By Peter S. Kim
Since the U.S. Federal Reserve Bank launched its historic rate hikes, investors held their breath for the "whale" to surface. Many investors swear by the theory that a major victim (whale) has to appear before the bottom of a bear market can be confirmed. Over the last couple of weeks, we have seen not one but three whales: With Silicon Valley Bank (SVB), Credit Suisse (CS) and First Republic Bank (FRB) collapsing in quick succession. But this time, the whale theory has to overcome many hurdles before we can confirm the end of the tunnel. Predictably, many free market advocates are coming out with severe criticisms of the response decision, with some even calling it the end of capitalism.
The logic behind the whale theory is that the surfacing of a dead whale would usher the policymakers into ending the monetary tightening so as to stem the contagion effect. We have yet to see the easing of policies, but the swift action to bail out the three banks was impressive by most measures. The shotgun wedding forced upon UBS and CS last weekend resembles the government-backed acquisition of Kia Motors by Hyundai Motor Group more than 20 years ago.
Since the Asian economic crisis, decades of deflation enabled by globalization and the proliferation of technology have made ultra-easy monetary policies a default option for policymakers facing financial strain. Also, the slow response that caused the subprime mortgage crisis is still fresh in the memory of central banks around the world, as evidenced by the instant reaction. However, a dovish pivot could prove to be much more difficult this time around, with the inflation genie out of its bottle for the first time since the 1970s. The decision by the U.S. Federal Reserve and European Central Bank to hike interest rates again in the face of liquidity turmoil highlights the dilemma between inflation and the liquidity crisis.
For now, the answer to the conundrum is to resort to fiscal stimulus while sustaining interest rates. Already, we see governments throwing money at problems by bailing out the banks and their depositors to the fullest and facing the consequences of moral hazard later.
For the U.S., it has already embarked on a government spending program through trillions of dollars in industry subsidies, as mapped out by the Biden administration. Many other governments may have no choice but to follow, leading to rising government debt as the go-to tool for policymakers. Even the most fiscally prudent, Germany has moved away from its "schwarze Null" policy during the COVID-19 pandemic. Also known as "black zero," the policy describes Germany's commitment to balancing the government budget at all costs. After the pandemic and witnessing the reaction of populist governments losing their fiscal prudence, abandoning fiscal discipline may be a trend catching on a global scale, including in the U.S.
The situation for many is reminiscent of Japan during the 1990s when it suddenly hit a growth wall, burdened by the collapse of its property market, paralyzing the domestic economy. The property market crash coincided with the yen strengthening, crippling many export businesses. The corporate sector, as a result, saw its debt rise, but in an effort to avoid a financial crisis or recession, the Japanese government stepped in to support its corporate sector.
The double whammy meant that Japan resorted to endless government spending, leading to a decline in corporate debt but a structural rise in government debt resulting in its "lost decades." For years I have theorized that China and South Korea could be heading down a similar path to Japan. Dragged down by plummeting birth rates and slowing growth from its traditional industries is something all three share. To add to the challenge for China is its battle with the U.S. on the geopolitical front.
At this early juncture, the past couple of weeks of events highlights investors of two key considerations. First, we will see government bailouts spreading a global moral hazard problem. The result could be more financial regulations by governments to avoid an accident in the sector, snuffing out profit growth and, over the longer term, innovation. We have seen the Japanese financial sector numbed into mediocrity as banks transform into national service institutions at the core of moral hazard. The banking sector from other nations may have to face similar pressure as evidenced by dramatic falls in financial sector share prices.
Second, the government debt is going to rise exponentially in the coming years as populist policies take over. While the justification for the bailouts is touted as a way to avoid a systemic meltdown, there is no question that rising nationalism has been an equally important driver of events over the past couple of weeks. Could we see Japan-like "lost decades" for many other nations in the coming years?
Peter S. Kim (peter.kim@kbfg.com) is a managing director at KB Financial Group.