No time for complacency

Central banks remain in firefighter mode and financial markets are dangerously addicted to unconventional monetary policies that are disguising problems

Healthy monetary and financial conditions are vital for the stability and prosperity of societies. With crucial responsibilities for setting interest rates, shaping liquidity and stabilizing economies during crises, central banks are at the heart of our collective efforts to maintain an orderly global monetary environment.

Since the 2007-08 global financial crisis, however, we have entered an era of prolonged monetary disorder. Serving as firefighters, major central banks in advanced countries all embraced unconventional monetary policies, pushing interest rates down to near zero or even negative levels and injecting massive liquidity through quantitative easing with the aim of encouraging lending and real-sector investment.

The results of such unconventional policies have been mixed and controversial. As a short-term expediency they helped to stabilize fragile financial systems and shore up economies in the midst of crises, but they have not cured the underlying diseases and have generated many harmful side-effects. Rather than effectively stimulating sustainable investment in the real economy and employment growth, their primary effects have been on stimulating inflated asset markets, fueling wide-ranging booms in stocks, bonds and real estate, which have worsened wealth inequality and undermined social cohesion.

Even more disturbing is the fact that these supposedly abnormal, ultra-loose monetary policies have arguably become a new normal for the global economy. For over a decade now, since the global financial crisis, major central banks remain in firefighter mode. Despite some initial attempts to normalize their policy stances between 2015 and 2018, central banks have loosened their monetary policies again this year, facing the prospect of economic slowdowns. In particular, the US Federal Reserve has cut interest rates three times by October, reversing its rate increases in 2018. As trade tensions persist and global monetary easing renews its momentum, the yield curve has inverted in many advanced economies, which is often a sign that a recession is coming.

Ultra-low interest rates combined with a flood of liquidity inevitably distort financial markets. According to the Bank of International Settlements, the amount of bonds with negative-yields have soared this year, reaching a new high of over $17 trillion in the late August.

Stock markets and property prices have continued to boom, seemingly with the sky the limit. Investors are pushed to buy risky assets at high valuations with low prospective returns, and often aggressively leveraging themselves up. Large corporations are more incentivized to conduct debt-financed stock buybacks and acquisitions than making new long-term investments to promote innovation.

Meanwhile, rising asset prices under current monetary conditions benefit wealthy individuals much more than the rest of the society. Credit Suisse has estimated that the poorest half of the adult population collectively accounted for less than 1 percent of total global household wealth in mid-2019, while the richest 10 percent owned 82 percent and the top 1 percent alone possess 45 percent of global household wealth.

All of these developments suggest that central banks are now pushing on a string with unsustainable monetary policies. In normal circumstances, the specter of inflation would impose some discipline on monetary easing. However, with surprisingly subdued inflation which might be due to various structural forces such as globalization, technological advances and demographic changes in labor markets, the traditional disciplinary mechanisms for the maintenance of monetary order has been profoundly attenuated. Global financial markets are increasingly and dangerously addicted to unconventional monetary policies which tend to disguise problems, blur troubling signs and breed complacency.

What is not sustainable will not sustain. The ostensible booms in financial markets with suppressed volatility will endogenously generate instability, which will eventually strike back, creating more severe financial chaos. In the previous global financial crisis, major advanced economies especially the United States had relatively sufficient policy space for monetary easing and fiscal expansion.

However, now the arsenal of global economic firefighting is much more limited, not least because many countries have been wasting their policy ammunition during the recent 10 years when they should have been preparing for future crises.

In this context, developing countries should be highly vigilant about the risks and fragilities under current global monetary and financial conditions. The trap for emerging markets is that low cost capital tends to flood in from advanced economies with ultra-loose monetary policies when markets are relatively calm, but whenever signs of trouble start to appear, capital inflows will likely stop suddenly and fly back to safe havens.

While there is only limited policy space for emerging markets to withstand the tidal waves of liquidity from advanced economies, it is entirely feasible to conduct domestic structural reforms to fix our own economic roofs in relatively sunny days and be more prepared for the next round of turbulences.

During recent years, as integral parts of its broader structural reforms, China has strengthened its domestic financial regulations and actively promoted deleveraging to support healthier and more sustainable growth. To counterbalance the contractionary effects of trade tensions and proactive deleveraging on economic activities, China's central bank has also adjusted its policy stance with some easing through cutting the reserve requirement ratio.

However, as Yi Gang, governor of the People's Bank of China, has commented, China will continue to maintain prudent and normal monetary policies and will not resort to competitively lowering interest rates to zero or engaging in quantitative easing. China's monetary policies will stay focused and targeted to support the real economy and coordinate with macro-prudential policies to mitigate systemic financial risks.

Global financial crises and recessions will inevitably recur, and nobody knows exactly when and how. Unfortunately, the current geopolitical atmosphere is much less conducive to international policy coordination than it was during the global financial crisis.

Without effective cooperation and coordination, there are real dangers that monetary and financial disorder will interact with and worsen the social and geopolitical disorders globally. While many factors are beyond the control of individual countries, it is crucial that policymakers start preparation for rainy days sooner rather than later.