In its May Monetary Policy Statement, the RBNZ identified key downside risks to the outlook for economic growth as including:
- the possibility of a global shift to more inward-looking and protectionist trade policies, and
- a more pronounced slowdown in China
These sound a little misplaced since we know that advanced economies are beginning to show signs of improved economic growth. Further, the Chinese economy is growing at about 6.5 percent annually. These risks, however, are quite substantial and a little interconnected. Some detail on them is provided in the April 2017 Global Financial Stability Report (GFSR) of the International Monetary Fund.
Firstly, the GFSR paints an optimistic picture of advanced economies stepping carefully into a more confident business environment. The GSFR says that global financial stability has improved in recent months. The corporate and banking sectors in many countries are experiencing lower credit risk and their firms are earning more from fixed deposit investments, now that longer-term interest rates have increased. The present low long-term interest rate environment is symptomatic of weak confidence, although a positive sign is that they have risen in recent months. Indeed the GFSR equates the recent rise in yields to a combination of higher real yields and increased inflation compensation. This means expectations of stronger economic growth.
The GFSR is further optimistic about a potential boost in economic growth from policies under discussion in the United States. These policies would raise cash flows to firms with corporate tax cuts and immediate expensing of capital expenditure, while also eliminating interest deductibility of debt. The latter policy would discourage excessive leveraging of firms’ balance sheets, which the GSFR sees as a risk to financial stability.
Amidst this optimism, the GFSR suggests that if advanced economies begin to be inward-looking and raise barriers to trade with emerging market economies, there is a risk for global growth prospects. The main risk to continued improvement in global financial stability seen by the GSFR, is a shift towards protectionist policies (such as policies to favour locally produced goods and services) in advanced economies. The GFSR says that this could lead to increased public indebtedness, raising risk premiums on public and private sector borrowing which would also spillover to firms in emerging market economies, such as in China, India and Brazil. The result would be a decline in the rate of economic growth globally as foreign firms are faced with higher interest rates on credit and lower demand for their output.
Even without protectionist policies, emerging market economies will already face challenges of rising global interest rates, partly driven by improved economic growth for advanced economies. Adding in protectionism, the GSFR sees the greatest adverse impacts for firms in China, India, and South Africa. Commodity sectors especially would come under pressure because metal and oil prices would fall as a result of the sharp decline in global growth.
China recently lowered its 2017 economic growth target to about 6.5 per cent from 6.5 to 7 percent. This signals a shift from policies supporting economic growth to policies supporting reforms to contain credit growth. It was necessary because China recognises the risk of a credit crisis to its economy. Credit growth is fuelling the rapid growth of the Chinese economy. However, the GSFR says that credit booms of this size are often dangerous and the likelihood of a financial crisis rises the longer a boom lasts and the larger it grows, especially if exchange rate flexibility is very limited. An important question is whether further constraints on China’s economic growth are necessary in order to avoid a credit crisis. If so, there is a very real risk of a further slowdown in China’s economic growth.
Banks continue to play a major role in the provision of credit in China, where total assets of China’s banks are more than triple the size of its gross domestic product. In addition, other non-bank financial institutions are using short-term funds for providing long-term credit, thereby raising their risk profiles. Borrowers must roll over their liabilities in the short-term, while the credit products they provide have much longer maturities. This maturity mismatch makes borrowers highly vulnerable to a sudden liquidity crisis.
Such a crisis may be precipitated by protectionist and inward-looking policies of advanced economies raising risk premiums on short-term borrowing of firms in emerging market economies.