Washington-based IIF flags danger of 'easing wars'

Tokyo

SOMETHING resembling a perfect storm could be brewing in global financial markets as monetary "easing wars", along with associated currency wars, intensify among major central banks and spread to emerging markets, the Washington-based Institute of International Finance (IIF) warned on Thursday.

In a report, it also warned of the growing risk of bubbles developing in stock and other asset markets as the tide of financial liquidity rises.

The influential institute, which describes itself as the "global association of the financial industry" and which speaks for some 500 leading financial institutions, said that the launch of quantitative easing (QE) programmes by the central banks in the US, Japan, Europe and the UK could force other central banks, including Asian ones, to follow suit, if only to prevent their own currencies soaring in value.

This unprecedented international monetary easing will lead to the sustaining of massive global liquidity and low - even negative - interest rates that could further "heighten uncertainty and market volatility" and create distortions in the financial system, said the report, which bears the unusually-blunt title of "Consequences of Central Banks' 'Easing Wars'".

As more countries join the "easing wars", this could lead to "gyrations in major exchange rates" that could in turn threaten global financial stability, warned the IIF, which is currently led by former US Assistant Treasury Secretary for International Affairs Tim Adams.

Easy money has created a surge in stock prices and other asset values, creating a "wealth effect" that has benefited relatively few, the IIF said.

Continued monetary accommodation is needed to support asset markets and growth, but this risks asset prices "becoming overvalued and vulnerable to correction".

Hung Tran, IIF's executive managing director, said at the launch of the report that the comprehensive QE programme of the European Central Bank (ECB) has brought to the fore challenges posed by the ECB and Bank of Japan (BOJ) easing.

"Other countries will either need to match these easing measures, or see their currencies strengthen against the euro and the yen."

Since the BOJ and the ECB launched QE , the yen and euro have weakened against the dollar by 40 per cent and and 10 per cent respectively, the IIF noted.

So far, "exchange rate movements have been deemed orderly and within the remit of monetary policy aiming to fight deflation risks and revive growth.

"However, if the US begins to experience a negative impact from adverse currency movements in its net trade position, damaging US growth, there would be more pushback against the exchange rate implications of monetary policy measures.

Besides the US, many other countries have experienced upward pressure on their currencies from the weakening euro and yen, the report said. It cited the soaring value of the Swiss franc after the authorities removed a cap on the currency last month; Denmark has been feeling upward pressure on its krone.

The IIF said: "Currency pressure has also been building up in Asia. Over the past three years, the South Korean won has strengthened by about 60 per cent against the yen, with other emerging Asian currencies also under upward pressure.

"China has experienced a similarly strong appreciation of the renminbi versus the yen. As the Chinese economy slows, a further strengthening of the renminbi against the yen would add pressure for more monetary easing in China in the foreseeable future.

Referring to the "gyrations" in major exchange rates and their effect on financial stability, the IIF report noted that volatility in foreign exchange markets has gone up significantly from very low levels just six months ago.

"A strengthening and volatile dollar could trigger an unwinding of the huge amount of US dollar-based carry trades that have been accumulated in recent years." (Carry trade involves investors using a low-interest currency to buy assets denominated in a higher-yielding one.)

"We estimate the volume of such carry trades to be some US$9 trillion - and the possible unwinding of carry trades could lead to disorderly market conditions, given the fact that secondary market liquidity has deteriorated noticeably in recent years."

The report added that more generally, the "fresh wave of QE will prolong a world of plentiful liquidity and zero or negative interest rates more than six years after the global financial crisis".

"Such a sustained period of extraordinarily accommodative monetary conditions - which can be justified as necessary to support the economic recovery - will also have important consequences which are now becoming evident."

The key instrument and channel of transmission of extraordinary monetary accommodation has been interest rates, all along the yield curve. Government bond yields in major countries have fallen irregularly over the past six years to record lows in many cases.

"What is unprecedented is the growing number of countries where nominal interest rates have become negative as well," said the IIF. The ECB, Swiss National Bank and the Danish central bank have adopted negative deposit rates and an estimated US$3.6 trillion in government bonds are now being traded at negative yields.

"A sustained period of ultra-low and even negative interest rates would lead to distortions in the financial system - many of which may be hidden today, but could accumulate and pose a significant financial stability risk the longer low rates persist."

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