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Down the rate-cut wishing well

As central banks race to fight the impact of the coronavirus, how effective are their tools?

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DOWN THE RATE-CUT WISHING WELL: As central banks race to fight the impact of the coronavirus, how effective are their tools?

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DOWN THE RATE-CUT WISHING WELL: As central banks race to fight the impact of the coronavirus, how effective are their tools?

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A Tokyo display of key stock index information for (from left) Shanghai, Tokyo and New York. Financial markets worldwide have seen downturns in recent days over Covid-19 fears.

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Christine Lagarde, president of the European Central Bank, and Mark Carney, governor of the Bank of England. The BOE has indicated that a further easing of interest rates is on the cards. The ECB too announced it was "ready to take appropriate and targeted measures". Yet just last month, Ms Lagarde sounded the warning on the limited room left for monetary policy to fight global threats.

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Prof Lee Boon Keng: "Once taxes are cut, it is very difficult to raise them again. It is easier to coordinate a multi-national monetary policy response than a fiscal policy response. The Fed's rate cut opens the gate for central banks around the world to follow suit without fearing that it would cause undue impact on their currencies."

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Analyst Jeffrey Halley thinks cutting rates to zero and printing electronic money in a classic monetary response to a global slowdown, will be ineffective this time around. This is because the coronavirus has "infected" the cogs that make up supply chains and consumer consumption.

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Prof Sumit Agarwal agrees that there is less dry powder with lower interest rates."The issue with monetary policy tools is that for them to work effectively, you need to have room to reduce rates by 400 to 500 basis points. With rates already so low around the world, these policies are hard to be effective."

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Economist Taimur Baig: "As demand takes a hit (from the Covid-19 outbreak) and credit risks rise, easier monetary policy can help. But given how low rates already are, more immediate relief may come from regulatory forbearance and fiscal policy."

IN less than three months, the outbreak of novel coronavirus has wreaked havoc on business operations, supply chains, sentiment and consumer consumption in over 40 countries.

Faced with plunging stock markets and panicky citizens, governments moved quickly to signal they are ready to step in. Central banks from China to Australia marched out with policy guns blazing, and the US Federal Reserve weighed in on Tuesday with a rare 50 basis-point emergency rate cut.

Yet markets took little comfort from the statements, continuing to fall.

China led in cutting interest rates early in February while also injecting masses of liquidity to support its stock market. Singapore lined up a S$6.4 billion support package in its February Budget. In the last week, Italy announced a 3.6 billion euro (S$5.6 billion) stimulus, handing out tax credits, tax cuts and cash, while Australia's central bank cut the country's interest rates by 25 basis points to an all-time low of 0.5 per cent. The Bank of Japan piled in with liquidity support to banks and planned asset purchases, and the Bank of England indicated that a further easing of interest rates is on the cards. The European Central Bank too announced it was "ready to take appropriate and targeted measures".

But just last month, ECB president Christine Lagarde, sounded the warning on the limited room left for monetary policy to fight global threats. She said in early February that after a decade of crisis fighting, policy makers now have few options for more monetary stimulus.

"This low interest rate and low inflation environment has significantly reduced the scope for the ECB and other central banks worldwide to ease monetary policy in the face of an economic downturn," Ms Lagarde said.

Countries such as Japan and Denmark, as well as the eurozone have already cut their ultra-low interest rates deeper into negative territory.

Critics argue that ultra-low interest rates have made yield-hungry investors take on greater risks and led to asset bubbles. Economists also point out that near-zero and negative interest rates are ineffective in encouraging risk-averse investors to move money into investments. Worse, ultralow rates are contributing to huge debt burdens that can only lead to a massive credit crunch when the time comes to reverse the policy stance.

As commentator Joachim Klement writes in his blog "Klement On Investing": "Apparently, the answer to everything is a rate cut, quantitative easing or both. It doesn't matter that the Covid-19 epidemic leads to a decline of supply while rate cuts address a decline of demand. Rate cuts can do nothing to help alleviate the growth slowdown due to disruptions of global supply chains. All they can do is lift sentiment and stock prices." And how low can interest rates go?

