Norman T L Chan: Can central banks save the world?
Keynote address by Mr Norman T L Chan, Chief Executive of the Hong Kong Monetary
Authority, at the 19th Annual Hong Kong Business Summit Luncheon, Hong Kong,
25 November 2013.
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C K (Chow), Stephen (Yiu), distinguished guests, ladies and gentlemen, good afternoon.
1. It has been five years since the onset of the Global Financial Crisis in 2008. The
Crisis - followed three years later by the European Sovereign Debt Crisis - exposed
the weaknesses of the global financial system and the vulnerabilities of the global
economy. Today, peripheral countries in Europe are suffering a sharp contraction in
their economies, and major advanced economies are experiencing very weak
growth, if any at all. The economic output of several European countries, including
the UK and France, is still below the levels prior to the Global Financial Crisis. The
US, which seems to be the only bright spot among the advanced economies, still
hasn't recovered in full the 8.7 million jobs it lost following the Crisis.
2. Confronted by this extremely difficult environment, it was not surprising that central
banks in the advanced economies began taking unprecedented steps to lower
interest rates as far as possible. And, once the rates hit rock bottom, they began
introducing different forms of very aggressive quantitative or credit easing. For
example, in the US, the Fed introduced QE1, QE2 and unlimited QE3, which inflated
the Fed's balance from US$900 billion in 2008 to US$3.7 trillion now. Separately, in
the past five years, the balance sheets of the ECB and the Bank of England have
expanded, almost two-fold for the ECB and over four times for the Bank of England.
And, the Bank of Japan, the forerunner of QE, has embarked on what is called
Qualitative and Quantitative Easing (QQE).
3. Today, the big question is: will the unconventional monetary policies undertaken by
these central banks actually work? Put another way: can central banks save the
world?
Is the World Worth Saving?
4. But before I try to address the question of whether central banks can save the world,
I would like to digress a little by raising a deliberately provocative question: Is the
World Worth Saving? You may think it a little odd that I should ask this question, as
the answer must surely be an emphatic "Yes". Indeed, the commonly shared desire
is that we must do whatever it takes to bring the world back to the path of economic
recovery, to enable more jobs to be created and to improve people's welfare and
livelihood. So, why do I ask this seemingly superfluous question? Let me explain.
5. On a number of occasions in recent years I have expressed the view that although
there were many factors leading to the Global Financial Crisis and the European
Debt Crisis, the root cause of our present predicament is the excessive leverage
and indebtedness built up over the past two to three decades in the household,
corporate and government sectors in the advanced economies. During this period,
the indebtedness of many industrial economies, such as the US, the UK, France
and Germany increased steadily from 160% or 1.6 times of GDP to over 320% of
GDP. Japan, of course, ranked the highest in this "league table" with over 450% of
GDP. This is alarming not just because the stock of debt was rising, but the speed of
the increase outpaced the economic or income growth of these economies by 100%
over this period. What is even more depressing is that the aggregate public and
private sector indebtedness ratios actually increased even further after the financial
crisis in most advanced economies except for Germany.
6. The increases were mostly due to a sharp pick up in public debt in most advanced
economies after the Global Financial Crisis, as substantial amounts of public funds
were deployed by the crisis-hit countries to salvage their financial systems, while the
real economies were suffering from falling fiscal revenues with slow growth and
rising public spending. In the US, for example, public debt increased by US$6 trillion
from the end of 2008, with the ratio of public debt to GDP rising from about 74% to
the current 100%. Another striking example was Japan where the
public-debt-toGDP ratio surged from an already precarious level of around 190% in 2008 to
almost 240% in 2012, and is expected to rise even further to over 250% by 2020
along with still more fiscal stimulus under "Abenomics". In terms of private-sector
debt, while the US and the UK underwent more significant private-sector
deleveraging, most European countries showed little progress on the reduction in
private-sector indebtedness. The weak peripheral countries aside, even in core
countries like France, the private non-financial sector debt ratio increased sharply
from about 200% of GDP at the end of 2008 to 230% of late.
