Currencies
Demographic Trends and the Financial Markets
September 21, 2007

By Stephen Jen | London

Summary and conclusions

In this note, I present some key demographic trends that I believe will have important implications for financial prices over the medium and long term.  Essentially, reflecting declining fertility and mortality rates, the population of the developed world is ageing, though different countries are ageing at different speeds.  On the other hand, much of the developing world (except for China) continues to enjoy a ‘demographic dividend’ from its young and growing population.  These demographic trends influence the potential growth rates of countries, the levels of interest rates, the shapes of their yield curves, and C/A balances. 

There never seems to be a good time to discuss slow-moving, though powerful, structural trends because investors and analysts like myself always seem to be in fire-fighting mode, dealing with short-term shocks.  While investors’ focus right now is understandably on the ongoing credit crisis, the housing slowdown in the US and the weakening dollar, I believe that we should be aware of these powerful tectonic trends and how they may affect financial prices and policies.

The basic issues

The world is going through a historically unprecedented demographic transition as both (1) fertility and (2) mortality rates are falling, particularly in developed nations.

Prior to 1900, world population growth was slow, and the age structure of the population was broadly stable.  This was primarily because relatively few people lived beyond the age of 65 and childhood mortality rates were relatively high.  In the 20th century, overall population growth began to accelerate, due to rising life expectancy. (In 1975, there was a 38% probability that at least one member of a married couple aged 60-65 would still be alive at age 90.  For the same couple currently aged 60-65, that probability is approaching 60%.)  Although in the first half of the 20th century there was little change in the age structure of the world, the second half was marked by a sharp decline in fertility rates (by almost half).  Though infant mortality also declined sharply, population growth decelerated.  According to current UN population projections, this trend will continue.  By 2050, the global population growth rate will likely decelerate from 1.25% currently to only 0.25%. 

The declining birth rate initially yielded a ‘Demographic Dividend’, as the working population rose as a percentage of the total population.  In fact, this effect is so dominant that half of the changes in US per capita income growth since 1960 can be explained by changes in this demographic composition of its population. 

These two global demographic trends − lower fertility and mortality rates − not only reduce the global population growth rate, but also raise the world’s age structure, i.e., the share of the young falling and that of the old rising.  These demographic changes will affect national saving, investment and international capital flows.  But, importantly, the ageing demographic structure will exert considerable pressure on the fiscal position of governments and pensions in particular. 

These demographic trends are different for different countries.  Japan is the world’s most rapidly ageing country.  2005 was the first year in which Japan’s total population began to shrink, while the working age population had already begun to shrink in 1996. (According to newspapers, Japan’s population started to decline in 2005.  However, the official data show a very small gain, from 127.73 million to 127.79 million.  The labour force has been showing slight gains since 2003, reflecting higher participation.  However, the working age population (15-64) began to decline in 1996.)  As a result, it faces a heavier demographic burden than all the other developed countries. 

The ‘dependency ratio’ – defined as the share of population over the age of 65 as a percentage of the working age (15-64) population – is expected to increase dramatically in Japan.  Europe will also experience a sharp rise in its dependency ratio, due mainly to lower fertility rather than increased longevity.  Within Europe, there are differences between countries, with Sweden having a fertility rate close to its replacement rate, while Italy and Spain’s fertility rates are very low.  By 2050, according to the United Nations, in some central and eastern European countries, the population will likely contract by around 30%, Italy’s population will likely contract by 22% and Japan’s by 14%. 

Chinais one of the few developing countries with a similar ageing problem.  The drastic decline in the fertility rate since the late 1970s in China (as a direct result of the one-child policy) has sown the seed for a sharp rise in its dependency ratio 20 years from now.  In China, the total number of children per woman has declined from close to six in the 1950s to less than two in the 1990s.(China’s one-child policy has only been enforced in big cities.  Two children are permissible in the countryside.  In practice, the officials are not certain about the fertility rate in rural areas, with the official census possibly underestimating the total population of China by 60-100 million.)  At the same time, longevity has improved with better nutrition and medical care. 