Doing the rate cut limbo

National University of Singapore Business School's Professor Sumit Agarwal agrees that there is less dry powder with lower interest rates. "The issue with monetary policy tools is that for them to work effectively, you need to have room to reduce rates by 400 to 500 basis points," he says. "With rates already so low around the world, these policies are hard to be effective."

Oanda Asia-Pacific senior market analyst Jeffrey Halley argues that the monetary transmission mechanism of quantitative easing since the 2008 Great Financial Crisis has proven woefully inadequate.

Mr Halley notes it didn't achieve the intended objective, because banks either hoarded the cash, or lent it to large corporations or for mortgages, but not to small and medium-sized enterprises (SMEs) which need the funds most.

"Ten years later, asset prices are in space, debt levels are higher than ever, yields on savings are almost non-existent, no-one feels more prosperous, and income inequality is at record highs."

He thinks cutting rates to zero and printing electronic money in a classic monetary response to a global slowdown, will be ineffective this time around. This is because coronavirus has "infected" the cogs that make up supply chains and consumer consumption.

"Working capital is the key in the world of the SME; if you can't pay your bills at the end of the month, you are done. Whether rates are at zero, or 10 per cent, makes no difference to that equation."

DBS Group Research chief economist Taimur Baig begs to differ. He tells The Business Times: "I take issue with the notion that lower rates have lost their effectiveness. Just look at what the three rate cuts by Fed accomplished last year with rerespect to global sentiment, liquidity, and asset prices."

The Fed's three insurance cuts brought the policy funds rate from 2.25 per cent to 2.5 per cent to 1.5-1.75 per cent. The move to support the economy amid muted inflation and simmering trade tensions between the US and China lowered mortgage rates and spurred growth in home purchases. Auto sales remained healthy as more Americans borrowed on easier credit to buy cars. Unemployment hit a record low while consumer confidence remained at historically high levels.

Dr Baig, who had an eight-year stint at the International Monetary Fund (IMF), notes that data shows lower rates, liquidity injection as well as macro- and micro- prudential policies have been effective in stimulating demand, asset prices, and investor sentiment worldwide in the past decade.

"Central banks are (by) no means out of ammunition, as shown by the Fed, ECB, BOJ (Bank of Japan), and PBOC (The People's Bank of China) under zero or historically low rates in recent years," Dr Baig says.

Lee Boon Keng, Nanyang Business School (NBS) associate professor, agrees that monetary policy has been relatively effective in preventing the global financial recession from developing into a global depression after the demise of the 156-year-old investment bank Lehman Brothers.

However, the effectiveness of monetary policy depends largely on how structurally efficient the economic system of a country is.

"Policies may appear ineffective because the problem faced by the world is less economic than social. A decade of ultra-easy monetary policy has lifted asset prices and led to widening income equality. Surely, countries where asset prices are sky high cannot be viewed as doing poorly economically, " NBS' Prof Lee says.

He cites Hong Kong as a case in point, where rising asset prices benefit the rich disproportionately more than the poor. The rich-poor divide widens as a consequence, leading to social problems. "However, monetary policy is never meant to solve the social problem that, ironically, it has created."

How low can interest rates go? Prof Lee says: "Technically, there is no limit on how negative interest rates can go as long as the financial market is willing to accept those rates."

Negative interest rates, after all, do not mean that the man in the street pays an interest when he deposits money with a bank. With negative interest rate policy, the central bank imposes an interest rate on the excess reserves commercial banks deposit with it. This is meant to discourage commercial banks from depositing their excess reserve with the central bank and instead lend them out for investments and spending.

Once you go fiscal..

Besides cutting policy rates, economists and some central bankers have urged governments to also deploy fiscal tools – taxes and spending – to lift the economy.

Peter Praet, ex-chief economist at the ECB, earlier told Bloomberg Television that the central bank for Europe's economic bloc should be wary of rushing in too soon to render relief in times of crisis.

