six emerging economies have reported their March trade numbers. Four showed very good export growth momentum: Brazil, Chile, Taiwan and Vietnam. Two had reasonable export growth in the month: China and Korea.

The good pace of export growth in March has brought year-on-year EM export growth back in positive territory, reflecting the Chinese recovery over the past few quarters and the better economic data coming out of the US. It is also in line with the better global PMIs of the past half year or so. We project EM export growth to average 6% in 2013, which, at first sight, looks good compared with the negative numbers recorded in the summer of last year, but this growth pace remains far below the 20-year average of 13%.

It is interesting to highlight the export statistics published by Taiwan this week. The best growth performance was in exports to China, ASEAN and particularly Japan, where year-on-year growth reached 17%, much above the 3% average. Europe continues to be the weakest link: Taiwanese exports to Europe fell by 12% compared with March 2012.

It will be challenging times for Asian exporters the coming quarters. We identify three issues: firstly, the continuous weakness in European demand; secondly, the likely slowdown in Chinese demand from Q3 onwards; and thirdly, the competitiveness pressures due to the weak yen and strong US dollar.

Willem Verhagen
Senior Economist

M.J. Bakkum
Senior Emerging Markets Strategist

Economic Outlook
Document à usage professionnel uniquement

Mardi 23 Avril 2013

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