Change in monetary policy is on the cards

TWO PIECES of important news have hit international markets during summer 2013. First, recession in Western Europe seems to be over and second, China appears in better economic shape than anticipated. Gross domestic product (GDP) growth rates in most of the European Union area are in positive territory. Unemployment rates are unlikely to drop much in the near future and one can hardly speak of European recovery, but it is significant. The news from China does not mean the Chinese economy is shining again. Its banking sector badly needs attention and labour costs are rising rapidly. Commentators, given this relatively rosy picture and the absence of inflationary pressures, have turned to central bankers and are wondering whether a change of tack is round the corner. Most observers believe the age of quantitative easing is coming to an end and that the new approach to monetary policy will imply higher interest rates on euro and US-dollar denominated assets. Certainly, under cheap-money conditions, all borrowers look solvent, but it is believed that now is the time to have a second look at risk profiles and to reassess debt-servicing capacities. It may be useful to categorise the world of debtors in three groups to see what this might look like in concrete terms. One group consists of bad debtors with little hope of being bailed out in times of difficulty. A second includes weak borrowers who can rely on relief schemes provided by non-market agents, such as governments, central banks or international organisations. A third group comprises trustworthy debtors who are hardly vulnerable to the business cycle. A rise in interest rates clearly means trouble for those financially-fragile debtors who cannot count on financial liferafts. Economies belonging to the no-lifebelt group are developing countries with full money sovereignty who can print their own money and possibly sustain higher debt levels through inflation. Monetary sovereignty gives bad debtors the possibility of monetising their headaches. The flip side, however, is that as soon as the news regarding generous monetary policy breaks out, creditors will dump the local currencies with dramatic consequences for those aggravated by foreign-currency denominated liabilities and with no white knight coming to the rescue. What about the second groups of debtors? This bloc is well exemplified by the Euro area, in which some countries, such as Cyprus, have benefited from a vague and potentially illusory - yet trusted - promise to bail them out. Public-finance conditions in Spain, Italy, and France are worsening with debt/GDP ratios rising quickly, and their budget-deficit to GDP ratios off target. Even a modest rise in interest rates in these countries can create havoc. If European Central Bank President Mario Draghi, has to choose between high inflation and a public-debt crisis triggered by relatively high interest rates, given this situation, he is likely to go for the first option. Economic commonsense would suggest that partial and selective bankruptcies, known as haircuts, are preferable to inflation, yet the political cost of the former is perceived to be greater than the economic cost of the latter. The impression is that the ECB is currently backing off from its earlier statements about tapering, and that it is also refraining from rebuking key countries which have failed to reduce public expenditure and meet their targets. Avoiding panic seems to be the new password, and fiscal discipline can wait. We are probably heading towards a rather articulated scenario in which the threat of gradual US tapering will come true but in which the effect of tapering will be different. Gradual tapering will provoke unease in a number of developing countries but it will also alleviate the situation in weak EU areas. The EU will benefit from investors looking for borrowers backed by a generous central bank which is more willing to bail out over-indebted treasuries than to keep inflation under control. In this light, it is not surprising that most EU central bankers are relieved when figures about the hoped-for recovery are disappointing. The weaker the recovery, the less is the need to make crucial choices. The authorities were hoping for fast growth until a few months ago. Now they are longing for stagnation, which offers them the best excuse to keep interest rates down and avoid triggering a systemic, public-finance crisis.

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