The Fed swaps one course of monetary drugs for another

Stephen King

December 19, 2013



Job done, at least for now. Ben Bernanke and his colleagues at the Federal Reserve will be delighted at the market reaction following their monetary pincer movement on Wednesday. The Fed will taper its asset purchases by $10bn a month in Januarydown from $85bn to $75bn a month – with a strong hint that further tapering will occur as 2014 progresses.

At the same time, however, the Fed has strengthened its “forward guidancemessage. Simply put, America’s central bank is promising low interest rates for longer. If the Fed’s forecasts are to be believed, rates will now be 25 basis points lower than previously projected at the end of both 2015 and 2016. Mr Bernanke has even managed to ease some of the tensions that had muddied the Federal Open Market Committee’s message over recent months. Those members who had previously offered a more hawkish view on interest rates appear to have had their talons trimmed.

We have, thus, shifted from one course of monetary drugs to another. The side effects from quantitative easing were becoming troublesome: the Fed’s rapidly-expanding balance sheet was raising eyebrows in Congress; financial assets were becoming ever-more expensive even as the pace of economic recovery remained lacklustre; and hot money flows globally were reigniting imbalances in parts of the emerging world

The Fed recognised much of this earlier in the year but, at that stage, hadn’t quite worked out a strategy to avoid the onset of post-QE cold turkey. With the imposition of forward guidance, Mr Bernanke has prescribed the economic patient a new set of monetary pills.

But just as QE came with side-effects, might we eventually discover that forward guidance also has its problems? After all, it only really works if members of the public believe the central bank’s view of the future and if those members of the public believe that other members of the public also believe the central bank’s view of the future (in other words, it works on the basis of Keynes’ beauty parade). At the very least, then, forward guidance is a fragile exercise in second-guessing.

Guessing, however, is not a good foundation for monetary policy. Despite the Fed’s best efforts, however, it’s difficult to see how guesswork can be removed altogether. Before the financial crisis, central banks were keen to offer maximum monetarytransparency”. Forward guidance and transparency, however, are not happy bedfellows.

The opaque nature of forward guidance relates in part to time and economic reality. Is forward guidance a promise not to raise interest rates until a certain date or, instead, is it a promise not to raise interest rates until certain economic conditions are met? The Fed’s statement suggests the latter. Defining those conditions, however, is hardly straightforward. We now learn that the 6.5 per cent unemployment rate threshold is only a “softtarget, with the FOMC judging that “it likely will be appropriate that to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6.5 per cent, especially if projected inflation continues to run below the Committee’s 2 per cent longer-run goal”.

That all sounds very dovish. What the Fed has not clarified, however, is the causal relationship between unemployment and inflation, a relationship that depends on the nature of the western world’s post-financial crisis economic funk. Typically, we tend to think that inflation is a lagging indicator relative to unemployment: demand picks up,the jobless rate falls, wages accelerate and prices eventually rise. On that basis, a big drop in unemployment is an early warning sign of higher inflation in the future, leading markets to anticipate a tightening of monetary policy.

In a post-financial crisis world, however, the causality may be reversed. Weak credit growthreflecting either a weak banking system or persistent deleveraging pushes inflation below target which, in turn, raises real interest rates (at the zero rate bound), pushes up real levels of debt and triggers further deleveraging

Under those circumstances, a fall in unemployment might be merely a cyclical accent within a story of underlying structural decline. This, after all, was the Japanese experience in the mid-1990s, when a modest economic recovery did nothing to prevent deflation from taking hold.

Which of these stories is relevant for the US is, at this stage, unclear. And that, ultimately, is the weakness with forward guidance. The Federal Reserve can’t make convincing promises because, like the rest of us, it doesn’t have a perfect crystal ball. But if those promises aren’t convincing, it’s not clear whether the real economy risk aversion which has limited the pace of recovery in the US will go away any time soon.


