Analysis. Global economy on a tightrope walk

Low growth, low interest rates and low inflation were the defining features of the global economy in the year that went by and it is interesting how major central banks have factored them into risk perception in their financial stability reports.

The Euro Zone is in the midst of slow growth helped by a long spell of unconventional monetary measures (sub-zero interest rates and easy money). But these very measures have the European Central Bank (ECB) worried because they affected bank profitability, increased the risk taking behaviour of intermediaries and caused asset price volatility.

Low oil prices were the major disruptor, impacting the zone in multiple ways — domestically, they boosted private consumption and growth and kept inflation low; but as emerging market economies (EME) were adversely affected, the Euro Zone’s exports to EMEs took a hit and their banks’ credit exposure to the energy sector in EMEs became riskier. EME stress is thus on the top of ECB’s risk list.

With a bank-centred financial system, subdued profitability of banks is the other top risk for the ECB. This was due both to low interest rates as well as rising bad debts (average non-performing exposures ratio was 7.1 per cent for the major banks), a phenomenon that is surprising in a low interest rate scenario, especially when contrasted with India where high interest rates are seen as one of the causes of NPAs.

Thus, the compulsions of keeping domestic interest rates low and yet managing the risks from it, together with the challenges from declining commodity prices in a trade dependent economy, summarise the dilemma of the ECB.

If oil prices and low interest rates were at the centre of the ECB’s worries, the USFSOC report acknowledges them but focuses on different risks. Unlike Europe, the US financial system is market dominated, wider and deeper and there is also the fortuitous circumstance of being the world’s reserve currency which enables it to suspend, as it were, conventional economic theorems. Thus, as the world’s largest importer and consumer, it can run up large current account deficits and high debt and yet enjoy an appreciating currency and low interest rates. Global trade slowdown poses less of a risk than in Europe. Unlike in Europe, the banking sector is smaller — it holds less than a fourth of total assets and meets only about 8 per cent of all credit needs. The US worries are more about rising debt, an old problem.

Debt drives the US economy and interest rates work their way through markets than through the banking system. Household debt is now a little over 100 per cent of disposable income (128 per cent in 2007) while corporate debt is growing at nearly 10 per cent. Low rates and lenient underwriting standards, which cause misalignment of asset markets and increased volatility, become a source of risk. Banks are a worry more from their riskier non-banking activities, especially post Glass Steagall. The main concern is that this combination of high debt, low global growth, low inflation and strong dollar could impact earnings and incomes whereby debt repayment could come under pressure.

In the Indian context, the contrast is striking. Low oil prices and slow global trade have not impacted our economy as badly as others, as evidenced by reasonably good growth rates. As for interest rates, the belief actually is they are too high, which does not quite square up with low bank profitability and high NPAs, the opposite of Europe and the US. Our financial system is also bank-centric, but with interest rate policy almost entirely aimed at influencing bank lending, it is their low profitability that prevents rate cuts being transmitted through.

The risks of interest rates causing misalignment or volatility in financial asset markets are insignificant as is the degree of interconnectedness of the system which the RBI acknowledges in its reports. Even the shadow banks are not a source of concern as they are regulated on par with banks. Yet if the RBI perceives the banking sector as the largest source of systemic risk, it seems to be derived from their primary business of lending and not so much from other factors.

The writer is an independent consultant

COMMENT NOW