MNI INTERVIEW:Tighter Money Could Test DM Banks, EM Corporates

Monetary policy may have drifted into a "regulatory black hole", a former member of the Bank for International Settlement's senior management staff told MNI, pointing to a potentially painful exit from extraordinarily easy conditions due to risks including dollar borrowing by emerging-market companies and growing interest rate risk in the banking system.

A sudden snap-back in bond yields could be painful following years of central bank balance sheet expansion, Philip Turner said in an interview. While post-Lehman crisis financial regulation has boosted banks' capital and liquidity positions, risk has migrated elsewhere in the financial system and banks too are now more exposed to interest rates via holdings of longer-dated bonds, he said.

"The key lesson from the policy mix after that crisis is that expansionary monetary policy was very effective and very safe because it went hand-in-hand with a major tightening of bank regulation," said Turner, who served as the BIS's Deputy Head of the Monetary and Economic Department until 2016. The expansion of non-bank financial intermediation with little regulation provides cause for concern, he said. "The future outcome may be less happy if monetary policy remains very expansionary and no action is taken on known financial risks in the non-bank sector."

BOND MARKET RISKS

In a recent paper for the UK's National Institute of Economic and Social Research, Turner warned that markets could become spooked by inflation risks and that the difference between equilibrium short-term interest rates and potential growth could grow, making it harder to justify expansionary policy even as bond markets slide into crisis.

"What concerns me most is that monetary policy may have walked into a regulatory black hole," he said.

There is a long list of potential systemic hazards which have become more acute during a period of unprecedented central bank accomodation, argued Turner, who noted that supposedly liquid bond and interest rate derivative markets have seized up suddenly on several occasions in recent times.

Together with the expansion of shadow banking, an area which should shortly see proposals from the Financial Stability Board for greater regulation, is the explosion of dollar bond issuance by non U.S.-companies, particularly from emerging markets, which has taken place over the past decade. Many are largely unknown credit risks even to institutional investors, Turner said. "Corporate bonds, even in the advanced economies, are usually illiquid. Bond funds bundle illiquid, even unlisted securities, together, quote a daily price and so give investors the illusion that they've got something liquid in their hand, something safe, something diversified," he said. "Just fine until things go wrong and stress spreads across markets in the stampede for the exit."

The FSB is due to publish policy recommendations for money market mutual funds in July, while also continuing work to examine open-end funds, margining and bond market structure and liquidity. It should act quickly, according to Turner.

"If the FSB proposes measures that really bite, some borrowers will face higher costs. Better that happens when monetary policy is still very expansionary and interest rates low," he said.

TARGET2

Another effect of extraordinary monetary policy has been seen in the eurozone in the shape of the accumulation of so-called Target2 imbalances at the European Central Bank, with critics saying creditor countries like Germany are essentially being forced to provide cheap loans to deficit countries like Italy, Greece and Spain.

"Countries with large credit balances, notably Germany, would like to limit their exposures," Turner said, "But how such limits could be squared with a single currency system and free capital movement escapes me."

While the ECB's response to the Covid-19 crisis has been exemplary, it now shares with governments responsibility for sustaining post-crisis euro area demand, Turner said. But, compared with the U.S., Europe's growth prospects remain "cloudy."

"Growth of domestic demand will be weaker in Europe. The euro area, and especially Germany, will have a larger current account surplus," he said, pointing to the possibility that the euro could strengthen in the longer-term but that capital could be drawn into the U.S., providing a short-lived boost to the dollar. "Very unbalanced growth is going to provoke tensions – in markets and also politically."