The real interest rate risk

Since 2007, the financial crisis has pushed the world into an era of low, if not near-zero, interest rates and quantitative easing, as most developed countries seek to reduce debt pressure and perpetuate fragile payment cycles.

Despite talk of easy money as the “new normal”, there is a strong risk that real (inflation-adjusted) interest rates will rise in the next decade.

Total capital assets of central banks worldwide amount to US$18 trillion (S$22 trillion), or 19 per cent of global GDP, twice the level of 10 years ago. This gives them plenty of ammunition to guide market interest rates lower as they combat the weakest recovery since the Great Depression.

In the United States, the Federal Reserve has lowered its benchmark interest rate 10 times since August 2007, from 5.25 per cent to a zone between zero and 0.25 per cent, and has reduced the discount rate 12 times (by a total of 550 basis points since June 2006), to 0.75 per cent.

The European Central Bank has lowered its main refinancing rate eight times, by a total of 325 basis points, to 0.75 per cent. The Bank of Japan has twice lowered its interest rate, which now stands at 0.1 per cent.

But this vigorous attempt to cut rates is distorting capital allocation.

The US, with the world’s largest deficits and debt, is the biggest beneficiary of cheap financing.

With the persistence of Europe’s sovereign-debt crisis, safe-haven effects have driven the yield of 10-year US Treasury bonds to their lowest level in 60 years, while the 10-year swap spread — gap between a fixed-rate and a floating-rate payment stream — is negative, implying a real loss for investors.

The US government is now trying to repay old debt by borrowing more; in 2010, average annual debt creation (including debt refinance) moved above US$4 trillion, or almost one-quarter of GDP, compared to the pre-crisis average of 8.7 per cent of GDP.

As this figure continues to rise, investors will demand a higher risk premium, causing debt-service costs to rise. And, once the US economy shows signs of recovery and the Fed’s targets of 6.5 per cent unemployment and 2.5 per cent annual inflation are reached, the authorities will abandon quantitative easing and force real interest rates higher.

Japan, too, is now facing emerging interest-rate risks, as the proportion of public debt held by foreigners reaches a new high. While the yield on Japan’s 10-year bond has dropped to an all-time low in the last nine years, the biggest risk, as in the US, is a large increase in borrowing costs as investors demand higher risk premia.

Once Japan’s sovereign-debt market becomes unstable, refinancing difficulties will hit domestic financial institutions, which hold a massive volume of public debt on their balance sheets.

The result will be chain reactions similar to that seen in Europe’s sovereign-debt crisis, with a vicious circle of sovereign and bank debt leading to credit-rating downgrades and a sharp rise in bond yields. Japan’s debt crisis will then erupt with full force.

BUY MORE, LOSE MORE

Viewed from creditors’ perspective, the age of cheap finance for the indebted countries is over. To some extent, the over-accumulation of US debt reflects the global perception of zero risk. As a result, the external-surplus countries (including China) essentially contribute to the suppression of long-term US interest rates, with the average US Treasury bond yield dropping 40 per cent between 2000 and 2008.

Thus, the more US debt that these countries buy, the more money they lose. That is especially true of China, the world’s second-largest creditor country (and America’s largest creditor). But this arrangement is quickly becoming unsustainable.

China’s far-reaching shift to a new growth model implies major structural and macroeconomic changes in the medium and long term. The yuan’s unilateral revaluation will end, accompanied by the gradual easing of external liquidity pressure.

With risk assets’ long-term valuation falling and pressure to prick price bubbles rising, China’s capital reserves will be insufficient to refinance the developed countries’ debts cheaply.

China is not alone. As a recent report by the international consultancy McKinsey & Company argues, the next decade will witness rising interest rates worldwide amid global economic rebalancing.

For the time being, the developed economies remain weak, with central banks attempting to stimulate anaemic demand. But the tendency in recent decades, especially since 2007, to suppress interest rates will be reversed within the next few years, owing mainly to rising investment from the developing countries.

Moreover, China’s ageing population and its strategy of boosting domestic consumption will negatively affect global savings. The world may enter a new era in which investment demand exceeds desired savings, which means that real interest rates must rise. PROJECT SYNDICATE

Zhang Monan is a fellow at the China Information Center and China Foundation for International Studies, and researcher at China Macroeconomic Research Platform.