7. There are many narratives on why this trend of rising indebtedness has occurred.
Perhaps the financial "deepening" had made credit much easier and cheaper for
many households and corporates to obtain. Or, financial innovation in the form of
securitisation and financial derivatives, such as CDS and CDOs, enabled leverage
to be amplified and distributed throughout the financial system and beyond. But, the
cause of this alarming trend is not the issue. The point I wish to make is that most
people had become insensitive to the excessive levels of indebtedness and
leveraging, and the resulting imbalances and vulnerabilities that had built up prior to
the Global Financial Crisis and the European Sovereign Debt Crisis. Clearly, many
people would now question the validity of this mindset. But have we learnt our
lessons? Unfortunately, I'm not so sure we have. While most people would agree
with the view that excessive debt and leveraging was a major factor leading to the
crises in the US and Europe, many would still think it is possible to overcome the
problems without having to deleverage or somehow avoid the pain arising from the
deleveraging process.
8. On the subject of pain, most of us understand what happens when we live beyond
our means through borrowings at the individual, household or corporate level.
Without any increase in productivity or income, excessive levels of debt can lead to
insolvency or bankruptcy, which entails very serious and unpleasant consequences.
However, the situation is a lot less clear when it comes to a country incurring
excessive debt because the usual bankruptcy rules do not apply. Indeed, when
compared to households or corporates, there are two significant problems relating to
governments spending beyond their means. First, there is the temptation for
governments to continue to incur deficits as the market seems to be quite willing, at
least for a while, to finance such deficits. In this context, Greece is a good recent
example. Secondly, there is the usual political pressure for governments to spend
and borrow now, and worry about repayment later. Unlike an individual borrowing
money, government borrowing can be rolled over and increased over such an
extended period that repayment becomes a problem for the next generation not the
present one. Sadly, this kind of behaviour is rather common and widespread. It is
hard to imagine a reasonable person wanting to maintain a good lifestyle now by
borrowing huge amounts of money which can only be repaid by his or her children
or grandchildren. In other words, allowing or asking governments to spend beyond
their means for an extended period of time is tantamount to society mortgaging the
income and livelihood of our future generations. Such action is irrational and
irresponsible, but it's happening all over the world. No wonder some people have
posed the question - if this is the kind of world we're living in, is it really worth
saving?
Can central banks save the world? "Yes and no"
9. Rather than trying to answer this metaphysical and provocative question, let me
quickly return to the subject of my remarks today: can central banks save the world?
The short answer is "yes and no".
10. When a financial crisis occurs and the financial system is facing imminent meltdown,
as happened in the wake of the collapse of Lehman Brothers in 2008, shockwaves
in the form of a severe credit crunch normally follow as banks and other financial
firms lose confidence in each other and hold on to whatever liquidity they can. The
breakdown in the collateral and credit supply chain can lead to the failure of not only
illiquid or poorly managed firms, but also otherwise sound and healthy firms.
However, central banks, playing the role of lender of last resort, can and should step
in to inject the necessary liquidity to allow the financial system to continue to
function. If not, illiquidity can quickly turn into insolvency on a systemic scale. Given
the ability of central banks to create money by expanding their balance sheets, the
Fed and the world's central banks did exactly that during the latest Global Financial
Crisis. This action helped prevent a global financial system meltdown. Therefore, we
can say central banks can and do save the world during a financial crisis.
11. Nevertheless, the ability of central banks to reflate the economy or boost
employment during the post crisis recovery is not as clear cut. After the 2008 Global
Financial Crisis, the US, followed by Europe and Japan, reduced interest rates to a
very low level. And, when they hit the near zero lower bound, the major central
banks embarked on unconventional monetary policies of quantitative or credit
easing. So far, the US has created and injected US$2.8 trillion into the banking
system and is currently pursuing a monthly US$85 billion asset purchase
programme. Mainstream thinking supports the use of this unconventional monetary
easing on the grounds that weak growth post-crisis is mainly the result of a lack of
aggregate demand and thus the solution is to boost demand generally by reducing
the cost of borrowing and inducing investors to shift from low-yielding government
bonds to riskier assets in search of yields.
12. While there was general agreement on the need and efficacy of action taken by
central banks during the crisis period to stabilise the markets, the same cannot be
said for using the extremely accommodative monetary easing by the advanced
economies to support economic growth and job creation. Looking beyond
mainstream thinking, there are some sound analyses by renowned economists,
such as Bill White of the OECD and Dr Rajan, the former IMF Chief Economist and
newly appointed Governor of the Reserve Bank of India, that suggest these
unconventional monetary policies are now in "uncharted waters" and may create
unintended consequences and risks to the global financial system. At this point, I will
mention three key costs or risks of these unconventional monetary policies.
