Policy Sedatives: Overwhelming Effects and Unintended Side Effects

Before the Financial Crisis in 2008, it was frequently claimed that the developed economies had permanently ended the cyclicality of prior eras. In fact – a name – the “Great Moderation” – was invented by Economists to describe the stable period from 1984-2008 when the variability of real GDP growth and inflation fell markedly. Recessions did occur during these years, but they represented short and fairly shallow punctuations between extended periods of moderate expansion. In 2004, Bernanke credited “better monetary policy” for the great moderation – meaning, of course, better monetary policy under Volcker, Greenspan and him.

That was before the Great Recession of 2008-09, by far the deepest since the 1930s. The financial crash made the term “Great Moderation” seem hubristic, if not absurd, and for a while it was banished from the lexicon. But now it seems to be back, albeit in a slightly different form.

Post the GFC, global Central Banks have not shied away from adopting a “whatever it takes” policy to support the global economy and avert another crisis. The fact that there is close to US$10tn of negative yielding debt globally bears testimony to this. It also appears that global Central Banks have succeeded in their new mission. After all the US economy is just two months away from surpassing the record 120-month 1991-2001 expansion while US equities have already hit their longest bull run in history.  So have Central Banks finally tasted blood in eliminating the obstreperous business cycle?

While it is difficult to say that business cycles have been eliminated, but it does look like they have been tamed. To put it simply, while unconventional policy response by Central Banks in recent years have avoided recessions, it has led to increased occurrence of mini-cycles. These mini-cycles are shorter in duration but occur more frequently and lead to weaker recoveries.

Below we elaborate some of the characteristics of these mini-cycles:

• The mini-cycles are entirely driven by the performance of the two largest economies in the world – US and China which together account for ~50% of global growth. The US economy is important because of its role as a supplier of dollar liquidity (via its current account) while the Chinese economy is important because of its impact on Asian supply chains
• The mini-cycles comprise shorter periods of boom due to the structural problem of debt and demographics as well as shorter periods of bust (slowdown) since policy-makers have now become very agile in their policy response
• The mini-cycles are a result of the conflict faced by Central Banks in managing short-term growth expectations vs. the longer-term destabilizing forces of excessive leverage
• Although, each mini-cycle elicits a strong policy response by the Central Banks but the subsequent recovery invariably turns out to be weaker than the previous one

Perhaps the best way to explain these mini cycles is to compare the economic environments in late 2015 and late 2018. In late 2015, the global economy was staring at the cusp of recession led by a plunge in oil prices and China induced global manufacturing weakness. As volatility roiled equity markets, policy makers quickly stepped in via the purported “Shanghai Accord”. This was the apparent quid pro quo that emerged from the G20 summit in February 2016 in which the Fed agreed to be patient in raising rates while China launched a major stimulus program. What followed for the next two years were a synchronized global growth recovery and a fierce rally in equity markets.

Fast forward to late 2018 and the environment looks eerily similar to what transpired in late 2015. A curb on leverage at the start of 2018 caused the Chinese economy to slow considerably. As Chinese growth faltered, so did several economies dependent on global trade. With risk assets in a state of turmoil, policy makers once again stepped in with Fed swiftly moving to dampen expectations of further rate hikes and China embarking on policy easing.  In fact, it now appears that these mini-cycles are closely linked to China’s credit cycle with some lag (Chart 1).

   Chart 1: Bloomberg China Credit Impulse (% of GDP)

Source: Bloomberg

While Central Banks through their unconventional policies have managed to depress large variability/volatility in macro data, they have been unable to tackle the issue of prolonged low nominal growth. The remarkable absence of inflation even after unprecedented monetary easing and tight labour markets is particularly startling. Technological advancement is now often used as an explanation for mysteriously low inflation. However, low inflation itself could be responsible for subduing the business cycle due to its dampening effect on incomes. To counter this, the proponents of MMT (Modern Monetary Theory) are now prescribing an unorthodox combination of fiscal expansion supported by Central Bank money printing. Despite criticism from many eminent voices, this new school of thought has been successful in garnering attention, as few within the Fed have now started talking about targeting nominal GDP growth as a policy objective.

However, be it QE or MMT, the fact of the matter is that volatility cannot be suppressed forever. With policy makers now pushed to the wall to either adopt unusual policies or risk deep contraction in asset prices, mean reversion of volatility appears to be the most probable outcome going forward.