The dependency ratio is projected to rise somewhat less sharply in the US, due to both a slightly higher birth rate and immigration.  (The elderly will make up a rising proportion of the total population.  At a global level, the elderly population is projected to rise from 7% of the total population now to 16% by 2050, according to the United Nations.)  In contrast, in the aggregate, developing and industrialising countries will experience a decline in this dependency ratio.

Economic and financial implications

There are several important economic and financial implications of these demographic trends.  I highlight the following:  

Implication 1.  The level of real long-term interest rates will be affected by the changing fiscal outlook of countries.  Potential economic growth rates vary with these demographic trends.  This should be a pretty obvious point.  Potential economic growth in countries with high dependency ratios will likely slow.  Not only will the growth of labour supply slow, which is precisely what we are witnessing in the US and Japan, but justifications for capital accumulation will be less compelling in an ageing country. (In theory, investment to enhance total factor productivity could keep output growth high, even with a shrinking population.)   Further, as the population of a country ages, ceteris paribus, the aggregate wage bill may shrink, reducing tax receipts.  At the same time, medical expenditures and other healthcare-related spending may crowd out the education expenses needed to enhance the productivity of the shrinking work force.  The end result is a shrinking tax base and rising budgetary demands. (Most publicly funded pensions are ‘Pay-as-You-Go’ (Paygo), while some are ‘Fully Funded’.  With the dependency ratio rising, Paygo will not be sustainable.  Further, unfunded pension liabilities are already quite large in many developed countries.  The scale of unfunded pension liabilities is less severe in the US than in Europe.  At around 100% of GDP – estimated by the Office of the Actuary, US, America’s unfunded pension liabilities are less than those of continental European countries, some of which have unfunded liabilities of up to two-and-a-half times the size of their economies.)  Without changes in the retirement age or female participation in the labour force, what this means is that the levels of real interest rates in countries with ageing populations may rise above what could be justified by their potential growth rates, as public borrowing needs grow and the private sector starts to dis-save during retirement. 

Implication 2.  However, yield curves should flatten in countries with ageing population and steepen in countries with younger populations.  Having said the above, the shapes of the yield curves may change as well.  With the monetary policy of most central banks driven by formal or informal inflation targeting, demographic trends could distort the shapes of the yield curves.  In a country with an ageing population (such as the US), in the short term, the Fed would need to have higher policy rates to stabilise inflation as potential growth decelerates.  In other words, it should be more sensitive to lingering inflationary pressures at every given level of growth rate of aggregate demand.  However, the long-term interest rate should be commensurate with the new, lower, potential growth rate and therefore should be lower, notwithstanding the possibility of a rise in the borrowing cost I mentioned above.  This implies a flatter yield curve in the US.  Similar logic suggests that the accelerating potential growth rates in younger countries tend to twist their yield curves counter-clockwise, i.e., steepening the yield curves.

Implication 3.  Ageing may affect the preferred structure of financial portfolios.(In developed countries, most retirees rely on public retirement benefits (accounting for about 40% of the total retirement resources in the US), and corporate pensions and housing (together accounting for another 40%).  Financial assets make up a small portion of retirement resources.)   Different generations have different risk preferences.  There are two competing theories.  On the one hand, it is thought that global ageing may raise the equity premium, as ageing households become less willing to warehouse risk.  As a result, ageing could benefit bond markets relative to equity markets. (In most countries, bills and bonds still rank first in asset allocation, ranging from 50-95%.)   This is, in fact, what most academicians contend should be the case. 

However, recent experience in Japan suggests an interesting alternative hypothesis.  Fixed retirement age, coupled with ever improving life expectancy, has created a ‘longevity risk’, whereby retirees can no longer be confident of their ability to defend their lifestyle if they end up living much longer than they expect at the time of their retirement.  In the case of Japan, this has led to more risk-taking, not less, as retirees try to enhance their expected investment returns by diversifying away from assets with low credit risk.  In contrast to the first hypothesis, this alternative hypothesis suggests that retirees should have a bigger appetite for equities. 

Data suggest that, while bills and bonds still account for the bulk of total pension holdings in the world, the share that is allocated to equities is rising.   Between 1994 and 2005, there was indeed such an increase in exposure to equities.  Incidentally, the recent decision by Norway’s Government Pension Fund, Global, to alter its bond-to-equity allocation from 60:40 to 40:60 is totally consistent with this global trend. 

