COVID | Emerging Markets | FX | Monetary Policy & Inflation
We were delighted to have former RBI governor (2013-2016) and former IMF chief economist (2003-2006) Raghuram Rajan as our podcast guest last week. We have distilled his key thoughts into a note in case you have no time to listen to the podcast – although I highly recommend you make some!
5 Stages of the COVID Recovery
Rajan outlined five key stages to managing the COVID crisis:
Relief: Relief measures for households and small business are needed while directly fighting the virus, but he cautioned that this stage can only last so long before stimulus measures drop back to more sustainable levels.
Repair & Restructure: Firms’ capital structures may need to be repaired (and debt restructured) to allow access to working capital, or to borrow to invest, once economies reopen.
Recovery: Targeted stimulus may be needed in this phase. Rajan gave the example of stimulating construction because the outdoor nature of building work leaves reduced risks of virus transmission while also boosting demand for raw materials.
Reforms: ‘Trying to fix the fault lines that have existed for some time but are even more highlighted by the pandemic’. Examples discussed were regenerating left-behind regions and reforms in employment.
Rajan highlighted that these steps may need to be combined or re-ordered to suit individual countries. But, in general, these are the five stages of dealing with the crisis.
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We were delighted to have former RBI governor (2013-2016) and former IMF chief economist (2003-2006) Raghuram Rajan as our podcast guest last week. We have distilled his key thoughts into a note in case you have no time to listen to the podcast – although I highly recommend you make some!
5 Stages of the COVID Recovery
Rajan outlined five key stages to managing the COVID crisis:
Relief: Relief measures for households and small business are needed while directly fighting the virus, but he cautioned that this stage can only last so long before stimulus measures drop back to more sustainable levels.
Repair & Restructure: Firms’ capital structures may need to be repaired (and debt restructured) to allow access to working capital, or to borrow to invest, once economies reopen.
Recovery: Targeted stimulus may be needed in this phase. Rajan gave the example of stimulating construction because the outdoor nature of building work leaves reduced risks of virus transmission while also boosting demand for raw materials.
Reforms: ‘Trying to fix the fault lines that have existed for some time but are even more highlighted by the pandemic’. Examples discussed were regenerating left-behind regions and reforms in employment.
Rajan highlighted that these steps may need to be combined or re-ordered to suit individual countries. But, in general, these are the five stages of dealing with the crisis.
We discussed what was holding back the recovery phase in countries such as Taiwan and China that have largely been successful in containing the virus. Rajan highlighted two factors: 1) ongoing concerns over the virus leaving high-contact services suffering subdued demand, and 2) weakness in global demand given major economies such as the US have yet to return to full capacity.
‘The playbook has shifted from “save the economy for a couple of months” to “we’ve got to take a look at the medium term and how do we deal with that.”’
Debt Levels Matter, as Does Who Will Eventually Repay
On the question of debt sustainability, Rajan’s view is less sanguine than others. ‘The reality is that we are at this point in a benign phase supported by enormous amounts of central bank liquidity emanating from the primary reserve currencies, the euro area, the US Fed, and to some extent the Bank of Japan and the Bank of England. But we must also recognize that there are no free lunches.’
Rajan expressed caution on the debt build-up seen across the world: ‘If you borrow today, there is a presumption that it will be repaid at some point. And so you are, in a sense, taking away resources from somebody else in the future, not just the ability to borrow, but forcing them to repay. Now, it may be a generation or two down the line. It may be children who are going to repay this, but somebody at least will have to be on the hook to repay.’
He dismissed the idea of MMT: ‘The idea that there are free lunches, which certainly is what the layperson takes away from MMT, the modern monetary theory, is sort of attractive, seductive, but it is absolute nonsense. So, if that’s the message that is sought to be communicated, it is wrong.’
The correct approach, according to Rajan, is to take advantage of periods where there is greater capacity to borrow and spend, but to spend wisely.
He stressed that borrowing through expansion of central bank balance sheet was, at the end of the day, the same as government borrowing. ‘Think of the central bank issuing debt as the same as the government issuing. That is the consolidated balance sheet you’re looking at. Somebody is responsible for repayment.’
As inflation and economic activity picks up, the ultimate borrower matters more because ‘the central bank often is financing itself with effectively forced loans from the banking sector. And there’s a limit to how much the banking sector is willing to do that, especially as economic activity picks up.’
