Interest gap could spell economic peril
On a recent Monday, the Fed called an emergency meeting. The discussion topics were not made known. Could it possibly be about turmoil in the UK bond market and the financial troubles of large investment banks? At this fragile time, the world cannot afford another Lehman Brothers-type disaster.
After all, economists are not good at predicting and protecting economies from crises.
In its World Economic Outlook report for January 2022, the IMF predicted Sri Lanka's GDP would grow by 2.6% in 2022 and 2.7% in 2023. The United Nations Department of Economic and Social Affairs also projected 2.6% growth for Sri Lanka in 2022.
No one seemed to be aware that Sri Lanka was about to face an economic crisis. Six months later, Sri Lanka's prime minister announced the economy had collapsed. I am disappointed that these world-class economists missed an important fact that Sri Lankan had grossly inadequate foreign reserves.
The country was obligated to pay $6.9 billion in foreign debt payments in 2022, but had only $3.1 billion of foreign reserve available at end-2021. That level of reserves could cover only 1.5 months of imports for which a minimum of three months of reserves was needed.
All public and private economic research institutions, except one, projected that Thailand 1997's GDP growth would be 6.8% to 7.2%. How could they ignore the fact that Thailand was experiencing a severe liquidity shortage, prompting the overnight interbank lending rate to double from 6.1 % in April 1996 to 12.1% in December 1996?
To push for positive growth in 1997, which meant demanding more liquidity, would put the entire economy at extreme liquidity risk. At that time, liquidity came mainly from foreign borrowing. On July 2nd, 1997, the Thai economy was hit by a once-in-a-lifetime financial crisis. Instead of the high growth projected, GDP growth was -2.7% in 1997 and -7.6% in 1998.
Just last week, the United Kingdom was on the brink of a financial crisis. Luckily, the Bank of England intervened by pumping £65 billion into the gilt market (the local name for UK government bonds) to save the day. Fear of rising bond yields triggered a massive sell-off of long-term gilts to the point that the market could have collapsed. The bank stepped in and was able to calm the market.
Most critics blamed Liz Truss government's "New Era for Britain" policy which included support for energy bills and tax cuts. These measures would result in more gilt sales to finance higher fiscal deficits.
This potential yield rise spooked investors into dumping current bond holdings to avoid investment loss. To give readers an idea of potential losses, a 1% rise in bond yield would mean a 10% loss in principal for 10-year gilt holders. Of course, if one holds 20-year maturity gilts, the principal loss would double to 20%.
However, I have doubts about this argument for three reasons. First, the announcement of the "New Era" took place on Sept 23 but the bond-selling panic happened five days later on Sept 28.
Normally, financial markets react instantly to news like this. Second, the New Era policy would have to receive parliamentary approval before taking effect. Third, even if the New Era policy was approved, it would take time before the market saw more bond supply.
To me, a better explanation would be rising bond yields in the US. After the Fed raised interest rates another 0.75% on Sept 22, US government bond yields rose steadily. The 10-year Treasury yield surged from 3.51% on Sept 21 to 3.97% on Sept 27.
The yield was about to break the psychological threshold of 4%. The next day, London's gilt market went berserk. Do not forget that London is five hours ahead of New York. The timing was a better match than for the fiscal deficit fear assumption.
To an economist, this is a typical capital inflow-outflow phenomenon arising from an interest gap. The Fed funds rate is 1% higher than the Bank of England's base rate. Naturally, money will leave England to seek a better return in America. The British pound plummeted to £1.07 to the dollar on Sept 27.
Why did the Bank of England not follow the Fed interest rate hike, and leave a sizeable interest rate gap between the two countries? Don't they know "interest rate parity" theory?
After all, the UK has been religiously following US rate hikes for the past 25 years. The answer probably is that the UK's economy is badly damaged by Covid-19 and facing an energy price threat. This might not be an appropriate time for a sharp rate increase. Of course, a pound depreciation is to be expected and the Bank of England is prepared to live with that. But the Bank of England does not anticipate a financial melt-down from the interest rate gap. Optimistically, they hope that 300-year-old British financial markets would behave rationally and perform orderly self-adjustments.
By the way, the bond market turmoil did not only occur in London. The Bank of Japan and Bank of Korea had to step in to support their markets too.
Two questions. First, do central banks have enough resources to stabilise bond markets when needed? The Bank of England's balance sheet of £400 billion is nothing compared to the gilt market size of £2.1 trillion.
Market intervention could be done only on a short-term basis. Second, what would the Bank of England and other central banks do when the Fed continues to raise interest rates? For 2022, the Fed is scheduled to meet in November and December. Analysts expect there will be interest rate hikes of 0.75% and 0.5% at those meetings.
Widening interest rate gaps between the US and other countries are not something to brush aside. In today's world of interconnected financial markets and a global bond market size of $120 trillion, equivalent to 1.2 times global GDP, central banks must be careful about running monetary policies if they care little for the Fed's rate hikes. Liquidity in one's country could run dry before the central bank governor realises it.
So much about economic risk in England. I am sure readers want to ask what about Thailand? The Bank of Thailand REPO rate is currently 2.25% lower than the Fed Funds rate and Thai government bond yields are significantly lower than the US's.
Unfortunately, it would require another article to explain the effects of widening the interest rate gap between Thailand and the US. But I will give readers a hint: from Aug 28 to Sept 23, there was another $12.4 billion reduction in Thailand's foreign currency reserves.
Do the receding reserves come from valuation effects or real capital outflow? Is Thailand's bond market safe and sound?
What is the future of the Thai baht? Is the economy really recovering? These questions will be answered in an upcoming article.
Chartchai Parasuk, PhD, is a freelance economist.