Is this the lull before the calm or the lull before the storm? For the past fortnight, foreign currency markets have been trading flat helped by a relatively short supply of market-moving news, data or policy announcements. Given the way global financial markets have behaved over the past couple of years, it is perhaps rational to expect this brief period of respite to presage another period of extreme volatility. Besides, it doesn’t take much effort to identify the risks that could trigger another episode of stress.
For one thing, Greece is back on the radar screen since there are growing doubts about its ability to implement the reforms on which its financial aid is contingent. First it was the International Monetary Fund (IMF) that expressed its concerns and now it is Germany. As German Deputy Chancellor Philipp Rösler put it somewhat bluntly last week, “Germany has reached the limit of its capacity and might not provide additional aid to Greece.” Thus, the prospect of “Grexit” from the European currency union looms again. Greece, incidentally, is due to redeem $3.2 billion of its sovereign debt today. Any glitch in this process could set the markets on edge again. A glitch, however, seems unlikely given the fact that Greece successfully picked up the required amount from the market through treasury bill auctions last week. The real risk of a blow-out in the markets could come in September when the troika (IMF, European Union and the European Central Bank, or ECB) review the Mediterranean economy’s fiscal health next month.
The US “fiscal cliff”, a combination of automatic expenditure reductions and tax increases that add up to a staggering four per cent of GDP, looms towards the end of the year. While it seems almost certain at this stage that US lawmakers will pass laws to prevent this, it remains to be seen how much partisan sparring precedes a resolution. If markets see an impasse, it could trigger a massive risk-off episode.
Then there is China whose headline macro data have not failed to disappoint over the last few months. Going forward, if there are indications that growth for 2012 is likely to drop below the 7.5 to eight per cent range, markets will panic. China’s demand, we need to remind ourselves, is propping up a whole bunch of things ranging from Germany’s car and engineering goods exports to the demand for global natural resources. A change in political regime is also likely towards the end of the year and that in itself (given the way markets are known to react to political change) could set off a “risk-off” episode.
That said, it would be remiss on our part to ignore some of the more positive developments over the past few weeks. Markets, for one thing, reacted with remarkable maturity to the disappointment over the ECB’s policy announcement on August 2. The policy, to put things in perspective, came in the wake of (what the market at least perceived to be) a commitment from ECB President Mario Draghi to take radical steps to stymie the rise in Spanish and Italian bond yields. From what the polls showed on the eve of the policy, the markets were factoring in everything ranging from a cut in the policy rate to an aggressive programme of sovereign purchases. The actual policy delivered nothing.
Research houses – including some of the American investment banking heavyweights – had predicted virtual mayhem in the markets if the ECB disappointed. Yet financial markets responded with surprising equanimity to the letdown, trading flat and in some cases, consolidating rather than shedding gains. One way to look at this unexpected response is that the markets are learning to be patient with policy makers and not lapsing into an immediate sulk if governments and central banks don’t fire their big bazookas every time the markets expect them to. This attitude, if it sustains, could lend a degree of stability in the months to come.
Finally, there are a couple of encouraging long-term trends that are quietly taking shape amid all the short-term anxieties and concerns. A couple of international research houses (including Capital Economics whose work I follow closely) have been pointing out that a significant portion of household de-leveraging in the US is over. The household debt-to-GDP ratio that hit a peak of 135 per cent in 2007 is likely to come down to a more sustainable 100 per cent in the next couple of years. The good news is that the remaining portion of the necessary de-leveraging could come from growing incomes rather than from households cutting down on consumption to pay off debt. Low interest rates that are likely to be the norm at least for the next two years will also lend a helping hand to this process. This simply means that the downward pressure on consumer demand is reducing and this could support growth going forward.
All might not be lost just yet!
The author is with HDFC Bank. These views are personal