The writer is HSBC’s chief global economist and author of When the Money Runs Out


The Trouble with China’s Troubled-Asset Relief

Zhang Monan

DEC 18, 2013
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Newsart for The Trouble with China’s Troubled-Asset Relief


BEIJINGBack in 2009, in the midst of the global recession, China’s government launched a massive economic-stimulus package that bolstered GDP growth by fueling a surge in bank lending. But now it is becoming increasingly apparent to policymakers and investors that easy credit and lopsided policies have generated significant risk for China’s banking system. Indeed, amid rising concern about banks’ troubled assets, defusing financial risk has become the authorities’ central goal.

According to the China Banking Regulatory Commission, commercial banks’ non-performing loans (NPLs) at the end of June totaled ¥539.5 billion ($88.1 billion) – nearly 1% of outstanding loans. The loan loss reserve-fund balance was ¥1.5 trillion (up 19% from the previous quarter), the provision-coverage ratio was 292.5%, and the loan ratio was 2.8%.

Government-backed loans amounted to ¥9.7 trillion, representing a 6.2% increase since last quarternine percentage points lower than the average growth rate for all categories of banking loans. And the balance of wealth-management products stood at ¥9.1 trillion, of which non-standard credit assets accounted for ¥2.8 trillion.

According to the official numbers, NPLs do not actually account for a very high share of total assets, and the NPL ratio (0.96%) is manageable. The problem is that most of China’s NPLs are off-balance-sheet loans, so the NPL ratio may be much higher – and China’s financial sector much riskier – than anyone realizes.

In fact, many banks’ off-balance-sheet loans often extended to higher-risk borrowers, like highly leveraged real-estate developers and local-government financing vehiclesnow exceed newly issued balance-sheet loans. If borrowers default on their off-balance-sheet loans, banks might choose to protect their reputations by covering the difference using internal funds, thereby transferring the risk onto their balance sheets and increasing the NPL ratio.

Banks’ exposure to local-government debt and the real-estate market has already undermined the quality of their assets, increasing debt pressure and weakening profitability. Moreover, off-balance-sheet lending has helped to fuel over-investment in some sectors (especially infrastructure, iron and steel, energy, manufacturing, and real estate), leading to overcapacity and priming the economy for the emergence of bad-debtdisaster zones,” which would increase NPL ratios further. Moves to liberalize interest rates will put even more pressure on asset quality and bank profitability.

Against this background, troubled assets will continue to be converted into liabilities. According to China’s Academy of Social Sciences, the volume of banks’ troubled assets fell from nearly ¥2.2 trillion in 2000 to ¥433.6 billion in 2010, while liabilities formed from these dissolved assets grew from ¥1.4 trillion to ¥4.2 trillion.

Eliminating banking-sector risk will require decisive government action, including comprehensive financial reform and effective risk-management strategies for financial operations in core sectors. But perhaps the biggest challenge will be determining which mechanisms will most efficiently address China’s troubled-asset problem. China has historically approached broad-scale relief of troubled assets through three channels capital injections, asset-management companies (AMCs), and the People’s Bank of China (PBOC) – all of which have serious downsides.

During the late-1990’s Asian financial crisis, China’s four major state-owned banks, which accounted for more than half of the country’s banking sector, had a capital-adequacy ratio of only 3.7% (compared to the international standard of 8%) and an NPL ratio of roughly 25%. In order to recapitalize these banks, China’s government issued ¥270 billion of special treasury bonds in 1998, injecting all of the proceeds into the banks as equity – and, in the process, creating significant financial liabilities.

In 1999, the government decided that four newly established AMCs would purchase nearly ¥1.4 trillion in troubled assets from these banks, using a combination of PBOC loans and AMC bonds issued to the banks. In order to mitigate the risk associated with these debt-funded loan purchases, the PBOC guaranteed the AMC bonds.

This approach generated substantial risk for the PBOC. And, although it strengthened the banks’ balance sheets considerably, the AMCs had an average troubled-asset-recovery rate of slightly less than 25% in 2006, with actual losses close to ¥1 trillion.