What this means is that, on the margin, as the developed world ages, there could be a structural bias in favour of equities over bonds.  At present, global pension funds may have more than US$20 trillion under management. (The most recent firm data we have is for end-2004, with total funds under management of global pension funds at US$16 trillion.  The US$18 trillion figure is a guesstimate.  Also, as of end-2004, life insurance companies in OECD countries had some US$9 trillion under management, or about 109% of GDP.  Retirement assets, measured by this proxy, are in the 140-150% range for Switzerland and the Netherlands, in the 120% range for the US and the UK, 60% in France, 30% in Germany, and 22% in Italy, according to an OECD study (Pension Markets in Focus, December 2005).  Including funds managed by life insurance companies, this figure could be more than US$30 trillion.  A small shift in asset preference will have a meaningful effect on global asset prices, ceteris paribus. 

Implication 4.  Asynchronous ageing patterns in different parts of the world have implications for C/A imbalances.   C/A imbalances are essentially savings-investment gaps.  If demographic trends drive the savings patterns in countries, then C/A imbalances should also be affected.  The permanent income hypothesis suggests that very ‘young’ and very ‘old’ countries tend to dis-save, while those with low dependency ratios should be saving.  The constellations of the C/A imbalances in the world are not consistent with this pattern.  What this may imply is that, as Japan ages, its savings rate should decline, as retirees start to draw down their savings.  This may very well start to happen.  With such a high C/A surplus position (4% of GDP), this prospective trend should not pose a problem for Japan.  However, the same argument applies to the US, but with such a high C/A deficit (5.5% of GDP as of 2Q07), the US does not seem to have a great deal of scope to dis-save further.  Two of the largest capital surplus countries in the world (Japan and China) are themselves facing ageing pressures, and therefore downward pressures on savings. The implications for the dollar will be a function of how fast the US savings rate changes relative to that of the rest of the world.    

Bottom line

Demographic trends have important economic and financial implications.  Without remedial action, global ageing in the developed world tends to raise the level of real interest rates, flatten the yield curves, benefit equities at the expense of bonds, and lower the value of the dollar. 

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UK
What Next from the Bank of England?
September 21, 2007

By David Miles | London

In the wake of the 50bp cut in rates from the Fed, and amid the continuing fallout from the problems at Northern Rock, there is much speculation about how UK monetary policy will evolve over the next few months. 

We start by making an obvious – but crucial – point about two different elements of monetary policy.  There is a sharp distinction between central bank operations to provide liquidity (open market operations, reserve management and lender of last resort) and the appropriate level of the policy rate. Policy on the former has changed – with a widening in the range of collateral against which liquidity (provided anonymously but at a penalty rate) is available. The latter is a judgment call made by the monetary policy committee (MPC) taken in the light of evidence about economic growth and inflation pressures. The MPC at the Bank of England will not want to rush to judge how a very fast-moving situation in the money markets will impact the wider economy over the next 1-2 years. This is why an emergency cut in the policy rate is not at all likely – indeed, a dramatic cut at the next scheduled meeting in early October is not very likely either.

There is an important difference between the Fed decision and the position of the MPC here.  The fallout in the wider US economy from the rapidly deteriorating situation in the US housing market has become much clearer in the past month or so. This is the major factor behind the decision of the Fed to cut rates sharply this week. In the UK the scale of any negative impact from the – very fast-moving – situation in the money markets on the housing market and the wider economy is as yet far from clear.

And in fact the knock-on impacts on consumer lending and spending will be difficult to judge for some time. Consider one of the most powerful potential mechanisms – effects stemming from re-pricing mortgages. It is clear that for some borrowers the cost of mortgage debt in the UK has gone up as a result of the credit situation in the wholesale markets – mortgage rates for people with patchy credit histories, with limited verifiable information on their incomes and for those wishing to borrow 95% or more of house value have already moved up. But there is an offset to this. Two-year sterling swap rates are now almost 50bp below where they were in mid-July. The cost of short-dated (2-5 years) fixed-rate mortgages for those with good credit records and with a relatively low loan to vale ratio is now lower at many lenders than it was before the credit problems.

