Turning to debt monetization as governments run out of options
For some time now, the direct monetization of fiscal deficit—where a central bank prints money to facilitate deficit spending—has been viewed by some market participants as an alternative approach to supporting economic growth. Increasingly, many believe that the effectiveness of monetary policy might has reached its natural limit and fiscal spending is now what’s required to boost growth.
The coronavirus outbreak, which required governments worldwide to ramp up spending rapidly to contain the economic fallout regardless of their fiscal position, lent a sense of urgency and credibility to these discussions. As interest rates around the world head southward—falling into negative territory in some instances—and central bank balance sheets grow larger, we believe the broadening adoption of direct debt monetization around the world seems all but inevitable.
Is it really a magic money tree for everyone?
MMT is often viewed as a fringe policy and has historically been dismissed out of hand as being a free for all. In reality, MMT/debt monetization is a much more nuanced concept. For it to work, there are constraints that governments will need to adhere to.
|Constraints||Why it’s important|
As interest rates around the world head southward and central bank balance sheets grow larger, we believe the broadening adoption of direct debt monetization around the world seems all but inevitable.
Conditions for adopting debt monetization
To adopt debt monetization in a sustained manner, a government needs monetary sovereignty, which is another way of saying it needs full macroeconomic policy autonomy. What this means is that, as a concept, monetary sovereignty isn’t an absolute; rather, it should be thought of as a spectrum where some countries could have more monetary sovereignty than others. There are, however, three necessary conditions:
- The government issues the national currency and can impose tax liabilities in that currency.
- The government issues debt denominated in its own currency.
- The currency is fully floating.
What these conditions tell us is this: Economies with a private sector deficit—where investments are funded by debt instead of savings—aren’t able to pursue debt monetization in a sustained manner. The buildup in debt would eventually lead to a private sector debt/financial crisis. Conversely, economies enjoying a long-term private sector surplus can pursue debt monetization to boost growth in a sustained manner.
Based on these conditions, it’s clear debt monetization, as an alternative policy approach, is a nonstarter for economies such as Italy, where monetary policy lies with the European Central Bank, or Hong Kong, whose currency is pegged to the U.S. dollar. Once an economy fulfills the three conditions, other factors come into play—the health of its fiscal account and the state of its private sector.
These conditions can be seen as an effective, if slightly simplistic, way of assessing which economies are able to pursue debt monetization as a policy to boost growth. However, it doesn’t take into account the health of each economy and how that could influence its ability to pursue such a policy. For instance, if a government chooses to reduce its spending, and the amount withdrawn from the economy isn’t replaced by one of the other sectors, then aggregate demand will decline.
In the event of a new cold war between major economies, an additional condition must be met
In a sense, economies with external deficits are, technically speaking, net borrowers from the rest of the world. In our view, economies that fall into this category should not pursue debt monetization as a policy option because it can lead to macroeconomic and financial instability. This is especially relevant in the midst of a cold war, typically characterized by heightened geopolitical tensions and volatile market movements. Monetizing debt during such a period can leave these economies much more vulnerable to external factors. Put differently, we believe that only economies with an external sector surplus are able to pursue debt monetization as a policy option during a cold war.
Given that running an external surplus is key to implementing debt monetization, it’s logical to assume that governments planning to pursue it would be incentivized to engineer that outcome. Mathematically, an external surplus can be achieved by running a private sector surplus that’s large enough to generate a current account surplus. Such policies are likely to be highly protectionist in nature and could include:
- R&D programs to move up value chains
- Tariffs/import controls/export subsidies to protect domestic industry and corporate profitability
- Domestic infrastructure development programs using domestic capital and labor
- Encouraging domestic consumption through higher household incomes
- The introduction of capital controls to keep extra liquidity from leaking overseas
- Currency devaluation
Economies with limited policy space to monetize debt or that are unable to adopt protectionist policy would need to join currency and trading blocs that do have the space. Unlikely as it might seem in this day and age, there are many historic precedents for this form of global fragmentation, for instance the gold bloc, the sterling area of the 1930s/1940s.