China is, of course, not the only country that has struggled with troubled-asset relief. Since the 2008 financial crisis, American financial institutions’ asset write-downs have amounted to 13% of GDP. The Bush administration’s Troubled Asset Relief Program and the Obama administration’s financial rescue plan cost nearly $2.2 trillion, with the Federal Reserve purchasing a massive amount of banks’ assets. In supporting financial-sector deleveraging, the Fed itself became highly leveraged, and troubled assets still plague its balance sheet.

Given the significant flaws in existing troubled-asset-relief channels, another optionsecuritization – is being discussed in China. The PBOC already has called for banks to securitize their high-quality assets and sell the securities to interbank-market investors; that could be a prelude to troubled-asset securitization. By selling troubled assets in the secondary market, commercial banks could strengthen their balance sheets while avoiding liability increases and enhancing asset liquidity.

But securitization creates its own challenges, such as how to price the assets. Moreover, once a loan is securitized, the bank that issued it no longer has any incentive to ensure repayment by the borrower, which raises the risk of default and drives up interest rates. Competitive securitization was a leading cause of the US subprime mortgage crisis; owing to defaults, mortgage loans remain America’s number one troubled asset.

In order to mollify investors in the face of increased default risk, China’s government might force commercial banks to strengthen their balance sheets through collateralization or to swap defaulted loans for new bonds, backed by China’s foreign reserves held in US Treasuries. But such requirements would lead to even more risk.

A better solution would be to develop the credit-rating market, establish a more comprehensive regulatory framework for the financial system, and create an effective mechanism for ring-fencing risk. Such measures could offer the security and credibility needed to enable the successful securitization of troubled assets, paving the way for China’s leaders to deepen financial reform.


Zhang Monan is a fellow of the China Information Center, a fellow of the China Foundation for International Studies, and a researcher at the China Macroeconomic Research Platform.


December 19, 2013 8:02 am


Taper in a teapot: The Fed’s tweaking of monetary policy

Value of Bernanke’s gesture is mainly symbolic, signalling desire to return to business as usual

U.S. Federal Reserve Chairman Bernanke begins his final planned news conference before his retirement, at the Federal Reserve Bank headquarters in Washington


The decision by the US Federal Reserve to reduce the monthly rate of security purchases by $10bn is best dismissed as a taper in a teapot. It is much sound and fury signalling not very much.

In effect, the Fed tightened current monetary policy almost indiscernibly, while at the same time using forward guidancethat is, the statement by the Federal Open Market Committee – to indicate that future policy would remain loose for at least slightly longer than previously anticipated.

This was a sensible way of tweaking the time profile of monetary policy. The US economy has been doing a little better than expected of late and can therefore digest this slightly tighter policy now.

At the same time, there remain serious concerns about America’s medium-term economic prospects. There is uncertainty about whether the disappointing pace of recovery will continue. There is the question of whether and when the alarming decline in the labour force participation, which has created the appearance but not the reality of lower unemployment, will be reversed. Given these uncertainties, it is entirely appropriate for the Fed to signal that it may be even more supportive of the economy in the medium term.

But these changes are inconsequential by the standards of the dramatic and unprecedented developments in monetary policy that we have seen since 2008; $10bn of monthly securities purchases are a drop in the bucket for a central bank with a $4tn balance sheet. Even if this month’s $10bn reduction is the first in a series of successive monthly steps in the same direction, it will take many months before the change has discernible impact on the Fed’s financial statement.

Wall Street may have had some trouble figuring this out on Wednesday afternoon, when the Fed’s statement seemingly threw the markets into a tizzy. But given a night’s sleep, stock traders should be able to recognise the Fed’s announcement for the non-event that it is.

