Markets, central banks, real economy playing risky ‘game’

The financial markets, governments, central banks and the real economy are playing a ‘game’ that could potentially be disastrous if events do not go the way they are anticipated to go. The stakes are high and the world cannot suffer another debacle.

Well, the opening lines are not the beginning of a thriller but based on the face of events that are unfolding everyday in the real world. The ‘game’ can unfold in three ways — one which can lead to the world and India coming slowly out of a growth slump, two which can take global and domestic growth expectations plunging downward and three which can create huge instability in financial markets.

The hope for everyone is the first option, but the risk taken by governments and central banks for achieving the first option can potentially cause the second and third options. The way the current scenario plays out in the next six months to a year will determine the choices mentioned above.

First, the financial markets. They have embraced whole heartedly the unprecedented fiscal stimulus of governments and the monetary accommodation provided by central banks. The governments and central banks action together have created a huge pool of global liquidity running into over trillions of dollars. The pool of global liquidity is finding its way into risky asset classes and is adding to inflationary pressures.

The table above shows that financial markets are front-running a global economic recovery as seen by the outperformance of equities and commodities over government bond yields. The financial markets are betting that the real economy will deliver and if it does not, there is a potential asset bubble in the making.

Second, the governments and the central banks. Governments across the globe have placed their fiscal situation under huge stress in order to prevent economies from collapsing.

Governments from US, UK, Japan and India are running up deficits of over 10% of GDP to pump-prime economies. The result of the huge fiscal stimulus provided by governments is a sharp rise in government bond yields as markets fret on the impact of deteriorating balance sheets of governments.

Central banks in their efforts to prevent economies from collapsing have cut policy rates to all time lows and are monetising the fiscal deficit by buying government bonds. The low policy rates, coupled with high liquidity due to central bank purchases of bonds, is adding to inflationary fears in the market leading to further rise in bond yields.

Governments and central banks are hoping that their actions will lead to economic stability, however, if economic stability is not achieved, there is no more scope for governments to increase fiscal deficit or for central banks to provide monetary accommodation.

Third, the joker in the pack, the real economy. The real economy is in short the creation of employment, rise in consumer spending, rise in investments etc. The financial markets are depending on domestic consumption increasing, leading to rise in investments, which leads to increase in employment. The government and central bank actions are aimed at achieving the above. The real economy has to now deliver with incremental data showing lower unemployment, rise in retail sales and higher fixed investments.

The data coming in so far has only shown that the pace of increase in unemployment is slowing, pace of decline in retail sales is slowing and fixed investments (except in China) not picking up. The real economy in not yet seeing the benefits of government and central bank actions and is nowhere close to the optimism levels of the financial markets.

Now, coming to the options. The first is the real economy delivers, justifying financial market optimism and government and central bank efforts. In this scenario economies will get back on the growth track, governments can go back to fiscal consolidation and central banks can remove their accommodative policies without causing major disruptions. This is a situation everyone hopes for but with their fingers crossed.

The second options is where the real economy fails to deliver and financial market optimism collapses, leading to sharp fall in asset prices. This can lead to incipient economic growth falling once again and this time both the governments and central banks will not have any ammunition left to shore up economies. The fiscal positions of governments are highly stretched and central banks are through with policy easing and monetary accommodation. Economies will then have to depend on their own enterprise to come out of the economic slump, which will take a protracted period of time.

The third option is where the real economy fails to deliver, but asset prices reach a speculative bubble, leading to high inflationary expectations. In this scenario, economies will see high inflation and falling growth, leading to financial market instability. This will force central banks to hike policy rates, manage currencies and reduce system liquidity while governments will be forced to become draconian in their measures to combat this kind of economic event.

Let’s all hope the first option plays out.

Disclaimer : The author is head - fixed income, IDFC Mutual Fund. Views are personal