And on who is bailed out/who eventually repays, more thought is needed on small taxpayers versus capital owners. ‘Why should one go to bail out the property rights of another?’
‘It strikes me that these guys who wanted to open up the government wallet and spend to protect everybody from the consequences of the pandemic don’t realize there’s one person bearing the hit. It’s that person who’s going to pay the taxes down the line to repay the government debt.’
Higher Debt Will Most Likely Mean Higher Inflation
The absence of inflationary pressures following the expansion of central bank balance sheets and run-up in government debt during the GFC doesn’t mean that inflation won’t pick up this time.
‘That point where the markets start believing you have no ability to service your debt going forward is going to be reached somewhere for industrial countries.’
Rajan said whether it’s 150% or 170% is difficult to know precisely. However, ‘there is a number there’ where markets believe a country has no ability to finance its debts. And he believes that Italy has already reached this threshold. ‘Italy right now at 140% of GDP, an industrialized country but effectively being supported by the ECB otherwise spreads would blow out. That’s an example where, you know, you pretty much have reached the limit of how much you can borrow.’
Once debt has reached a tipping point where markets no longer believe in an ability to service debt, the options are then 1) higher inflation and 2) outright default. Given countries who borrow predominately in their own currency don’t generally default (albeit with some exceptions) the more likely outcome is higher inflation (the fiscal theory of the price level).
I asked how to think about Japan in this context. Rajan pointed to Japan’s domestically financed investment indicating higher comfort levels with debt (‘more leeway’). But he also pointed to outliers such as Argentina who have defaulted at much lower debt/GDP ratios.
USD Unlikely to be Replaced as Reserve Currency
We discussed the growing unease over the dominance of the USD and the gradual reduction in USD reserve holdings. Rajan doesn’t think the USD is likely to be replaced as the primary reserve currency anytime soon and believes that the conditions needed for this to happen are generally underestimated.
‘I think the notion that it’s easy to displace the reserve currency, the primary reserve currency, the United States. I think people sort of underestimate what is needed.’
He added: ‘More than just having a big economy, you certainly need deep financial markets. You need a lot of liquidity in those financial markets, the ability to go in and out – the ability to do that without asking too many permissions and confidence that financial markets will not be used as a weapon against you.’
‘You don’t see the financial markets of either the euro area or the renminbi area being deep enough to displace the United States as of now. Now that doesn’t mean that it won’t happen over time, but it needs a lot of work and it needs a lot of confidence in the political structure of the country.’
And Rajan believes that there is still ‘tremendous confidence that the United States political structure will get it right.’
China: Held Back by a CPC Put
The lack of democracy is a big hurdle in the way of China escaping the middle-income trap, according to Rajan.
‘The temptation will be to intervene primarily because people knowing you have the power will hold you responsible. And so you basically become responsible for all the problems the markets create.’
‘Think of it as a gigantic Communist Party put… and when you have that kind of put, markets don’t work well.’
India: A Worrying Trend
Rajan is concerned that India is ‘becoming more centralized, more authoritarian, [and] less willing to entertain different opinions.’ This will limit the country’s future progress and leaves India at risk of going way off track if questions cannot be asked and necessary changes made.
But he remains hopeful that these trends can be reversed. ‘I think [the trend towards more authoritarianism] can be reversed. I think India has strong democratic instincts.’
Globalization at the Expense of Sovereignty and Democracy
Rajan sees technological change as an integral part of many of today’s problems. Such change has facilitated globalization but has brought with it ‘a push for more centralized governance.’
‘There’s a tremendous amount of centralization in the name of the markets so that the markets can have a level playing field. And you see that increasingly in international trade agreements.’
Very bluntly, he says, ‘we have at this point globalization coming at the expense of sovereignty and democracy.’
How to achieve the globalization we need? Rajan advocates that free trade and investment are possible but only with much more awareness of rules and constraints this can entail.
On the rise of populism and authoritarianism, Rajan sees this as a reaction to inequality. ‘The old order was unsustainable. The levels of inequality simply didn’t work.’ Rajan hopes that the pandemic forces us to ‘re-examine our resumptions. But instead of jettisoning everything, we will reformulate it better.’
Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)