The one consistent impact of Wednesday’s FOMC announcement was on the dollar exchange rate, which rose sharply against the yen and other currencies. This should not come as a surprise. Even a slightly tighter Fed policy now makes for a significantly stronger dollar, since monetary tightening will not only strengthen a currency but cause it to overshoot its new equilibrium value, other prices being slower to move. Thus, we should expect to see the dollar give back some of the ground it gained in coming days. The rise in the dollar will turn out to be another tempest in a teapot.

Finally, the FOMC announcement is unlikely to have much impact on emerging markets, in contrast to Mr Bernanke’s tapering talklast summer, which led to a very sharp emerging market correction. For one thing, investors this time are better prepared. They may not have been certain that tapering was coming this week but neither were they as surprised as they were by Mr. Bernanke’s statements last May.

For another, emerging markets are better prepared. Their exchange rates and stock markets are not as overvalued as last summer. Their financial markets are not as dependent as then on foreign money as they were then. Hence they are not as vulnerable to correcting downward.

Finally, policy makers in emerging markets have already gone one round with the Fed. If they gained anything from their less than happy experience last summer, they at least learnt what kinds of responses are more likely and less likely to reassure the markets.

The value of this week’s FOMC decision is mainly symbolic. It is a way for the Fed to signal to its detractors that it hears their criticisms of its unconventional monetary policies, and that it shares their desire to return to business as usual. The decision beats back some of the criticism to which the Fed is subject and diminishes prospective threats to its independence. But, at the same time, the central bank has also signalled that it is not prepared to return to normal monetary policy until a normal economy has returned. As Hippocrates would have said, it has at least done no harm.


The writer is professor of economics and political science at the University of California, Berkeley

Copyright The Financial Times Limited 2013.


Italy’s president fears violent insurrection in 2014 but offers no remedy

By Ambrose Evans-Pritchard

Last updated: December 17th, 2013

Hundreds of students wrap themselves in an Italian tricolour during a Pitchforks Movement protest in Turin on Wednesday
Hundreds of students wrap themselves in an Italian tricolour during a Pitchforks Movement protest in Turin on Wednesday. (Photo: EPA)


Events in Italy are turning serious. President Giorgio Napolitano has warned of “widespread social tension and unrest” in 2014 as the Long Slump drags on.

Those living on the margins are being drawn into “indiscriminate and violent protest, a sterile lurch towards total opposition”.

His latest speech is a veritable Jeremiad. Thousands of companies are on the “brink of collapse”. Great masses of the working people are on the dole or at risk of losing their jobs. Very high rates of youth unemployment (41pc) are leading to dangerous alienation.

“The recession is still biting hard, and there is a pervasive sense that it will be difficult to escape, to find a way back to full growth,” he said.

Now why might that be? Might it not have something to do with the central overriding fact that Italy has a currency overvalued by 20pc or more within EMU: that it is trapped in a 1930s fixed-exchange system run a 1930s central bank that is standing idly by (for political reasons) as M3 growth stalls, credit contracts, and deflation looms?

Mr Napolitano offers no answer. A former Stalinist who applauded the Soviet invasion of Hungary in 1956 (a youthful indiscretion), he has long since switched his ideological fervour to the EU project. He is by nature incapable of questioning the premises of monetary union, so don’t expect any useful insights from the Quirinale on how to break out of this impasse.

He does concede that the eurozone crisis “has put a severe strain on social cohesion” but leaves the matter hanging, his argument unfinished, more descriptive than analytical.

Without going as far as to warn that the Italian state itself is at risk, he said the growing threat from insurrectional forces must be confronted. The law must be upheld strictly. The country must continue to be governed. “Europe is watching us,” he said.

Mr Napolitano is alarmed, and so he should be. The “forconipitchfork revolt has taken a disturbing turn for Italy’s elites. Police took off their helmets in sympathy at the latest mass demo in Turin.

This is becoming an anti-EU movement. One of the Forconi leaders has just been arrested for climbing up the EU offices in Rome and ripping down Europe’s blue and gold flag.