(a) First, these policies punish the savers and pensioners: The suppression of
interest rates at close to zero is helpful to debtors, but I should hasten to add that
only those debtors who can refinance themselves at the lower rates can benefit. So,
most of the US home owners in negative equity or with low credit scores have not
been able to benefit from the all-time-low mortgage rates (which once dropped to as
low as 3.55%). At the same time, the low interest rates cause a great deal of harm
to savers, whose deposits have been earning virtually no interest at all. There are
millions of savers, including households, pensioners, corporates and investment
funds that have remained prudent and have avoided falling into the excessive
leverage trap. These prudent savers have been punished badly in the past four
years under the "low-for-very-long" policies. With a sharp drop in recurrent interest
income, the behaviour of this group may have changed by scaling down their
consumption or investment. This offset, at least partially, the potency of low interest
rates and QEs.
(b) Secondly, these policies create moral hazard: The suppression of interest rates
and the injection of huge amounts of liquidity through QEs create considerable
moral hazard in several ways. It delays the necessary adjustments in the debt
overhang through deleveraging by households, corporates and governments. If one
agrees that excessive leverage is the root cause of the latest crises, deleveraging
across the board is the only way to escape the trap. It is hard to imagine why the
problem of excessive leverage can be overcome by adding more debt to the system.
As QEs can reduce the short term pain and pressure brought by adjustments, there
is a real risk the implementation of the much needed reforms in the private sector
and the fiscal reform in the public sector could be delayed, or dropped altogether.
This means the fundamental cause of the imbalances in the global financial system
is not being addressed at all. The problem is particularly acute in the fiscal positions
of many advanced economies that have built up high levels of public debt.
According to the "Ricardian Equivalence" theory, when people believe the fiscal
positions of their governments are unsustainable and that at some future stage the
governments have no choice but to raise taxes to pay back the debt, this will
materially curtail the citizens' desire to spend and invest now because they need to
save more to prepare for the "rainy" days ahead.
(c) Finally, the third important cost or risk factor is the misallocation of resources and
investments: Given the near zero interest rates and abundant liquidity in the
financial system, it is to be expected that the asset markets, especially the stock and
housing markets, will benefit. With US stock markets continually reaching historical
highs and with a strong rebound in the housing market, the positive wealth effects
should help boost consumption and investment. So, this must be good news - apart
from the inconvenient questions one asks from time to time about "How long will it
last?" or "Is it sustainable?" For Emerging Market Economies, we have all witnessed
the inflow of capital at the initial stages of the QEs, which drove up asset prices and
inflationary pressure. This is not surprising as investors have no choice but to take
aggressive steps to search for yields globally. This results in a misallocation of
resources, as the abnormally low interest rates distort investment decisions by
allocating capital away from productive real investment into risky assets that yield
higher returns. The lack of real investment in turn reduces medium-term potential
growth. Indeed, business investment growth in the US has been lacklustre since the
economy recovered from the global financial crisis. The misallocation of resources
aside, the search for yield behaviour also leads to a mispricing of risks across a
wide spectrum of asset classes. In the US, junk bond issuance has risen sharply in
the past few years, accounting for about 24% of all bond issuances so far in 2013,
while the average high-yield spread has fallen below 5%. While the buoyancy in the
asset markets helps support the economy in the short term, imbalances could build
up in the economy and the financial system that may pose a threat to systemic
stability when the unconventional monetary policies begin to unwind.
13. Ladies and gentlemen, before moving on to what lies ahead, let me briefly
summarise my key message - excessive leverage is the root cause of the global
financial crisis, but surprisingly, not much has changed. Many have still not learnt
the lesson, and think the problems can be solved by further leveraging. And
policymakers advocating extremely accommodative monetary easing still believe
liquidity-driven growth is the answer. Indeed, it's ironic that low interest rates,
mispricing of risk and excessive debt levels, which contributed to the crisis in the
first place, are now considered the "solution".
What lies ahead?
14. So, we have now entered "uncharted waters" or the "world of the unknown". It has
often been argued that the Global Financial Crisis was unprecedented and one
which demanded unprecedented policy action. As most of the advanced economies
have very little, if any, fiscal headroom to support growth and job creation, the use of
zero interest rates and QE, and leveraging on central banks' seemingly limitless
ability to expand their balance sheets, appears to be "The Only Game in Town".