In the last few years, like the global economy, the Indian economy has also been experiencing mini-cycles characterized by low growth and low inflation (Chart 2). Apart from global factors, domestic issues like absence of financial slack (declining household savings rate) and health of balance sheet of various stakeholders have led to this subdued environment. While on a relative basis, the Indian economy is the fastest growing economy in the world, the problem is low growth for long (real as well as nominal) coupled with declining investment rate can lead to marked decline in potential growth.

Chart 2: The Indian Economy has been experiencing low growth low inflation in the last 5 years

Source: CMIE Economic Outlook

However, unlike global Central Banks who have tried to fight all headwinds via a “whatever it takes” policy, the RBI seems to have fallen short. While the RBI has been infusing liquidity into the system via OMO’s and forex swaps, the injection has been more reactive rather pro-active (even in the wake of the current NBFC crisis). Their single-minded focus on inflation targeting has meant that the economy has been grappling with oppressively high real interest rates which in turn has been deterring private investments and lowering the economy’s potential output.

Recently, the RBI has expressed its concern over fiscal slippage. In the medium-term, yes that has to be resolved because crowding out is a genuine issue when financial savings are low. However, growth considerations need to take precedence over other things at the point of time. Rather than being dogged down by the fear of inflation (which is non-existent), the RBI needs to err on the side of excessive easing. Moreover, to be more effective, RBI liquidity injection has to be directed towards troubled segments like MSME's, rural economy and NBFC's.

While the ingredients for a sustainable growth cycle may be missing in India, without significant Central bank easing, there is a risk that India’s growth may structurally shift downwards.With India’s medium term growth outlook plagued with uncertainty, the Indian economy/markets in line with the rest of the world cannot escape volatility ahead.

Riding the Liquidity Tiger

"Last thing I remember, I was running for the door, 

  I had to find the passage back to the place I was before, 

 'Relax' said the night man,

  We are programmed to receive

  You can check out anytime you like,

  But you can never leave"  

                                                                                                     The Eagles - Hotel California

Against the expectations of another solid year after a stellar 2017, last year turned out to be fairly miserable for investors with every asset class significantly under-performing cash. In our regular year end survey in 2017, we found that consensus was expecting mid teen returns from EM equities in 2018 with not a single strategist calling for a negative return year for EMs. In contrast, MSCI EM ended the year down 17%, while the strongest of the markets like the US also suffered its first double digit losses this decade. The pain in risk assets was felt despite US GDP growth hitting 4%, global EPS rising to fresh highs (15% yoy growth), US corporates alone buying back ~1trn of equity and unemployment falling to multi-decade lows in US and Europe.

While there are various explanations to the sudden risk off (including possibility of a US recession in 2019), the most plausible explanation could be that the World is currently experiencing a liquidity squeeze. Post the Global Financial Crisis, we were in a slow deflationary recovery, prone to aftershocks (Eurozone periphery, China) which forced Central Banks to print money in vast quantities. It all started with the US Fed, but as the contagion spread to other economies, they also pursued  large scale monetary easing. The result was 713 rate cuts, US$12trn of asset purchases and global bond yields falling into negative territory.  In fact, 2017 alone saw a whopping US$2trn of asset purchases by the ECB and BoJ (the highest ever). Not surprisingly, it was this flow that conquered all risk assets, resulting in a stellar rally in global equities with preposterously low volatility in 2017. 

However, 2018 marked an important turning point with the script changing from quantitative easing (QE) to quantitative tightening/tapering (QT). It is the US Fed which started withdrawing stimulus from last year, while both the ECB and BOJ continued with their asset purchases, but at a much slower pace. Consequently, total assets of major Central Banks peaked at $15trn in Mar-18 and has now fallen to $14.2trn at the end 2018 (chart 1). With liquidity getting scarce at the margin, assets that performed exceedingly well when liquidity was abundant (stocks, bonds, EMs) are now struggling, while assets that performed miserably under QE (cash, US$) are now outperforming. Moreover, volatility across risk assets has shot up significantly.

