To be sure, there’s something terribly ironic about the central bank for central banks telling the world that the market is too dependent upon central banks, but then again, the Bank for International Settlements isn’t exactly shy about making scary-sounding declarations and criticizing its board members (listed below) in its "closely-watched" (if only by those who are aware of the institution’s shadowy existence and give any credence to what they say) quarterly reviews. As we put it back in June:
The BIS serves to encourage and perpetuate the power and prestige of the world’s central bankers and provides a top secret forum for the monetary policy cabal to meet and commiserate safe at all times from the prying eyes of those to whom the bankers should by all rights be accountable.
In this context it’s somewhat absurd that the bank’s reports — which, as a reminder, are required reading in treasury departments and monetary policy circles around the globe — contain scathing critiques of the very same policies which were no doubt devised, tweaked, and honed over dinner and fine wine in Basel. Nevertheless, the BIS’ latest tome is replete with criticism for the idea that the very people who make up the bank’s Board of Governors are indeed omnipotent.
Last year alone for instance, the bank warned of a “puzzling” disconnect between the economy and “euphoric” markets, excessive risk taking and depressed volatility fostered by ultra accommodative monetary policy, and the effect of a strong dollar on the solvency of EM corporates. Earlier this year, the BIS joined the cacophony of analysts, pundits, and commentators suddenly screaming about the absence of liquidity in corporate credit markets.
Well, the bank is at it again in their latest quarterly report and although most of what’s discussed in the 187-page document will be no surprise to regular readers, BIS Head of the Monetary & Economic Department, Claudio Borio’s prepared remarks are worth a review as they serve to underscore the fact that some very “serious” people in Basel are apparently quite concerned about the risks facing their board members.
Borio begins by noting that the defining feature of Q2 was turbulence, first in Greece, and then in China, where a multi-hundred billion yuan unwind in a half dozen backdoor margin lending channels triggered a market meltdown:
We often look at the world as a set of still frames, rather than as a movie, as we should.
The still frame of the last quarter - the period under review in this issue - has one distinguishing feature: turbulence. Initially - think of it as the left side of the frame - it was Greece that grabbed all the attention and headlines. Market participants had hardly had the time to breathe a sigh of relief when Asia, in particular China, appeared in the centre of the frame. First, the origin of the shock was the Chinese stock market, which on 8 July saw its largest one-day drop ever; then, on 12 August, it was the authorities', admittedly rather small, devaluation of the currency as they officially shifted towards a more market-oriented exchange rate regime.
The shocks in July and August set off much bigger and far-reaching tremors. Stock markets around the world weakened. More importantly, commodity prices plummeted - accelerating their previous longer-term decline - and volatility spiked. The oil price gyrations were remarkable. The price sunk to a new trough below $40 on 24 August, undoing the whole of the partial recovery in the second quarter of the year, then soared some 30% in only one week before dropping back again.
The story progresses logically to the predictable and well-documented effect the above has had on EMs, with Borio also noting that the market's extreme reaction to developments in China may have something to do with the extent to which market participants are hanging on every last movement in the SHCOMP and, more importantly, the yuan:
The exchange rates of emerging market economies (EMEs), especially commodity exporters, were hit hard, and their credit spreads widened.
Why such a big difference in the response to the initial sharp drop in Chinese equity prices in June and the subsequent shocks? In part, this may reflect market participants' selective attention. More fundamentally, though, it mirrors their shifting perceptions of background economic conditions and of the power of policy.
And there's the seemingly obligatory discussion of dollar-denominated EM corporate debt, which is of course a potential landmine in an environment where capital is flowing out of EMs and where the effect of a Fed hike is magnified by the fact that in a world where asset classes have become increasingly correlated, risk-parity funds may be forced into the dollar should everything else begin to sell-off at once:
The data reveal a certain bifurcation in global liquidity, with credit to China, Russia and, to a lesser extent, Brazil being especially weak. Here, the role of credit denominated in US dollars plays a critical role. As highlighted in a number of BIS publications, the total amount of dollar credit to non-bank borrowers outside the United States had risen by over 50% since early 2009, to 9.6 trillion by end-March 2015, and almost doubled for EMEs, to over 3 trillion. Much of it has found its way to corporates, raising serious questions about the financial vulnerabilities involved and the implications for self-reinforcing movements in exchange rates and credit spreads.
Finally, Borio warns that increasingly interdependent "policy arrangements" have proven ineffective when it comes to smoothing out the business cycle and have in fact served only to magnify the scale of booms and busts (and argument we and others have made tirelessy for years):
Taking an even longer-term perspective, as argued in detail in the latest BIS Annual Report, all this points to weaknesses in domestic and international policy arrangements - arrangements that have so far been unable to constrain sufficiently the build-up and unwinding of hugely damaging financial booms and busts across countries.
But despite all the evidence (2000, 2008, etc.) which points to the fact that attempting to use monetary policy to micromanage economic outcomes very often ends in tears, the world has nevertheless become more dependent on central banks than ever before:
Hence a world in which debt levels are too high, productivity growth too weak and financial risks too threatening. This is also a world in which interest rates have been extraordinarily low for exceptionally long and in which financial markets have worryingly come to depend on central banks' every word and deed, in turn complicating the needed policy normalisation. It is unrealistic and dangerous to expect that monetary policy can cure all the global economy's ills.
The cryptic conclusion: "All this is reminiscent of the old joke about the stranded tourist who, having asked for directions, was told: 'If I were you, I wouldn't start from here.'"
We agree - we think.