Presumably, this means the situation has become so bad, we may as well try these
unconventional policies to see if they work. However, as I outlined earlier, the
efficacy or potency of these policies has not been as strong as first thought. In the
US, the pace of economic recovery has been rather moderate, if not disappointing,
despite the unprecedented fiscal and monetary support packages launched since
2009. In Europe, the situation is even more disheartening, given the fact the output
of many peripheral countries and the UK and France is not yet back to pre-crisis
levels. Again, when faced with criticisms that the central banks had gone beyond
their remit and capabilities by taking up the role of supporting economic growth,
mainstream thinking argued that, even though QE was not as potent as it was
hoped, the economic conditions post-crisis would have been a lot worse without
these unconventional monetary policies. At this juncture, based on the empirical
evidence available so far, it is hard to judge one way or the other whether the
unconventional monetary policies have worked, or will work.
15. However, it should not take long to find out the answer. This is the fifth year of QE in
the US; and the main issue now is not to what extent QE has helped economic
recovery since 2009, but what happens when the Fed actually exits from these
accommodative policies. Of course we don't know exactly when the Fed will exit,
which entails three stages: tapering in the asset purchase programme, ending the
purchase programme and eventually raising policy rates. Chairman Bernanke and
some FOMC members have made it clear the timing of these stages is still uncertain
as it will depend on the actual pace of economic recovery and improvement in the
job market. The three stages have long been known to the markets and are nothing
new. However, when Chairman Bernanke talked about a possible timeline for
tapering in May and June, the US and global asset markets reacted strongly with
both bond and stock prices taking a beating. It is particularly noteworthy that
Chairman Bernanke's remarks triggered selling off in many emerging market
economies, especially those with weak current account positions. As a result, it took
the Chairman and his FOMC members considerable time and effort to clarify that
tapering was not "tightening" and there was still a long way to go before US interest
rates would rise. Lately, there has also been some rather strange market behaviour,
with the markets going down when the economic or employment data showed some
improvement, which in theory should have been good news; and markets rising
when jobs or employment data showed signs of softening. This pattern is quite
different to what conventional wisdom would suggest. It also highlights the
uncertainty and risk that when asset markets have been supported by low interest
rates and high liquidity for a prolonged period, the normalisation of the interest rate
and liquidity conditions could create the kind of market dynamics that may
destabilise the financial system and dislocate the recovery path of the real economy.
16. Nevertheless, we don't know how long these perverse market dynamics will persist
and how they may impact on the Fed's exit. We certainly hope the world will benefit
from an orderly exit from the QE and zero interest rate policies. As we don't have a
crystal ball, we can only wait and see what will happen in the re-pricing of assets
across the globe as and when interest rates begin to normalise. In the meantime, it
is crucial we are well-prepared for possible turbulence and shockwaves.
17. But, I believe Hong Kong is on the right track. While we have been at the receiving
end of massive international capital flows for several years, prompting a rise in
inflationary pressure and overheating in the property market, we have acted swiftly
to contain the adverse impact of such unprecedented monetary easing policies.
Since 2009, the HKMA has undertaken six rounds of countercyclical prudential
measures on mortgage lending, coupled with other supervisory action on bank
capital and liquidity, to enhance the resilience of the banking system so it is better
equipped to cope with future shocks. We have also launched a series of measures
to contain credit growth, and recently we have further required banks with relatively
fast credit growth to ensure they have stable funding sources to support that growth.
18. The prospect of a tapering in quantitative easing in the US has already caused jitters
on global financial markets, including fund flows and exchange rates in some
regional economies. Such volatility may continue, if not magnify, in the next couple
of years. Therefore, we must remain vigilant against the possible spillover effects
from other economies, as well as any other emerging risks. We will continue to take
proactive steps to ensure our banking system is resilient to a possible reversal of the
credit cycle, and to enhance banks' liquidity planning and management in
anticipation of any sudden outflow of funds.
19. In conclusion, ladies and gentlemen, we will keep reminding and warning the public
not to allow ourselves to incur excessive debt simply because interest rates are
currently at very low levels. We don't know whether and when these shocks will
materialise, but we must stand ready to face them and be able to emerge from the
next crisis relatively unscathed, as we have done in the past.
20. Thank you very much.