On balance, we expect that there has been some net tightening in lending conditions for households – but the scale of that is actually pretty hard to judge.

In the light of this, I suspect that the MPC will not want to rush into a decision to cut rates. However, it will likely come to see some reduction in the policy rate as warranted soon. And because of the position of the economy, any such decision is both reasonable and could not sensibly be interpreted as abandoning the principle that targeting inflation is the over-riding goal in setting the policy rate.

In brief, the position of the economy is this:

1. Inflation is now somewhat below the Bank of England target level.
2. Domestically generated inflation pressures remain contained.
3. Commodity price rises – for food and oil in particular – may take the inflation rate slightly above target in the near term, but do not imply that ongoing inflation pressures will be greater.
4. With short-term rates at 5.75%, we judge monetary policy to be mildly restrictive. In a report published this week, we present evidence confirming our view that a neutral level of interest rates in the UK is likely to be in the 5-5.5% range.

In the light of this – and with clearer signs of a slowing housing market with its potential to affect spending – we do expect the Bank of England to cut its policy rate in the next few months. Conceivably that could happen at the October meeting. I expect that it remains more likely to come in November at the time of the publication of the next Inflation Report. We have long taken the view that a slowdown in consumer spending growth will be significant, and so should rates be cut initially by 25bp, we doubt that this would be the end of easing. A further 25bp cut is plausible and would take the policy rate to our central estimate of a neutral level.

Liquidity provision and bank guarantees

The other – quite different – aspect of monetary policy is about liquidity provision, emergency lending and deposit guarantees. Here things have already changed. The strategy on liquidity provision and emergency lending was set out in a letter BoE Governor Mervyn King released last week. The subsequent provision of a credit line to Northern Rock – one which has hardly been used – fell in the category of lender of last resort operation. It was lending at a penalty rate against a wider range of collateral than had until then been accepted for normal (and anonymous) liquidity provision.  The acceptable list of collateral for open market operations is now being reassessed and a decision to inject cash against a wider range of collateral – including mortgages – has now been taken. This lending against a wider set of collateral is, however, at a rate no less than 1% over the base rate.

Another new element in recent events – following a bank run against Northern Rock – is a government announcement that it would guarantee all the retail deposits of Northern Rock. This has been interpreted by some as a dramatic move to guarantee the total stock of all retail deposits in the UK – which would be a guarantee against several hundreds of billions of pounds of deposits. The Financial Times even described the announcement as representing a “nationalization of deposits”.

That is a mis-leading interpretation, in our view. What the government effectively said was that a bank that was in the same position as Northern Rock would have its deposits guaranteed beyond the level already covered by the Financial Services Compensation Scheme. In other words, the depositors of a bank that was receiving lender of last resort support from the Bank of England would get extra guarantees from the government. Such a bank would be one judged solvent by the Financial Services Authority – the UK bank regulator. Such a bank would almost certainly have seen its share price fall (as did Northern Rock’s) on news that it was receiving emergency support from the central bank – so its management and shareholders would have paid a heavy price. And in the event that such a bank subsequently failed – despite being judged solvent by the FSA – the government would presumably only be providing top-up guarantees to the existing (industry-funded) deposit insurance scheme that already covers more than 90% of the first £35,000 of deposits.

 

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South Africa
South African Manufacturing More Sensitive to Interest Rates than Previously Thought
September 21, 2007

By Andrea Masia and Michael Kafe | Johannesburg

On the eve of the June MPC meeting, we highlighted that any further tightening of monetary policy was likely to intensify the weakness in South Africa’s manufacturing sector without having any meaningful impact on inflation (see Looking Through the Noise, June 6, 2007). Thus, when results of the Bureau for Economic Research’s 2Q07 manufacturing sector survey released after the June rate hike showed continuously bullish prospects for the sector, we were agnostic. Not surprisingly, the 3Q07 survey released this week shows that manufacturers have now awoken to the reality that monetary tightening could combine with a somewhat stronger-than-expected currency to hurt business conditions in that sector. Broadly speaking, results of the survey show that manufacturing business confidence has slowed sharply, domestic sales and orders have dropped, capacity pressures have eased, export performance has deteriorated, and a possible moderation in fixed investment growth is on the cards.