Reality check: where do key economies stand in regard to debt monetization
|In our view, Japan has plenty of space to monetize debt. Even though the country has been running a chronic fiscal deficit since 1965 (apart from the bubble period in the late 1980s, early 1990s), limited external debt and its equally chronic current account surplus have insulated Japan against currency and inflation instability.||It should come as no surprise that we think the United States has traditional space to monetize debt. This is in no small way due to the U.S. dollar’s global reserve currency status. In fact, we believe Japan’s experience, specifically through the Bank of Japan’s bond purchasing program, suggests the U.S. Federal Reserve still has room to triple its assets to fund massive budget deficits in the years ahead.||China’s policy space has become increasingly constrained due to the marked erosion in its current account surplus in the past decade. This explains China’s more cautious approach to delivering stimulus in the wake of COVID-19 given the risk of destabilizing the renminbi and domestic inflation.||At the aggregate level, the eurozone can lean on the European Central Bank to print money. But at a national level, no member state can issue debt denominated in its own local currency or has the sovereign discretion to monetize its own debt. In a sense, the eurozone denied itself the capacity to monetize debt by design. Fiscal rules that member states need to adhere to also shrink an economy’s sustainable fiscal space, since the agreed deficit cap may not be enough to sustain aggregate demand.|
What does this mean for Asia?
Based on the conditions required for debt monetization to be implemented effectively, we have a reasonable grasp on which Asian economies could theoretically turn to debt monetization as a policy option. Economies in the Asia-Pacific region with consistent external as well as domestic private sector surpluses and budget deficits include Japan, China, Thailand, and Malaysia; however, we believe that China is running out of policy headroom. Meanwhile, it’s fair to say that if Thailand and Malaysia were to pursue debt monetization aggressively, it could cause unease among investors.
Separately, there are several economies in the region that run sustained external deficits and budget deficits where debt monetization isn’t a sustainable option: Australia, India, Indonesia, New Zealand, and the Philippines. Taiwan, Hong Kong, and Singapore aren’t able to pursue debt monetization as a policy given their managed exchange rates. That said, some economies that, theoretically speaking, shouldn’t monetize debt have either gone down that path (e.g., Indonesia and Philippines) or signaled that they weren’t closed to it, namely New Zealand.
If debt-financed fiscal spending were not only an inevitability, but a development that will play an increasingly significant role in the global economy, what would it mean for investors? The following is a summary of how we expect things to play out and likely investment implications over different timeframes.
Key macro themes
|Short term: next six to nine months||
|Medium to long term: six months to five years||
There can be no doubt that debate over the question of whether debt monetization works and if it should be taken seriously as a policy option will continue. In regard to the first question, it’s probably fair to say that it could be years before we’ll get anywhere close to having a definitive perspective. Where the second question is concerned, we believe that ship has sailed—as we’ve mentioned earlier, the broadening adoption of direct debt monetization seems inevitable. That said, we believe that relying on it as a policy tool beyond an emergency period would be risky in the medium term.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.
The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.
This material, intended for the exclusive use by the recipients who are allowable to receive this document under the applicable laws and regulations of the relevant jurisdictions, was produced by, and the opinions expressed are those of, Manulife Investment Management as of the date of this publication and are subject to change based on market and other conditions. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only as current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.
Neither Manulife Investment Management or its affiliates, nor any of their directors, officers, or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment, or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment, or legal advice. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer, or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against a loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.
Manulife Investment Management
Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams, along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.
These materials have not been reviewed by and are not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at manulifeim.com/institutional.
Australia: Hancock Natural Resource Group Australasia Pty Limited, Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area and United Kingdom: Manulife Investment Management (Europe) Ltd., which is authorized and regulated by the Financial Conduct Authority; Manulife Investment Management (Ireland) Ltd., which is authorized and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad (formerly known as Manulife Asset Management Services Berhad) 200801033087 (834424-U). Philippines: Manulife Asset Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G). South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC, and Hancock Natural Resource Group, Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.
Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates, under license.