Developments in international financial markets can have profound impacts on developing economies like Bangladesh through financial and economic links. Therefore, particular attention is needed to potential risks emanating from economies that have significant links with Bangladesh, direct or indirect. These include the United States, the European Union (EU), China, India, Singapore and Japan.
The current instability in global financial markets was triggered by President Trump's decision to impose tariffs on an additional US$300 billion worth of Chinese goods and categorising China as a currency manipulator in the wake of China's decision to allow the renminbi to depreciate. But the global financial risk outlook has been influenced by various other factors also coming from different directions. Vulnerabilities in international financial markets remain high and the US-China trade conflict just has only aggravated the situation. Now to further aggravate the situation, the US has announced the imposition of additional US$750 billion in tariffs on goods such as aircraft, cheese and wine coming from the EU.
In addition to uncertainties caused by the US-China trade conflict there are worries like an increased prospect of a hard Brexit and political and economic instability in many major economies belonging to G20 such as Italy and Argentina. Of particular concern are the economies of the UK and Germany which are contracting and business investment in the US which is falling along with continually declining manufacturing output. data published early last week indicate further fall in the US manufacturing output, the lowest level since the immediate aftermath of the 2007-08 global financial crisis (GFC).
Now the fundamental question is: how long central banks can continue to inject money into the economy, or more precisely into the financial system without causing a system crisis. The central banks not only in industrialised countries but much widely in G20 countries like Australia (twice already and one more likely this year) and India (already four times and at least one more likely this year) have cut interest rates. Interest rates in all major economies are record low and moved into the negative zone in many advanced economies. The world's central banking watchdog, the Bank for International Settlements (BIS) has already warned that there is little room left for cutting interest rates further and asked governments around the world to inject more fiscal support.
Interest rate cuts leading to increased money supply do have effects on the economy, including impact, albeit, over different time frames, on the level of economic activity, inflation, unemployment and the exchange rate. But there is no complete consensus about the transmission mechanism via which increased money supply is transmitted from the financial sector to the real economy. However, it is generally agreed that money is held both as a medium of exchange and as a store of value (as an asset). Once the asset role of money is taken into consideration, the linkage between money supply and the real economy become very problematic. If money and financial assets are seen as close substitutes, in an uncertain economic environment as we are witnessing now, the increase in money supply would have no impact on the real economy as investors and consumers would hold back on spending. Therefore, the role of monetary policy has its limits and beyond that limit the relationship between money and economic activity may be weakened.
There is now a general consensus among leading central banks such as the European Central bank (ECB) and the Federal Reserve (Fed) in the US that there is no point in trying to normalise monetary policy rather they are moving further to stimulate their economies with stimulus packages with further quantitative easing (QE). In view of the weaker economic growth outlook asset prices have also risen and continue to rise aided by very low risk-free interest rates and low compensation for risk (interest rates and bond prices are inversely related). Now in turn this has created an unprecedented situation where last month government bonds were trading at negative yields, but since then the situation has improved.
The fall in long-term interest rates as reflected in bond yields is in itself a clear indication of a very poor prospect for global growth. Under such circumstances investors look for safe havens to invest their cash that has been pumped into the economy other than in the real economy and go for buying financial assets. Furthermore, investors are also factoring in negative yields on the bonds they hold and prefer to lose a little bit to hedge against losing a lot more. Such a sentiment is deeply disturbing for the outlook for the global economy. But even then, bond holders are going to win, as inflation remains very low, far below the 2.0 per cent range - even in the negative range in countries like Switzerland - mean that asset holders, bankers and creditors will find the value of financial assets to rise relative to prices and incomes.
But more profoundly disturbing is that negative interest rates have not been so far been able to stimulate the economies that have tried them. In effect in many instances they have had adverse effects for the people and the banks. The prolonged low interest rates regime and governments' responses to the GFC have contributed to the excessive build-up of global debt over the last decade and likely to destabilise the global financial system. These high levels of global debt will leave households, businesses and governments in many countries, especially in the EU, vulnerable to adverse shocks.
The ECB has been in the negative interest rate zone for about five years. Yet there is no silver lining in the EU. The latest cut of interest rates by 10 basis points was not designed to depreciate the euro as alleged by President Trump but to keep the EU falling apart as something that could happen with Brexit and the threat coming from Italy to follow suit. The interest rate cuts would enable fledgling EU economies to have access to plentiful funding all most free.
The latest ECB cut was particularly helpful for Italy with massive government debt; it would not have to abandon the euro or move out of the EU. Also, the new ECB rules require a "bail in'' before a government "bail out'' can be rolled out for a failing bank. The "bail in'' programme effectively shifted bank losses from government to bank creditors and depositors which scared off investors and depositors making troubled banks even more vulnerable. The leading German bank, Deutsche Bank (DB) is now an imminent candidate for a bailout as Berlin failed to find a buyer for the bank. Now the banking crisis in the EU, which started in the south, is now creeping up to the north.
If the Federal Reserve goes for negative interest rates (which is most unlikely), that will cause large-scale outflow of funds with serious consequences for the US domestic economy. And, more importantly, the US dollar being the international currency is tied up with the interest rate swap derivatives market estimated at US$500 trillion worth and that could cause collapse of the derivatives market with serious consequences for the US economy. Furthermore, the Federal Reserve's policy of QE has subsidised an enormous build-up of debt without increasing interest rate burden proportionally. This has led to higher debt and corporations to go for leveraged buyouts and stock buybacks. Now the private sector debt in the US is so high that any further interest rate cuts are unlikely to translate into increased demand. Also, in China, corporate and household debt is high relative to income and Chinese economy is showing signs of slow down.
Interest rate cuts by central banks are also fuelling currency wars, continuing downside risks to the global economy and subdued inflation in the major economies are adding to a great degree of uncertainty.
Almost all major trading partners of Bangladesh are experiencing economic slowdown and further downside risks to growth have also increased. While Bangladesh clothing industry could gain from a prolonged US-China trade war, countries like Vietnam, Sri Lanka and Turkey could also take advantage of the trade conflict to their advantage.
Also, the Bangladesh taka appears to maintain an almost fixed exchange rate with the US dollar causing the taka to appreciate as the US dollar appreciates when currencies of China, India and Sri Lanka have experienced depreciation and that is making Bangladeshi exporters less competitive in the global market. While Bangladesh Bank is not bound by the global rate trend, it can not at the same time ignore it. If Bangladesh Bank ignores these shifts in easing monetary policy, the taka exchange rate would appreciate as the US dollar appreciates. Therefore, the alternative strategy could be to have a freely floating exchange rate which will give Bangladesh Bank an independent monetary policy regardless of what other central banks do.
In this uncertain global economic environment, the best defence for Bangladesh to safeguard its economic interests is to take some textbook-based structural economic reform measures such as overhauling the tariff, tax and regulatory regimes and investment in infrastructure along with working out long-term water and energy policies. These measures will enable the country to create a more business-friendly environment with a greater degree of certainty to boost investment and innovation and help the country to gain further competitive edge over its competitors in the global market.
Muhammad Mahmood is an independent economic and political analyst.