Manufacturing activity and the cost of money

In an earlier research note (see “South Africa’s Manufacturing Sector: A Tug of War Between the Real Exchange Rate and Interest Rates”, EM Economist, July 17, 2006), we highlighted that although long-run coefficients suggested that manufacturing activity was more sensitive to the exchange rate than interest rates, the short-run dynamics showed that such influence could vary over time, and that one needs to know which of the two drivers is dominant at any specific point in time in order to make an informed call. The analysis also showed that, since 2001, it is the cost of money, rather than the exchange rate, that is the dominant driver of activity in the sector, and we warned that a move to tighter money would hurt manufacturing activity unless there was a greater-than-commensurate offset from currency depreciation. Since then, interest rates have risen a further 250bp, while the currency has been broadly stable after the short-lived bout of weakness in September 2006. It is therefore not surprising that, after staging some signs of a comeback in 2005 and 2006, thanks to easier money in 2003-05, South Africa’s manufacturing sector has shown, at best, sporadic signs of vigor since the start of this year as interest rates rose again. Growth in manufacturing has slowed from 8.3% saar in 4Q06 to a pedestrian 0.5% saar in 2Q07. And with the looming prospects of an additional 50bp tightening in monetary policy at next month’s MPC meeting, we believe that the manufacturing sector and, indeed, overall domestic growth prospects are significantly dimmer than current market expectations. Such a view has been confirmed by the latest BER manufacturing sector survey.

Higher interest rates a “serious constraint”

According to the BER, “the survey revealed that manufacturing fixed investment may be more sensitive to interest rate movements than previously assumed” and “the cumulative effect of the interest rate increases we have witnessed to date is starting to impact in that manufacturers have rated the cost of credit as a serious constraint on activity”. Quite notably, there was a sharp rise in the percentage of respondents who cited short-term interest rates as a constraint on business from 25% to 38%, and short-term interest rates have now replaced insufficient demand in the top three constraints on manufacturing activity – the top two being the shortage of skilled labor and raw materials. In fact, the rise in the percentage of respondents who cited short-term interest rates as a constraint on business was sharper than the movement in any other constraint surveyed. This deterioration was most pronounced in the Metal Products, Textiles and Paper industries.

The survey also shows that manufacturing business confidence has dropped from 78 to 65 index points, while the manufacturers rating business conditions as satisfactory fell from 26% to 5%!  For the first time since mid-2004, furniture and clothing manufacturers have experienced declines in domestic sales and orders, while producers of chemical, non-metal mineral and transport equipment reported weak growth, thanks to slower domestic demand generally. 

What’s worse, higher rates are not only impacting negatively on confidence and production tempo, they are beginning to impact investment decisions too. The percentage of manufacturers rating the cost of credit as a serious limitation to invest over the next 12 months increased sharply from 22% in the previous survey to 32%, a level not seen since 2002-03.  Not surprisingly, the percentage of manufacturers looking to increase their expenditure on fixed investment over the next 12 months declined from 27% to 22%. This is a worry as far as growth propelling capacity build-up in the sector is concerned.

Pockets of strength still evident

But despite the bad news, there are still some sectors that are not doing badly – at least, not yet. For example, domestic sales and orders of locally produced food and beverages continue to accelerate, as do non-electric machinery and metal products. The latter two sectors in particular, together with petroleum products, should remain well positioned to benefit from the government’s ambitious R416 billion capital expenditure plans announced in the 2007 National Budget.

Sacrifice ratio still biased toward tighter money

Will the looming slowdown in manufacturing activity force the SARB to hold fire on interest rates at the upcoming MPC meeting? Not necessarily. Given that the SARB operates a rather strict inflation-targeting regime, we believe that it will give pre-eminence to the recent negative developments in both the headline and core CPIX. The fact that it now expects CPIX to fall comfortably in the target range only in 2H08 further raises the odds for another rate hike, especially when combined with prospects of a significant deterioration in inflation expectations in the upcoming survey. As far as the SARB is concerned, the sacrifice ratio between growth considerations versus interest rates is likely to remain firmly in favor of the latter, in our opinion. In fact, given its view that South Africa is still growing above potential, the SARB may actually have adopted the view that slower economic growth would be beneficial from a demand-pull inflation perspective.

