Avoiding chaos after the crisis

THE departure of US Federal Reserve chairman Ben Bernanke has fuelled talk about when and how the Fed and other central banks will end huge purchases of long-term assets, known as quantitative easing (QE).

Observers seize on every new piece of economic data to forecast QE’s continuation or a quickening of its decline. But more attention needs to be paid to the impact of either outcome on different economic players.

There is no doubting the scale of the QE programmes. Since the start of the financial crisis more than half a decade ago, the Fed, the European Central Bank, the Bank of England, and the Bank of Japan have used QE to inject more than €3 trillion of additional liquidity into their economies. When these programmes end, governments, some emerging markets, and some corporations could be vulnerable. They need to prepare.

Research by the McKinsey Global Institute suggests that lower interest rates saved the US and European governments nearly €1.2tn from 2007 to 2012. This windfall allowed higher government spending and less austerity. If interest rates were to return to 2007 levels, interest payments on government debt could rise by 20%, other things being equal.

Governments in the US and the eurozone are particularly vulnerable in the short term, because the average maturity of sovereign debt is only 5.4 years and roughly six years respectively. Britain is in better shape, with an average maturity of 14.6 years. As interest rates rise, governments will need to determine whether higher tax revenue or stricter austerity measures will be required to offset the increase in debt-service costs.

Similarly, US and European non-financial corporations saved in the regions of €700bn from lower debt-service payments, with ultra-low interest rates thus boosting profits by about 5% in the US and Britain, and by 3% in the eurozone. This source of profit growth will disappear as interest rates rise, and firms will need to reconsider business models that rely on cheap capital.

Emerging economies have also benefited from access to cheap capital. Foreign investors’ purchases of emerging-market sovereign and corporate bonds almost tripled from 2009 to 2012, reaching €250bn. Some of this investment was initially funded by borrowing in developed countries. As QE programmes end, emerging-market countries could see an outflow of capital.

By contrast, households in the US and Europe lost $630bn in net interest income as a result of QE. This hurt older households that have significant interest-bearing assets, while benefiting younger households that are net borrowers.

Total household debt in the US, Britain, and most eurozone nations is still higher as a percentage of GDP — and in absolute terms — than it was in 2000. Many households still need to reduce debt further and will be hurt with higher interest rates.

Some companies, too, have been affected by QE and will need to take appropriate steps if such policies are maintained. Many insurance companies and banks are taking a considerable hit.

The longer QE continues, the more vulnerable they will be. The situation is particularly difficult in some European countries. Insurers that offer customers guaranteed-rate products are finding that government bond yields are below the rates being paid to customers. Several more years of ultra-low interest rates would make many of these companies vulnerable.

Similarly, eurozone banks lost a total of €200bn in net interest income from 2007 to 2012. If QE continues, many will have to find new ways to generate returns or face significant restructuring.

We could also see asset-price bubbles return in some sectors, especially real estate, if QE continues. Last year, the IMF said there were already “signs of overheating in real-estate markets” in Europe, Canada, and some emerging-market economies.

In Britain, the Bank of England has said that, in February, it will end its Funding for Lending Scheme, which let lenders borrow at ultra-low rates in exchange for providing loans.

Of course, QE and ultra-low interest rates served a purpose. If central banks had not acted decisively to inject liquidity into their economies, the world could have faced a much worse outcome. Economic activity and business profits would have been lower, and government deficits would have been higher. When monetary support is finally withdrawn, this will be an indicator of the economic recovery’s ability to withstand higher interest rates.

Nevertheless, all players need to understand how the end of QE will affect them. After more than five years, QE has arguably entrenched expectations for continued low or even negative real interest rates — acting more like addictive painkillers than powerful antibiotics, as one commentator has put it. Governments, companies, investors, and individuals must shake off complacency and take a more disciplined approach to borrowing and lending to prepare for the end — or continuation — of QE.

* Richard Cooper is Professor of International Economics at Harvard University. Richard Dobbs is a director of the McKinsey Global Institute.

Copyright: Project Syndicate