Chart 1: Total Assets of Major Central Banks

Source: Ed Yardeni Research

There are other factors which have amplified the recent equity market correction:

Debt funded share buybacks: Loose monetary and fiscal policy have led to unprecedented buybacks. Massive share buybacks not only have boosted EPS but have also led to reduced equity market float. Over the past decade, S&P 500 companies bought back ~$5 trillion shares. Less number of shares for trading means less liquidity. Less liquid markets amplify the market gyrations.

Side effect of the dominance of passive investors: Typically, active investors buy when stocks are undervalued and sell when overvalued. This active role has been critical, and the basis of mean reversion led cyclical investing.  Relative to active investing, passive investing is more about momentum. However, as more and more markets are under the grip of passive investors the buying (liquidity) support which active managers tend to provide is now missing. This in turn has exacerbated the downward spiral in equities (especially in the US where the speed of the fall since October has taken everybody with surprise).

These technical issues are also in some ways offshoots of grand monetary experiment that various Central Banks have done at varied time periods since the Global Financial Crisis. However, what is now clear is that:

Peak Central Bank Liquidity = Lowest volatility (what we saw in 2017)

Liquidity withdrawal by Central Banks = Heightened volatility (what we are witnessing now)

While most Central Banks around the world have started to withdraw their liquidity support, there is one Central Bank which has expedited liquidity infusion since 4QCY2018. That Central Bank is the RBI. So far in FY19, the RBI has conducted purchases of government bonds to the tune of Rs.1.9trn via Open Market Operations (OMOs). Further, the RBI has stated that it will infuse another Rs.500bn worth of liquidity per month from January to March-19. Also, it mentioned that the “OMO amount stated above is indicative and RBI retains the flexibility to change it, depending on the evolving liquidity and market conditions” – basically implying a strong commitment to infuse durable liquidity.

Important to note that liquidity of such large magnitude has never been provided by the RBI ever before in its history. The last time RBI had infused liquidity of somewhat similar quantum was back in FY13 when it did OMO purchase worth Rs.1.5trn.

In our last article, we had argued that the recent decline in household savings in India meant that capital availability (liquidity) in the economy is likely to become a structural challenge. This year, the situation got amplified by the sharp rise in oil prices during middle of the year as well as the government crowding out the private sector. With respect to government finances, the need to support the farm/rural economy (in the form of loan waivers, higher MSP and direct cash transfer) is now acting as a permanent drain on the fiscal side. Lower than expected GST collections in the election year means that the Govt. is now looking for new and innovative ways to fund its spending program – and yet is likely to fall short!

As we know, the oil led brief BoP shock caused a sharp decline in forex reserves which in turn led to the decline in base money. Therefore, the RBI anyways had little choice but to generate sufficient reserve money in order to sustain growth. However, it was the ILFS default and the consequent shadow banking crisis that acted as a catalyst for the RBI to really step up its liquidity operations. While the RBI has been guilty of committing several policy mistakes in the last couple of years (and we have been critical of it), it is currently doing a commendable job of supplying durable liquidity at a time when the economy really needs it. The financial slack in the system is fairly limited as evident from the highest ever banks' credit to deposit ratio (chart 2). Also, the gap between call money rate and the repo rate along with corporate credit spreads continues to remain quite elevated despite the recent sharp correction in oil prices. This suggests that without the RBI’s liquidity support, economic growth will most likely suffer.

Chart 2: Record High Bank Credit to Deposit Ratio

Source: CMIE Economic Outlook

To conclude, the last few months have made one thing very clear. We are in an era where markets are overly  dependent on Central Bank support. The design of the QE framework was that it will work mainly through the financial (asset prices) economy rather than real (capacity creation) economy. Therefore, when there is even whiff of withdrawal of quantitative stimulus the markets are reacting very negatively. The message from the markets is that the World is in QE trap and the foundations of the decade old expansion (post GFC) is on extremely shaky ground.  Balance sheet normalization has been and will be a major challenge for all the policymakers. Markets would force the policymakers more than ever to continue to pursue loose monetary policy. Case in point is this Friday, when in response to weak Chinese economic data, the PBoC announced a RRR cut and even the Fed Chair Powell (despite a bumper labour market data) conveyed that the “Patient” Fed will be flexible with all of its monetary policy tools, including the all important balance sheet. In a nutshell, whether it is the RBI, Fed, PBoC, ECB or BoJ, the burden of heavy lifting squarely rests on their shoulders. They are riding a liquidity tiger and no matter how hard they try, there is no jumping of it!