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Bracing for the turning point

Once monetary supply tightens, global financial markets will become more unpredictable.
Feb 22,2018
This year’s outlook for global capital markets is shaky. Global stock prices that rode strongly on an extended uptrend from last year crashed in February. Investment sentiment in risky assets soured on concerns that the U.S. Federal Reserve may accelerate tightening and monetary hikes upon signs of inflationary pressure in a fast-recovering economy. The flight of global liquidity sent bond yields sharply higher and depreciated stock and currency values in emerging markets.

Investors need not panic out of fear. The global economy is in a solid recovery phase and companies are turning out strong earnings. The stock markets may be undergoing a procedural correction after last year’s bullish run. Still, volatility in global markets and asset prices this year will worsen as lending rates go up and money supply tightens. The financial markets where sentiment is important are exposed to unexpected upsets and shocks. Investors should closely watch market movements and adjust their holdings in risky assets and expensive debts.

Authorities must be vigilant to respond timely to risks. They must flexibly moderate financial, monetary, and currency policies against changes in global markets. They should tend to weak spots in the domestic economy to build resilience against external shocks. They must rein in household debt and restructure ailing companies while cooling the overheated real estate market. Surveillance on financial integrity and stability must strengthen.

Legendary stock investor Warren Buffett said, “You only find out who is swimming naked when the tide goes out.” Companies and the economy expose their true state when all the foam and packages are removed. In order not to get burned in the aftermath of the easy money binge, one should get dressed before the party ends.

The decade of ultra-low interest rates is coming to an end. Central banks across the world are normalizing rates. Given the growth and inflationary pace in the United States, the Fed is expected to raise interest rates by 25 basis points four times or by one percent this year. The massive corporate tax cut and fiscal spending by the Trump administration is feared to stoke overheating in the economy and the bursting of asset bubbles.

Nobel laureate Robert Shiller noted stock valuation in terms of cyclically adjusted price-earnings ratio in 2017 had been overvalued a couple times before in history — around 1929 during the Great Depression and 2000 at the burst of the dot-com bubble. Concerns for inflated asset prices do not end in the United States but exist across the world. The British, European Union, and Japanese central banks are ready to veer away from loose monetary policy and raise interest rates.

Once monetary supply tightens, global financial markets will become more unpredictable. Bond yields will go up when central banks gradually unload bonds they purchased in mass and reduce their assets. The liquidity redemption is expected to cause a tantrum in emerging markets. Capital in globalized markets can flow in and out in big tides. Past data showed fast retreat in capital from emerging markets when interest rates went up in the United States. Capital flight can be hazardous and even fatal to economies with heavy external debt and fiscal and trade deficits or a weak financial sector.

Korean and Southeast Asian economies were pushed to the brink of national default because of a sudden ebb in foreign capital 20 years ago. Seoul had to seek international bailout because its foreign exchange reserves were not enough to cover for short-term external debt dues of financial institutions and corporations.

Korea today is safe from a liquidity crisis like that of 20 years ago. The private sector does not have a high level of short-term debt and the central bank has enough foreign exchange in its coffers plus emergency backing through currency swap agreements with multiple counterparts. But a crisis in neighboring emerging economies and trading partners could spill over to the Korean economy.

Mexico is twice the size of Korea in population and size. It was much richer and had a bigger economy than Korea until the mid-1980s. But now, its per capita income is at $9,200, a third of Korea’s. Mexico suffered a financial crises in 1982 and 1994 and never recovered. Mexico’s crisis came because it did not respond well to monetary tightening in the United States. An emerging economy’s fate hinges on apt responsiveness towards changes in the global environment.

Korea has weathered its crisis well, but the economy has been mired in slow motion since 2008. It must be fully ready for another turning point in the global financial market.

Translation by the Korea JoongAng Daily staff

JoongAng Ilbo, Feb. 15, Page 27

*The author, a former chief economist at the Asian Development Bank, is a professor of economics at Korea University.

Lee Jong-wha