IIF blames market malaise on central bank liquidity drought
Tokyo
THE global slump in the price of stocks and other financial assets comes from a contraction in central bank liquidity, which is likely to continue and drive markets further down, the Washington-based Institute of International Finance (IIF) warned in a report on Thursday.
It rejected the idea that China's slowdown and an accompanying slide in emerging-market economic activity are the chief factors behind the wider financial market slump, and suggested that the world was in "a crisis of risk appetite" caused by swings in monetary policy.
The IIF report comes as the Bank of Japan (BOJ) and the European Central Bank, among others, step up liquidity injections - moves which the IIF implies are likely to have limited impact in fending off further contraction in global economic activity.
Adding to the litany of suggested risks on the horizon, the IIF warns that the BOJ's move to impose negative interest rates could set off a round of competitive easing among central banks, even as the danger of "flash crashes" in financial markets grows.
Intensive focus on China's economic slowdown has masked the fact that the main driver of market and economic developments since the 2008 financial crisis has been extraordinary monetary policy, including quantitative easing (QE) and negative interest rates.
This has worked primarily by boosting appetite for risk assets, said the IIF, which counts many of the world's leading banks and private financial institutions among its more than 500 members.
Inflated values for these assets have in turn trickled down to stimulate consumption and investment, underpinning a lacklustre recovery.
The IIF report said: "However, trends over the past 12 to 18 months reflect growing signs of an erosion of risk appetite, fed by the perception of deterioration in fundamentals and growth prospects in many economies. This has sparked a correction in asset values so far in 2016 - and suggests a risk of overshooting on the downside. In short, we may be in a crisis of risk appetite."
In the five years following the global financial crisis in 2009, the world's central banks collectively added an average of some US$400 billion in liquidity to global financial markets every quarter through asset purchases, the IIF noted.
Yet, the wealth effect of this liquidity-driven increase in asset value had been small. The lion's share of gains had accrued to the top 10 per cent of the population, which has a relatively low marginal propensity to spend. As a result, economic recovery since 2009 has been anaemic in the US, the weakest in post-war history."
Liquidity injection from central banks worldwide slowed significantly from 2014; there was, in fact, an outright decline between mid-2014 and mid-2015 as foreign-exchange sales by many emerging-market central banks offset the bulk of BOJ and ECB asset purchases.
This reduction in central bank liquidity injection was a primary impetus for the 2015-2016 moderation and subsequent correction in asset prices.
Given "persistent concern about global growth prospects and diminishing scope for further support from central banks, risks remain elevated, particularly as previous corrections have tended to overshoot on the downside".
Further erosion in asset values "would likely be driven by a growing realisation that fundamentals in the global economy have deteriorated noticeably since the financial crisis".
The single most important negative development in terms of economic fundamentals has been a "clear and persistent slowdown in productivity growth in both mature and emerging market economies", said the IIF.
Seven years of plentiful central bank liquidity and zero interest rates - in fact, about US$5.5 trillion, or a quarter of mature market sovereign bonds now have negative yields - has spawned a difficult challenge for policymakers.
"Further monetary easing - or more competitive easing - would bring progressively smaller benefits while adding to the risk of fostering financial distortion and excess. In addition, the prospect of sustained slow growth will create significant social and political tension, adding to the negative effect of interconnecting geopolitical risk and events."
Meanwhile, slowing potential growth, in turn, makes the record level of debt in mature and emerging market countries even more pernicious. "Poor fundamentals, especially declining corporate earnings and weakened credit quality as well as the debt overhang, will not sustain any meaningful recovery in asset values in the foreseeable future."
All this "could substantially increase market volatility, raising the risk of flash crashes, given already-fragile liquidity conditions in financial markets", the report said. In the meantime, the debt time bomb is ticking.
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