INSUBCONTINENT EXCLUSIVE:
By Satyajit DasThe US Federal Reserve minutes released Wednesday show that central bank officials are increasingly committed to raising
While economic signs remain mixed, continued growth, rising inflationary expectations, tightening labor markets and the need to temper asset
prices would all seem to argue in favor of higher rates.
Other central banks are likely to follow
The Bank of England and the European Central Bank have foreshadowed normalisation of interest rates
The ECB seems likely to scale back its bond purchases
Markets are now factoring in multiple US interest rate rises in 2018
The yield on the 10-year US Treasury note has risen from 2.4 per cent to 2.8 per cent in 2018 alone.
Rising rates seem like a valedictory
What the celebration misses, though, is how swelling levels of debt will amplify the effect of any rate rises.
According to the Institute of
Since 2007, when borrowing levels were a key factor in the financial crisis, debt has increased by $68 trillion, or more than 50 per cent of
global GDP.
In developed markets, the ratio of debt-to-GDP is around 380 per cent
In emerging markets, the ratio is above 200 per cent
A decade of unprecedently low global rates and abundant liquidity appears to have encouraged a spree of public and private debt
accumulation.
If the current calm is an argument for raising interest rates, those higher rates may in turn be more destabilizing than many
higher interest rates will exacerbate the risk of financial distress for highly indebted corporate and sovereign borrowers
This will particularly affect illiquid, riskier corporate and high-yield bonds, which have attracted significant attention as investors have
sought out yield in the prevailing low-return environment.
Losses will flow into the banking sector
The increase reflects, in part, a risk premium for the uncertain effects of US monetary policy, increasing bank credit risk and rising
demand for funds to guard against anticipated market stress.
Second, higher rates will generate large mark-to-market losses on existing debt
The loss from a 1 per cent increase in US government bond interest rates would exceed $2 trillion globally
Losses on corporate and other securities would add to the damage
Holders may be forced to raise capital or liquidate, compounding the pressure on rates
For banks, such losses could constrain their capacity to supply credit.
Third, higher interest rates will drive investors to switch from
stocks and other risky assets to bonds
Lower stock prices may affect the collateral value securing financings
The debt-funded share buybacks and acquisitions that have propped up equity prices will slow down.
Fourth, higher rates will divert cash to
This will dampen economic activity, as companies reduce their investments in the real economy and households, burdened by record levels of
borrowing in several countries, cut back on their purchases.
Finally, and perhaps most importantly, higher rates will restrict the ability
of governments to deploy fiscal stimulus to extend and solidify the recovery
The US is headed for trillion-dollar annual budget deficits from 2020, driven by tax cuts and higher public spending
Higher rates and rising deficits will sharply increase the amount needed for debt service as a percentage of expenditure
According to the Congressional Budget Office, net interest payments would rise to 3.1 per cent of GDP in 2028, up from 1.6 per cent in 2018
The problem will be compounded if growth slows because of higher rates, as well as other factors such as trade disputes and geopolitical
It assumes that the easy money of the past decade was spent productively and is generating the earnings required to service the borrowing
In fact, to a substantial degree, borrowings simply financed consumption and leveraged purchases of existing assets rather than new