Where this is going is anybody’s guess. Citigroup says Italy will remain stuck in depression with growth of 0.1pc in 2014, zero again in 2015, and 0.2pc in 2016. If so, Italy’s output will be 10pc below the former peak a full eight years after the crisis, a far worse performance than during the Great Depression.

Even if the eurozone recovers over the next three years or so, the best that Italy can hope for is stabilisation at levels of mass unemployment20pc if you include Italy’s extremely high level of discouraged workers (three times the EU average) who have dropped off the rolls. The question is how long society will tolerate this. None of us know the answer.

Italy has for now avoided a return to “years of lead”, the 1970s and early 1980s terrorism when Bologna’s railway station was blown up by Fascists and former premier Aldo Moro was seized and murdered by the Red Brigades. But it is not as far away from such violence as people think. The head of the tax agency Equitalia was nearly blinded by an anarchist letter bomb in 2011. There have been repeated instances of fire bomb attacks since then.

My guess is that there will be an incident at some pointrather like the clash between French troops and dockers in Brest in 1935, when a worker was beaten to death with a rifle butt, setting in motion events that ultimately forced Laval out of power and France off the Gold Standard.

To those who keep insisting that Italy should tighten its belt and claw back competitiveness by cutting wages, I would contend that this is mathematically impossible in a climate of EMU-wide deflation or near deflation.

The reason should be obvious to everybody by now. You cannot allow the nominal debt stock to rise on a shrinking nominal base. Such a policy causes the debt trajectory to spiral upwards. Italy’s debt has already jumped from 119pc to 133pc of GDP in the last three years in large part because of the fiscal austerity policies.

This ratio will soon punch through 140pc under current EMU policies, despite Italy’s primary budget surplus – a level beyond the point of no return for a country with no sovereign currency or central bank. Such is the power of the denominator effect.

Just to be clear. I do not think Italy should leave the euro as a first resort. There are other steps that should be taken first, if only to build as moral and political case.

Italy can change its diplomatic strategy, pushing for a debtors' cartel of Club Med states with French leadership to seize control of the ECB and the EMU policy machinery. They have the votes, and the full legal and treaty authority to force through a reflation strategy that would change everything, if they dare.

This is more or less the new plan of Romano Prodi, Italy’s former premier and “Mr Euro”. He is now calling for Italy, Spain, and France to band together rather than deluding themselves that they can go it alone, and to “bang their fists on the table”.

Nobel economist Joe Stiglitz echoes the theme at Project Syndicate. If Germany and others are not willing to do what it takesif there is not enough solidarity to make the politics work then the euro may have to be abandoned for the sake of salvaging the European project,” he said.

The ECB’s Mario Draghi warned yesterday at the European Parliament that EMU exit would lead to a 40pc devaluation and a crisis that would bring any country to its knees even more brutally than has the one it now faces. This is the sort of argument always heard in defence of fixed exchange rate systems, whether gold in 1931, or the ERM in 1992, or the Argentine peg in 2001. It was was demonstrably false in the case of Italy in the 1990s when devaluation worked like a charm.

It dwells on the immediate trauma, but skips over the much more corrosive effects of perma-slump. Countries can in fact recover very fast if the exchange rate takes the strain. You could equally argue that there would be a flood of pent-up investment into Italy the moment it lances the euro boil and restores currency equilibrium.

In any case, Mr Draghi’s argument assumes that the ECB would let a 40pc slide happen, even when northern powers have a very strong interest in ensuring an orderly Italian exit? The ECB could intervene in the FX markets to stabilise the lira for a few months until the dust settles. That would avoid an overshoot, avoid crippling losses for German bloc creditors and exporters, and avoid a deflation crisis in Germany, Holland, Finland, and France.

What Mr Draghi is implicitly saying (without meaning to) is that the ECB would behave in a reckless fashion, punishing Italy for the sake of it, even though this would make the whole ordeal worse for everybody. It would have been nice if an MEP had asked him why the ECB would do such a thing.

What seems certain is that no democratic country will endure semi-slump and mass unemployment for ever when plausible alternatives are on offer.