 

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Japan
Fiscal Monster Rears its Ugly Head
September 21, 2007

By Robert Alan Feldman | Tokyo

Unseen by markets, a fiscal monster is starting to rear its ugly head in Japan. Political competition has started a race to spend, and to rescind even scheduled revenue measures. Once markets notice the backward turn in fiscal policy direction, JGB yields could feel upward pressure, due to a rising fiscal risk premium.

At the moment, the market has discounted very little – if any – fiscal risk premium for Japan. Indeed, JGB yields have been moving almost in lock-step with US Treasury yields in recent months. Domestic factors appear to be taking a back seat role, if any role at all, in the market. This stability comes despite several major changes in the political scene, which herald at best a halt, and perhaps even a reversal of fiscal consolidation.

The first step in the as-yet-unnoticed reversal of fiscal policy came in the campaign for the Upper House election. The opposition party promised increased spending on rural areas, small business support, and regional economy support, while at the same time changing its stance to oppose a consumption tax hike. Some countervailing measures were proposed as well, but these measures were criticized heavily by many commentators as inadequate.

The second step came after the opposition was successful at the ballot box. The ruling LDP has countered with similar proposals, most likely knowing that a general election could occur at any time. For example, the leading candidate to succeed PM Abe, Yasuo Fukuda, has reportedly called for freezing the hikes in health insurance co-payments. Under PM Koizumi, these co-payments for the elderly were raised from 0% to 10%, and were scheduled to rise to 20%. (Note that there are no insurance contributions at all for the elderly, and that even the 20% rate is below what non-senior insurees pay.) Mr. Fukuda’s proposal is thus a step backward on the reform path. Similarly, the LDP’s coalition partner, the Komeito, has reportedly called for postponing the target date for achieving a surplus in the primary balance. That target is now – and has been since the early Koizumi years – to reach a zero primary balance in 2011. Heretofore, the big debate was whether to raise the bar – in order to lower the ratio of debt to GDP from its current level near 160%. Now the prospect of achieving even the original target is receding.

What happens next? Political competition is now defined by extra help for regions, farmers and small business, just as budget season is getting under way in earnest. It seems likely that a supplementary budget for fiscal 2007, much like the many such budgets in the 1990s, will be formed in the autumn, once the dust settles from debate over the anti-terrorism law. A spending scale of JPY 2 trillion is the minimum needed to create any meaningful political effect. Then debate begins on earnest on the fiscal 2008 budget. The government’s proposal will come in late December, and the political debate will occur over the January-March period, when a general election becomes even more likely. There is likely to be a competition to spend. Yes, lip service will be given to deficit reduction, but investors are likely to hear such words with skeptical ears. And tax hike talk is effectively off the agenda.

The reaction of markets is predictable. If the current political spending competition continues, it is highly likely that markets will begin to build an increased fiscal risk premium into JGBs. As the global economy faces challenges from the spread of credit problems, and as Japan faces imperatives of capital deepening in the face of an ageing and shrinking labor force, a higher fiscal risk premium would be bad news for long-term growth prospects. Long-term earnings expectations would also suffer, bringing a doubly negative effect to equities.

 

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Japan
Will History Repeat Itself?
September 21, 2007

By Takehiro Sato Tokyo

From crisis to renewed euphoria

To allow for the impact on the real economy of disruption in the global financial markets due to the subprime problem, in mid-September we decided to lower our forecasts on a global basis. However, we do not see the current disruption in the markets as heralding a global recession. There is still headline risk for the subprime problem itself, and this is likely to weigh on the economy, but we believe that this is being swiftly discounted in financial markets, making it possible to expect a relatively smooth market recovery from the shock through appropriate policy responses. The ultimate result of this kind of policy response may be renewed euphoria.

