Pre-empting this week’s interest rate hike, RBI governor, Urjit Patel, published a very interesting article in the Financial Times over the weekend which provides some insight into his multiple concerns. The article was, in a sense, a letter to the US Fed recommending that it tone down its unwinding of quantitative easing. He suggested that the Fed should continue to buy government bonds by reinvesting coupons (which it has currently stopped), to take into account the increase in supply of treasuries needed to fund the expected higher deficit resulting from the Trump tax cuts.
His concern is that “if [the Fed] does not [slow plans to shrink its balance sheet], treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable,” which would affect emerging markets adversely. Clearly, the governor remains concerned not just with the domestic inflation trajectory but also with this potential threat to India’s reserves and the rupee.
While it is a sensible suggestion, the fact remains that, even at the most cooperative of times, central banks would—and should—look to their own needs first, and, as we all know, these are not the most cooperative of times.
With US unemployment at a shocking low of 3.8% and the economy growing steadily, an upsurge in inflation, and correspondingly higher interest rates, could well be around the corner in the US—in other words continued monetary tightening would seem to be the primary need of the US economy. Further, given that deficits as a result of tax cuts usually end up higher—and, often, much higher—than projections, upward pressure on inflation could be even stronger than anticipated. This means that the pressure on emerging market currencies, which appears to have abated, could suddenly restart, probably with a vengeance, before too long.
Indeed, it is worth pondering whether we may—finally—be at the end of the super long period of sub-normal borrowing costs. Looking across the Atlantic, it appears that rates in Europe, too, will need to rise, and, perhaps substantially. The political trauma in Italy, which is too-big-to-leave-the-EU-without-triggering-a-breakdown, has once again called into question the future of the Euro and is compelling a serious rethink of the underlying structure of the Euro and, indeed, the EU.
One story I heard was of talk of a two-tiered Euro, where part of each company’s earnings and costs would be in Euros and the balance in some yet-to-be-determined new currency (which would, of course, be much weaker)—shades of our own partial convertibility in 1991 where 40% of the foreign exchange remitted could be converted at the official exchange rate while the remaining 60% would earn a market determined rate.
Another, and in my view much more likely, possibility is that there would be a loosening of the 2% fiscal deficit requirement of the Maastricht treaty. This would enable Italy, and other countries, to ease the considerable austerity burdens on its people, reducing the domestic political pressure and, hopefully, enabling growth. While this would not be easy to pass, given the rigours of getting anything done in Brussels, such a move would effectively weaken Germany’s control over the Euro and the EU, which, again, would be a big political plus across the region. It is worth remembering—and there is little doubt that it will be brought up—that in the early years, immediately post-Maastricht, Germany itself had run deficits in excess of the limit for a few years.
Italy, of course, is not, and never will be, Germany, and recognising this, the deficit rule-change, if it comes, will need to be permanent, rather than it being seen as providing a window during which the economic cultures could merge. Perhaps, a new fiscal structure will evolve taking a page out of the old EMU snake, where there were two variation bands—2.5% for currencies like the Deutsche mark and the French franc, and a wider 4% band for the Italian lira, the Spanish peseta and others.
This would mean accepting larger deficits, higher inflation and a weaker Euro. Interest rates would, of course, rise, reinforcing the story from the US. Of course, such structural changes take time, generate volatility and have widely unpredictable consequences, even in the most cooperative of times. Given that the global framework itself is in a nervous flux with Trump’s unilateralism, I would bet that the volatility in global markets will rise.
In particular, as already explained, global borrowing costs are set to go up, as a result of which this week’s monetary action by RBI is likely to be merely a beginning.
CEO, Mecklai Financial