"What worries me probably more – the sort of of perception you know, especially in financial markets, that central banks always have to react," he said.

"Every time you get a shock in the system, you get high expectations of a reaction of the central bank that's quickly incorporated in market expectations. But there's only so much a central bank can do."

Yet a rate cut has been, since the escalation of "quantitative easing" after the 2008 financial crisis, the tool of choice to tackle an imminent downturn.

NBS' Prof Lee says monetary policy received more attention mainly because it is faster and easier to implement. The central bank alone decides. Fiscal policy, on the other hand, requires a majority in the government to agree. "That takes time and is prone to political horse-trading."

Most economies have a menu of policy tools at their disposal to deal with recession, as NUS' Prof Sumit points out. DBS' Dr Baig says there are three main ways the public sector can impact demand and sentiment:

  • structural reforms (for example, China's opening up of the bond market last year);
  • revenue impulse (US income tax cuts in 2018, consumption tax increases in Japan last year),
  • expenditure impulse (infrastructure spending in China and Indonesia).

However, many fiscal tools cannot be easily deployed. Tax measures are a minefield one way or the other, and tend to be subject to political bias.

In the US for example, "Democrats would target poor people and the Republicans would target rich people. Democrats would target small business tax cuts and Republicans would target big corporations and capital gains taxes," says Prof Sumit.

Further, fiscal policy lacks the calibrating tool of monetary policy, notes Prof Lee. "Once taxes are cut, it is very difficult to raise them again. However, a central bank can raise or lower interest rates quite easily."

Prof Lee adds: "It is easier to coordinate a multi-national monetary policy response than a fiscal policy response. The Fed's rate cut opens the gate for central banks around the world to follow suit without fearing that it would cause undue impact on their currencies. It would be difficult for all governments to agree on spending. Perhaps that is why the IMF and World Bank have taken over that spending effort."

The IMF on Wednesday announced a US$50 billion package of emergency financing, with priority given to emerging market governments with "limited fiscal space".

Let it go...?

What of the argument that the economy should be allowed to run its course and go through a bust to reset the economy, instead of trying ways and means to salvage it?

In theory, that's a good idea (and as economists would put it, ceteris paribus or all things being equal), says NUS' Prof Sumit. But of course, there can be many unintended consequences.

"We tried this approach during the 2007 recession in the US and let Lehman Brothers go under, and we learnt the unintended consequences. Lehman Brothers had so many interconnections that it impacted the entire financial market... So we cannot leave it to chance."

NBS' Prof Lee suggests that structural reforms to make the economy more efficient and resilient to economic shocks are a good way to ensure that the business cycle is smooth with lower volatility. Examples of structural reforms are reducing redtape, raising skills level and introducing automation.

"Naturally, they may not be popular and are often difficult to implement, given that the economy may have to undergo short- to mediumterm painful adjustments."

While being efficient would seem to be the obvious choice, it is in direct conflict with distribution goals. "Hence, structural effectiveness must go beyond efficiency to include policies that focus on ensuring a relatively healthy rich-poor divide."

One thing's for sure. The coronavirus outbreak, resulting in a sudden and direct hit to production for manufacturers of all stripes as well as demand for businesses ranging from airlines to retail to events, has reinforced the case for wide-ranging monetary and fiscal support worldwide.

Considering that the private sector investment is lacklustre and consumption momentum is soft, how 2020 pans out for the world would depend crucially on the effectiveness of fiscal measures taken in the wake of Covid-19. The OECD has already warned that the outbreak, as yet unfolding and still ridden with unknowns, could hurt global growth seriously.

As DBS' Dr Baig writes in a report issued last week: "The disruption to travel and production stemming from the Covid-19 outbreak is already manifesting in weak demand and sentiment. As demand takes a hit and credit risks rise, easier monetary policy can help. But given how low rates already are, more immediate relief may come from regulatory forbearance and fiscal policy."