Andrew Gawith: Changes needed for healthy recovery

Opinion

The financial crisis is over, long live the recovery.

That seems to be the consensus among traders and economists.

Shares and bonds have bounced back remarkably fast and far, from one of the most severe and pervasive poundings seen in financial markets for a very long time.

Economic growth is now following suit with the traditional lag, but, like sharemarkets, most economies will remain short of where they were in 2007 for probably another year.

It would be a worry if economies and financial markets were not on the mend, given the intensive care they have been under and are still receiving from governments and central banks.

The big question this year is what happens when banking systems and consumers are moved out of intensive care: that is, monetary conditions start moving back to neutral from their very stimulatory settings, and governments try to rein in public spending.

The timing and extent of the adjustment in monetary conditions is a hot topic in New Zealand. Reserve Bank Governor Alan Bollard's statement in December indicated he would keep the official cash rate at 2.5 per cent until the middle of this year.

He will begin hoisting rates sometime during the June quarter.

Central banks around the world face the dilemma of either moving too soon and stalling the tender recovery; or moving too late or too slowly and sowing the seeds of higher inflation, but securing economic growth.

Central banks will favour the second option on the basis that growth will help distance economies and the banking system from the dysfunction they were suffering from just a year ago. Higher inflation (3 to 5 per cent) is likely given the size of the stimulus from both monetary and fiscal policies, not to mention the increasingly buoyant market for commodities.

Governments will also need to decide when to close down the fiscal flow that has been so helpful in oiling spending and sustaining employment while financial markets have been out for repairs. Unlike monetary policy the cost of the fiscal stimulus is clearly reflected in sharply rising public debt ratios.

United States gross public debt has risen by around US$2 trillion over the past year and is now equivalent to more than 80 per cent of US GDP. New Zealand's public debt ratio is also rising but is under half that of the US.

The cost of servicing all this debt will rise for at least three reasons:

The sheer quantity of debt being issued will force market clearing interest rates higher

Worries about higher inflation eroding real returns - a nightmare from the 1970s

An increasing appetite for risk - Governments have been able to issue debt at very low interest rates because of the widespread aversion to risk the financial crisis engendered.

But, as the crisis fades and investors' appetite for risk returns, government bonds will no longer be the only "safe" investment in town.

The financial crisis will push many developed economies into varying versions of vicious fiscal cycles where rapidly rising debt-servicing costs will stoke deficits until sufficiently secure and/or brave governments either prune spending, raise taxes or sell public assets. (The cost of supporting ageing populations will only add to the fiscal misery over the next decade.)

There's only one way for government bond and mortgage rates to go over the next five years - up.

The recovery in sharemarkets over the past year has been helped along by massive infusions of liquidity from governments and central banks, and also some aggressive cost cutting.

There's little doubt there was some fat to trim from business costs but companies will need a more substantial strategy if they are to justify further rises in the value of their shares.

Basically they need to generate more revenue, either by finding new customers, or by getting existing customers buying more of (or paying more for) the products and services businesses supply.

In the US (still the world's biggest economy) consumers will remain hunkered down for a while yet, given the high rate of unemployment and the devastation of their savings.

So there's little prospect of increased earnings from this source.

However, there are signs that the low US dollar is helping US firms to find new customers abroad. A sizeable chunk of US businesses have earnings from offshore subsidiaries in emerging economies where new customers are much easier to come by.

There's room for earnings to rise still but over the medium term the majority of US businesses will find it difficult to lift earnings without a household renaissance.

In the aftermath of one of the most severe financial crises in more than 50 years, it would be astonishing if the developed world in particular were to recover to full health without some side effects from the drugs they've been on, or a big change in lifestyle.

* Andrew Gawith is a director of Gareth Morgan Investments www.garethmorgan.com