As the unprecedented expansionary monetary policy that went into effect nearly a decade ago came to an end with the first rise in short term interest rates since 2006, jittery markets alongside darkening outlooks on economic growth have called into question the efficacy of this policy. And what impact it will continue to have as side-effects make themselves felt.
Seven years of zero interest rates and an expansionary monetary policy via the quantitate easing caused investors to pour money into commodities, real estate and commercial debt. As borrowing costs rise and asset prices fall, markets have turned treacherous. Financial disruptions have caused fear on the future of asset prices and economic growth.
A gush of credit that flowed into the monetary system from 2008 onwards led to investors pouring $973 billion into corporate bonds and a further $219 billion into real estate markets. Companies for the most part used the debt not to expand operations, but to buy one another and their own stock. Banks and companies alike used money flows to snap up assets at levels that were seen as attractive.
Financial intermediation was replaced by asset gathering in large part. In emerging markets, companies racked up $3.4 trillion in dollar-denominated debt, more than double the pre-crisis level according to the Bank for International Settlements. With the recent resurgence of the dollar and falling commodity prices, these debts become harder to pay off and have led to widening bond spreads, triggering alarm bells for refinancing risks. This might lead to a precipitous default cycle.
These warning signs need to be taken into context. Most violent market gyrations don’t lead to crises. The global financial crisis was a reflection of not enough capital and fickle regulations; this time around vigilance is far more robust and banks remain well capitalised.
However, it does bring into question the role of such intermediaries and the nature of credit pumped into the economy. For the most part, as data reveals, asset gathering became the norm, both by financial institutions and the companies that were the beneficiaries of the credit gusher. This led to a bidding up of asset prices throughout the globe, as investors chased yields, sparking a V-shaped rally after the depths of the crunch that was felt in 2009.
As the monetary stimulus gets unwound, markets remain spooked about the prospects of spending cuts in emerging markets. And this loss of confidence is what has precipitated the decline in asset prices through 2015. Headlines abound about the extent and severity of spending cuts that must be undertaken by the Gulf states, and the resultant impact that this will have on economic growth.
This ‘New Normal’ hypothesis was first made in 2010, foreseeing that when monetary policy is eventually tightened, there would be no room for financial assets to rise higher. Consequently the impact would be felt in the form of a secular stagnation — long periods of low economic and asset growth as the amount of leverage and financial engineering reached its logical plateau.
Alarm bells have been ringing on the lack of liquidity in the markets due to the stretching of receivables and the consequent strain this is expected to exert on corporate balance-sheets.
However, even if this credit dries up, the fallout may not be dramatic provided that fiscal policy becomes expansionary at this stage. Two decades ago, when oil prices were at all time lows, a fiscal stimulus kept economic growth humming along in the Gulf states.
Similarly, today, a shut-off of credit has led to a reduction in share prices and real estate values (almost certainly overdone by valuation metrics), but need not lead to a fall in investment levels in the economy as infrastructure programmes remain broadly in place. This implies not only a reduction of reserves that have historically been built up by oil producing countries, but also the ability to raise debt to finance continued spending, albeit at higher interest rates as borrowing costs move higher.
It is this continued spending on ambitious infrastructure programmes that will determine the future course of economic growth in the region. Talks of curtailing spending will have a further deleterious impact on growth after a decade of asset gains that spurred economic activity on the back of a monetary policy stimulus.
Although a slowdown is inevitable, it is fiscal stimulus that will ensure the effects of lower oil prices are curtailed. On a global scale, a reduction in oil prices will continue to add stimulus to economic activity, and it is on the back of this future expected growth that fiscal policy has to take the baton.
Governments in the region will need to maintain spending for the most part by drawing down on reserves built over the last decade, and financial intermediaries will have to increase lending to SMEs and trade finance sectors, moving away from asset gathering, if the New Normal hypothesis is to be rendered invalid.
Dubai and the UAE in general have already announced plans that indicate infrastructure spending plans will remain broadly in place, thus taking the lead in the region towards indicating that sustainable economic growth is here to stay.
Other countries in the region will be well-advised to follow in these footsteps, with financial intermediation being the key towards a reallocation of credit away from financial asset gathering in the next few years.
This implies that in the upcoming cycle, it will be economic activity that will be the cornerstone for asset price rises, and not the other way around.
Recent declines in asset prices look likely to have been overdone if the fiscal paradigm remains in place. Astute investors who capitalise on the recent downturn (as has been evidenced by recent bargain hunting) will be amply rewarded for staying the course.
The writer is Managing Director of Global Capital Partners.