The Hindu Business Line : Strategies for uncertain times

Central banks would be using unconventional strategies in uncertain times. These may include monetising Government borrowings, changing inflation target to price target, managing debt defaults and pushing bitter pill pension reforms.

WORLD treads on to 2003 with a cautious mood and rightly so. Last two years sprung their own surprises and created volatility in the financial markets. The events of September 11, 2001 did not push US into a deep recession, but resulted in a brief dip.

The pace of recovery remained a concern throughout last year. Structural imbalances in the US economy looked like a roadblock to return- to-trend rate of growth. Equity markets reeled under a tight bear hug which did not seem like loosening. Central banks acted pre-emptively to further loosen monetary policy towards the end of the year. What are the major risks that the financial markets would face this year?

The world braces itself up for geo-political tensions. There is a war hysteria brewing up in West Asia and similar concerns are germinating in the Korean peninsula. One of the risks from any armed conflict would be it escalating and becoming a drawn-out event. The US would have to bear almost the entire cost of this war. Estimates of the possible expenses range from $50 billion-$150 billion depending on the tenor of the war. One worry would be how the US would be able to fund this cost in the wake of the current high level of deficit. Many would argue that higher borrowings by the Government may not cause significant rise in interest rates as the private sector does not have significant capital spending growth and is not likely to get `crowded out'. But high deficits could start affecting the long-term interest rate expectations when the yield curve has significantly flattened.

Fighting inflation has been the main planks of monetary policy of central banks around the world. The world has not seen any significant inflation over the last decade even during the fast expansion. The US Government would be sharply moving away from the balance budget `dream' to return to large deficits. Governments may have an incentive to deliver surprises on inflation when they are borrowing, as this reduces the real stock of Government debt. War could cause crude prices to move up and cause some energy prices-led inflation. But inflation may not be a significant risk.

Volatility in financial markets may cause a threat of systemic financial failures. We know that the Japanese banking system is awash with bad debts and is also exposed to equity market declines. Risk of banking failures are not confined to Japan. The US and British banks are well capitalised; however, German banking system has both low profitability and rising bad loan exposure. The Federal Reserve has a system that works well to cancel out the systemic risk as quickly as possible. We witnessed the quick reaction from the Federal Reserve during the Long Term Capital Management Fund bankruptcy in 1998. German central bank's ability to act as lender of last resort remains untested.

There is a lot of debate over threat of deflation. Consumer spending has remained robust even during the last two years. The US has witnessed increase in productivity over the last decade. This is a sign of corporate ability to unwind the excesses. Central banks' are prepared to use loose fiscal policy as the monetary policy loses its efficacy. The US President is planning to announce another large tax cut this year. In such a scenario, deflation may not be a short-term threat.

Another risk is of the emergence of a sustained recovery. Economist consensus growth forecast for American GDP is around 2.7 per cent. The US trend rate of growth is around 3 per cent. The economy would have to grow in excess of 3 per cent to unwind the excess resources. In case we see a growth in excess of this figure we would see rapidly rising profits and much higher long term interest rates. One caveat here, corporate balance sheets are still under strain and this would remain a major roadblock.

We have seen policy measures around an event turning the markets in the past. There are a few event risks that one could envisage at the start of the year. Central banks would be using unconventional strategies in these uncertain times.

These may include monetising Government borrowings, changing inflation target to price target, managing debt defaults and pushing bitter pill pension reforms. If conventional policies do not work, unconventional ones have a better chance to win!

(The author is Senior Manager, Corporate Treasury Sales - Southern India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)

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