Heading toward excess liquidity post-crisis due to the supply of liquidity

It might seem absurd to raise the possibility of euphoria when overseas money markets are still in the grip of a liquidity crunch, but there are grounds for doing so. In the past, major adjustment phases in asset markets have been accompanied by a contraction in liquidity, but once the policy response to a liquidity dry-up is successful and risk contained, a side-effect is that excess liquidity generates euphoria in asset markets. For example, the latest crisis might be seen as a once-in-a-decade type event such as Black Monday in 1987 or the Asian/Russian crisis in 1997-1998. When these crises surfaced, the authorities moved to support liquidity. At the end of the 1980s this led to a land/share price bubble in Japan and at the end of the 1990s it led to a global IT bubble; asset inflation was generated in one form or another. Though it does not fit in with a 10-year cycle such as the one described above, after the collapse of the IT bubble at the end of the 1990s, the Fed adopted a real zero interest rate policy, and this inflated a housing bubble. Given this history, there is value in keeping in mind the risk of renewed asset inflation up ahead. In this context, the strong response by the September FOMC looks highly significant. In the UK as well, the authorities have shown flexibility in accepting collateral, for example, as cash outflow problems at financial institutions have surfaced, adopting measures to supply liquidity that go somewhat beyond the normal framework. The result is moral hazard, creating the possibility of renewed excess liquidity due to a reduced perception of risk.

On the other hand, downside risk is present because an intensified credit contraction could lead to a cascade of bankruptcies due to cashflow problems by financial institutions and firms. As the Japanese experience from the late 1990s until the early 2000s indicates, the benefits of interest rate cuts against a full-blown credit contraction are limited, and if the necessary response is delayed, the effect on the real economy can drag out. However, in the US money markets, the volume and the value of commercial paper has recovered since last week, and the Fed’s lending facility has started to exercise its core functions; there are signs that the credit crunch may be abating. Cashflow concerns are likely to persist through the end of September, but it appears that the risk of a cascade of bankruptcies by financial institutions and firms is receding. The greater-than-expected rate cut by the Fed this week is likely to contribute to a reduction in this kind of risk.

Policy-induced bubble a necessary evil

The authorities are frequently criticized for inflating asset bubbles by their response. Indeed, with housing trouble spreading, criticism has surfaced that former Fed Chairman Alan Greenspan was responsible due to the Fed’s real zero interest rate policy and its subsequent measured pace of rate hikes. However, all responses involve a balance of benefits and costs, and so long as the benefits outweigh the costs, or if the costs can be controlled, then the authorities should shoulder the risk and press on. I thus personally defend the position of the former chairman. If he had not aggressively shouldered the risks as he did in 2003, the US economy might have fallen into a genuine deflation, which could have triggered a global recession. Now much later he is criticized for not having taken sufficient account of the size of the costs, but before criticizing it would be best to consider the opportunity costs had there been a global recession. There may be a lesson for Japan in the stance taken by the US authorities of shouldering risk early. In Japan at the crucial period, the central bank was far-sighted in coming out with the ingenious idea of ABS, ABCP and even stock purchases, but it was slow to act. This is criticism with the benefit of hindsight, but at the time of the first-ever default in the call market in November 1997, had the BoJ conducted quantitative easing, it might have been possible at least to avoid cash flow failures by a major bank, and the subsequent crisis in the financial system might have developed quite differently. Deflation might not have dragged on as long as it did. This is again arguing with hindsight, but at times policy involves necessary evils. Under a new chairman, the Fed this time has once again shouldered risk.

Gauging from the Fed’s statement, however, the atmosphere does not seem to be one where it will continue to repeatedly take pre-emptive, generous measures based on a downward assessment to the economy. In any case, our impression is that the Fed has moved to shore up the confidence of the market and supported it with its surprise rate cut, while nonetheless leaving its policy options for October completely open, as our colleague David Greenlaw argues.

What’s next?

Finally, coming right after a collapse in credit markets, the next wave of asset inflation is unlikely to involve credit investment. Areas that appear to be good candidates for funds going forward are resource and energy-related markets and associated stocks, in our view. These have already risen despite concerns over a global economic slowdown, but even as Europe and the US are still in the grips of a liquidity crisis, excess liquidity remains in the emerging markets, meaning that conditions are different from past crises on a global scale, and that primary asset prices may remain robust. With income flowing back to resource countries and with such income coming back to developed counties as a kick-back, we believe that it is possible to expect the risk of a global recession to recede.

 

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