Janet Yellen is sworn in as Chairman of the Federal Reserve: “It now owns an extraordinary 30 per cent of all outstanding Treasury bonds ” © Bloomberg via Getty Images
The prospects for global economic growth are looking better this year as economic recovery in the developed world trumps a slowdown in emerging markets. Dominating the investment agenda are US “tapering” of quantitative easing and China’s planned economic transition.
The Federal Reserve is beginning the process of undoing its bold monetary policy experiment. This has involved not only a long period of near zero interest rates but also an expansion of the central bank’s balance sheet to about four times its usual size. It now owns an extraordinary 30 per cent of all the Treasury bonds outstanding. Contrary to some expectations, inflation has not resulted—indeed by some measures it has fallen to multi-decade lows—and it will be with considerable relief that the central bank takes the first steps towards normalisation before any unpleasant side effects have manifested themselves.
With no precedent to go on, how, or even if, quantitative easing works will continue to be debated. But what is for certain is that a large and willing buyer of Treasury bonds will be leaving the market.
When, in April last year, the Federal Reserve first started talking about reversing its “extraordinary measures,” expectations of higher interest rates rose rapidly. It proved a hard struggle to subdue them even as the most sensitive areas of economic activity slowed sharply. After a dismal economic performance since the financial crisis most central banks would rather be late than early in raising interest rates. Low global inflation buys some time but avoiding a repeat of 2013’s scare will be one of the challenges for 2014.
It also looks as if 2013 was an inflection point for the Chinese economy. The western financial crisis had seen China’s exports collapse. To fill the gap it then embarked on an enormous debt financed capital spending programme. At over 50 per cent of GDP it far surpassed the previous records of Japan in 1973 (36.4 per cent) and Thailand in 1991 (41.6 per cent). Both previous episodes ended badly. In November, the Third Plenum of China’s Communist Party set a new direction for the economy, emphasising domestic consumption at the expense of exports and capital spending.
It may be that so-called “red capitalism” can succeed where others have failed, but smoothly achieving such a transition has usually proved a hard task. Even if successful it points to a slower growth rate and this will be felt across the world, particularly in other developing economies. Over the last few years China has accounted for more than 100 per cent of the growth in demand for many raw materials. This has directly benefited its suppliers, many of whose economies are dependent on the level of commodity prices.
Of more concern is how China’s financial system will handle the transition, and the knock-on effects on financial confidence elsewhere in the developing world. Already Turkey, Venezuela, Indonesia and Argentina are experiencing increasingly acute crises of confidence as capital flows reverse. Brazil and South Africa have seen their currencies weaken further in 2014 after steep falls last year. Since 2009 a commonly used measure of Chinese debt— “total social financing”—has expanded by an amount equivalent to 15 per cent of global economic output.
Moreover China’s shadow banking system, which has also expanded hugely, is now caught in the cross hairs of the struggle between the Communist Party and the new entrepreneurial class. There are worrying signs that the first cracks are beginning to appear.
Financial markets try to look ahead and neither Federal Reserve tapering nor the risks associated with the emerging economies are new themes for 2014. Indeed, emerging markets, commodities and government bonds were some of the worst investments of 2013, just as developed world equity markets were among the best. The strengthening recovery in the developed world and increasing stresses in emerging markets will carry on exercising a powerful two-way pull on markets. For the moment, the broad trends set in 2013 look set to continue. The wild card is China.
