Has the World Economy Survived the Global Financial Crisis? Concerns over central banks' massive holding of government bonds

Faculty Fellow, RIETI

Seven years have passed since the collapse of Lehman Brothers. The world economy appears to be doing relatively well despite a number of risk factors such as the slowdown of the Chinese economy and Greece's debt crisis. After surviving the global financial crisis, the world economy is beginning to see the seeds of new crises in a very different financial landscape. This article examines the macroeconomic administration of the global economy in the post-crisis era in the mid- to long-term perspectives, with emphasis on Japan, the United States, and Europe.

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In order to overcome the global financial crisis and cope with the ensuing slow growth phase, major central banks around the world implemented and maintained large-scale monetary easing policies. They not only brought the key interest rate down to almost zero, but also made massive purchases of government bonds and other securities to boost the monetary base.

This resulted in a substantial expansion in central bank balance sheets (See Figure). Assets held by the Bank of Japan totaled 113 trillion yen before the collapse of Lehman Brothers as of the end of March 2008, but nearly tripled to 323 trillion yen (approximately 65% of the gross domestic product (GDP)) by the end of March 2015. Most of them are long-term government bonds. The gross assets of the U.S. Federal Reserve Board (FRB) jumped by almost five fold over the same period to nearly $4.5 trillion (approximately 25% of GDP). The European Central Bank's (ECB) assets saw a 70% increase over the same period to around 2.4 trillion euro as of the end of March 2015 (23% of the Eurozone's GDP), and the ECB began buying bonds at a monthly rate of 60 billion euro as of March 2015.

Figure: Assets Held by Major Central Banks Jumped after the Collapse of Lehman Brothers

Figure: Assets Held by Major Central Banks Jumped after the Collapse of Lehman Brothers
Note) Indexed with the Q1 FY2008 level set at 100

The state of massive government bond holdings by central banks will have to stay for the time being. The FRB is likely to raise its official interest rate by the end of this year, but it is suspected that the pace of interest rate hikes will be slow, keeping the official rate at a relatively low level for the foreseeable future. The first reason lies in the forecast of slow economic growth rate in the United States.

The second reason is the possibility that a rapid and substantial interest rate hike could trigger capital flight in emerging economies, adversely affecting the foreign exchange and stock markets. A rapid interest rate increase could also lead to a sharp downturn in government bond prices, which would cause capital loss to the central bank and financial institutions.

The third reason is the need to raise the interest rate for reserve funds in order to increase the policy interest rate while retaining a large amount of government bonds. This would directly increase the burden on the central bank for interest payments.

Major central banks' quantitative easing policy had a major effect on the bond and foreign exchange markets due to its effect of rebalancing the portfolios of financial institutions that sold government bonds and the general expectations that the low-interest rate policy would continue. However, central banks' massive ownership of government bonds is creating constraints for future monetary policies, which in turn is causing new risks.

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First, keeping the interest rates low even if there should be an upturn in economic growth would increase the risk of an economic bubble occurring and bursting. Assets could become a bubble if their value exceeds the fundamental value based on their future return and risk. The skyrocketing prices of properties or share prices are not the only types of economic bubble. For example, when high-risk bonds such as junk bonds or government bonds of countries with high debt have a low yield (high price), they are in a bubble.

Reflection on the global financial crisis has led to the introduction of various regulations such as the increase in the risk-adjusted capital ratio and leverage (equity capital-to-asset ratio) on major financial institutions operating globally. For this reason, the leverage of financial institutions is at a lower level than in the pre-Lehman days. There is no great concern about asset prices continuing to rise up to now, accompanied with credit inflation. However, it is difficult to determine in real time whether asset prices are in a bubble, which tends to cause a delay in policy response.

Today, the United States is seeing an increase in junk bonds and leveraged loans to companies with low credit rating, resulting in low yields. If the prices of such bonds took a downturn, investment funds and pension funds would suffer a loss, straining household spending in the end.

Second, the risk of a fiscal crisis will intensify. Having central banks buy a massive amount of government bonds and keeping the interest rates low is a convenient situation for fiscal authorities. However, it does not provide stability in the long run, as the incentive for reducing fiscal deficit weakens under low interest rates.

Many industrialized countries saw the balance of fiscal debts surge following the financial crisis, yet, with a tide of economic recovery, the increase in public debt-to-GDP ratio in the United States and countries in the Eurozone in general is slowing down. However, other Eurozone countries such as Greece continue to hold huge government debt. In Japan, the public debt-to-GDP ratio (including debts held by the Japanese National Railway Settlement Corporation and in the special account for the debt management of the national forestry business) jumped from 80.5% at the end of 2007 to 142.9% at the end of 2014, with further increases anticipated.

According to simulation conducted by Professor Selahattin Imrohoroglu of the University of Southern California and others, Japan's net public debt-to-GDP ratio will top 210% by 2030 without a change in the current policies. The balance of gross public debt (total without deducting financial assets) is even greater. This means that Japanese government bonds rapidly will become more dependent on foreign investors, which will drive bond yields higher.

There is another reason why the combination of low interest and fiscal deficit is unstable in the long term. The government could become hesitant to tighten monetary policy even when signs of inflation or bubble begin to appear, out of fear that an interest rate hike could increase its fiscal burden. In principle, monetary policy must be combined with monetary regulations, especially to control economic bubbles. In practice, however, a continued fiscal deficit makes it difficult to implement such a macro-prudence policy. These concerns may escalate into the development of a high-interest and high-inflation condition.

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What kinds of policies are required to reduce these two risks?

Behind the backdrop of the current low interest rates in industrialized countries lies a low rate of return on real capital, which is a factor of production. To reduce the risk of an economic bubble, it is important to take a "growth strategy" to raise the rate of return on real capital including production facilities, human capital, and knowledge capital. At present, Japan is promoting corporate governance reforms. Seeking a greater emphasis on the rate of return in business management on the part of both investors and corporate management is a sound approach also from the perspective of preventing a bubble.

Efficient distribution of resources through corporate business realignment and the transfer of labor/fund among firms and industries should raise the productivity of the overall economy and the rate of return on real capital. Japan has a lot of room for improvement in this regard and must accelerate its labor market reform.

As for the fiscal risk, Japan's fiscal reform has the greatest significance on the global scale. Yet, the nation's fiscal soundness goal of bringing the primary balance for both the national and local governments into positive territory by FY2020 already appears to be impossible. The Cabinet Office estimates the deficit to be around 9.4 trillion yen (1.6% of GDP) in FY2020 without any expenditure cuts on the premise that the nation achieves an average real growth rate of 2% and a nominal rate of 3% over the next five years.

The government's Council on Economic and Fiscal Policy debated whether to seek greater growth to boost tax revenues or reduce expenditures to cover the estimated scale of deficit. However, it is extremely unlikely for all of the debated options to be achieved. Japan's potential growth rate is estimated to be only around 1%. With an aging population, it would not be easy to tighten expenditures further in the area of social security. Prime Minister Shinzo Abe has already called off debate on raising the consumption tax rate to above 10%. However, Japan would soon lose its comfortable stability without an early introduction of social security reform as well as fiscal revenue reform.

>> Original text in Japanese

* Translated by RIETI.

June 16, 2015 Nihon Keizai Shimbun

August 13, 2015