The Federal Reserve's rate cut this week was followed by falling share prices on the New York Stock Exchange. Photo / Bloomberg
The Federal Reserve's rate cut this week was followed by falling share prices on the New York Stock Exchange. Photo / Bloomberg
COMMENT:
You know you are in trouble when an emergency rate cut by the most powerful central bank reassures financial markets for little more than a nanosecond.
The markets have come to recognise that the coronavirus epidemic will be a much bigger shock than they had thought, to a worldeconomy that is not in good shape to cope with it.
The global economy has been losing momentum for a couple of years. World gross domestic product grew just 2.9 per cent in 2019, its weakest rate since it stopped contracting 10 years ago. The average rate over that decade was 3.8 per cent.
And global growth got weaker as the year went on, with Japan's economy contracting in the December quarter while the euro area eked out a mere 0.1 per cent growth. Both are now at risk of recession.
Hopes for a rebound in global output this year have been dashed; the only question is how bitterly.
The OECD this week outlined two scenarios. Their base case, which assumes that the epidemic peaks in China about now and that "outbreaks in other countries prove mild and contained", would see annual global GDP growth drop to 2.4 per cent for 2020 as a whole before picking up to around 3.25 per cent next year.
But at the time of writing, 79 countries have reported confirmed cases of the virus. Most of them would not be able to match China's ability to put whole cities into lockdown, which suggests that "mild and contained" is an unlikely condition to be met.
So the OECD's darker "domino" or "broader contagion" scenario looks more plausible. On this scenario, the virus spreads much more intensively than it has yet through the wider Asia-Pacific region and the major advanced economies of the northern hemisphere — collectively representing about 70 per cent global GDP.
The OECD's modelling indicates that would cut global GDP growth this year to about 1.5 per cent. Gulp.
Initially, the adverse impact is concentrated in China but the effects in the rest of Asia, Europe and North America build up through 2020.
A health worker screens the temperature of a passenger arriving from Italy at Debrecen International Airport in Hungary. Photo / Bloomberg
Faced with such a large negative shock and an extended period of high uncertainty, several central banks could find themselves constrained by the zero lower bound of policy interest rates, the OECD says, including Australia, Korea and the United Kingdom.
The Reserve Bank of Australia this week cut its equivalent of the official cash rate to 0.5 per cent, followed by an emergency cut by the US Federal Reserve, by 0.5 percentage points to 1 per cent.
The limited remaining scope for rate cuts by central banks is only one of the negative side-effects of the prolonged period of exceptionally easy monetary policy which has prevailed since the GFC.
Another is inflated asset prices. In New Zealand that is seen especially in the housing market. It is also evident, for example, in high price/earnings multiples on the New York stock exchange.
But perhaps the most debilitating side-effect of a prolonged period of ultra-easy money is high debt levels.
Total debt-to-GDP ratios — the combined indebtedness of government, corporate and household sectors measured against the size of the economy — are much higher now than they were on the eve of the GFC, which was all about excessive debt.
Across the G20 the ratio climbed from 181 per cent in 2007 to 223 per cent by the September quarter last year, the most recent data available.
For the US it has risen from 229 to 254 per cent of GDP and for the euro area from 218 to 267 per cent. China has seen a staggering increase from 146 per cent of GDP in 2007 to 257 per cent of its much larger GDP now, with a particularly steep rise in corporate debt.
New Zealand is a bit of an outlier in this. Our total debt ratio is little changed — 208 per cent of GDP in 2007 and 204 per cent now.
The increase in global leverage is troubling because leverage is a fair-weather friend. It amplifies gains in a rising market but amplifies losses in a falling one. There is a reason the Reserve Bank has imposed loan-to-value ratio curbs on mortgage borrowers and more recently required banks to hold more capital.
The increase in corporate debt in the major economies is especially problematic in the event of a global slowdown.
The recent sharp reaction in financial markets to the spread of the coronavirus adds to persisting financial vulnerabilities from the tension between slower growth, high corporate debt and deteriorating asset quality, including in China, the OECD says.
Federal Reserve chair Jerome Powell. The Federal Reserve cut its main policy rate by half a percentage point this week. Photo / AP
Globally, just over half of all new investment-grade corporate bonds issued in 2019 were rated BBB, the lowest investment-grade rating, while a quarter of all non-financial corporate bonds issued last year were already below investment grade.
"These developments raise the risk of significant corporate stress if risk aversion intensifies from already high levels, especially in the event of a sharp economic downturn."
In these circumstances, the case for unstintingly stimulatory monetary and fiscal policy is incontrovertible. But it is no panacea. Measures which ensure credit is cheap and people have money to spend do not ensure that they will be willing to do so.
Business confidence was already weak.
And the things consumers might want to spend money on need to be available. To the extent that this is a supply-side shock reflecting disrupted supply chains in manufacturing and a potentially large part of the workforce in service industries off sick, policy measures to boost demand don't really help.
Finally, there is a political problem.
The OECD stresses the need for a co-ordinated policy response across the G20 economies. Co-ordinated action would create positive spillover effects through trade and improved confidence, it argues, resulting in a larger output gain in each country than if they acted alone.
But the largest of those economies is led by a man whose doctrine is America First. And by America he really means one American in particular — himself. Multilateralism is out of favour, bigly.
Donald Trump has surrounded himself with second-rate yes-men, a stark contrast to Barack Obama's team during the GFC, and has only recently been given carte blanche by the US Senate.
The resulting vacancy at the centre of world affairs at this critical time may prove costly indeed.
