Squeeze but don’t drown / Analysis by Ricardo Avila – Sectors – Economy

When it appeared last Wednesday, Jerome Powellpresident Federal Reserve Bank of the United Statesascending to the podium, it was enough to recognize the little signs of the stage to anticipate the stern tone of the message he held in his hand: the podium flanked by two flags, the dark blue curtain in the background, and the gray of the official’s tie.

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As soon as he began speaking, his words emphasized that the announcement was far from routine. He noted without much of the preamble that the Federal Open Market Committee, attached to the entity he chairs, has decided to increase three-quarters of a percentage point in the interest rate it charges financial entities in its orbit to give them resources, a jump not seen since 1994.

He pointed out that the volume of securities held by the institution will continue to decline. Besides the details, the signal from Washington was loud and clear: The cost of money will rise—and will continue to do so for the foreseeable future—as liquidity dwindles, Something that fundamentally changes the conditions in which the world’s largest economy develops.

In an almost parallel way, other central banks have moved in the same direction. Australia had already decided at the beginning of June, while the European Central Bank indicated in the middle of the month that it would do the same. For their part, there was additional tightening in both England and Switzerland, with a basic lesson: developed countries react to rising inflation and will do everything in their power to control it.

Whatever you take – whatever it costs

In Italy, for example, the yield on 10-year government bonds has reached more than 4 percent per year, not to mention the state of emerging economies.

The use of monetary policy tools probably does not say much to the average citizen at any latitude, until the consequences of this renewed identification are noted. Over the past few days, there has been a significant drop in stock market indices on Wall Street and other markets, along with rising public and private bond yields.

Without going any further, shares on the New York Stock Exchange fell 5.8 percent on average last week, their worst performance since March 2020, when the pandemic broke out. The hardest hit part is tech companies, whose drop is 21 percent, which is already being described as a major correction.

For its part, an increase in risk perceptions, along with higher returns on options considered safer, has destabilized debt markets. In Italy, for example, the yield on 10-year government bonds has reached more than 4 percent per year, not to mention the state of emerging economies.

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Added to this is the collapse of assets such as Bitcoin, which is 72 percent below its maximum level last November. If the well-known cryptocurrency was trading at over $67,000 seven months ago, it is now at less than 19,000, in a sector where there are more cases of issuers and operators having trouble when it comes to fulfilling their obligations.

But what happened will only be an initial boost to what’s to come. Until the starvation rate begins to decline, more doses of the same drug will come in. For the average person, this means that they will have to pay higher loan installments, which will eventually reduce disposable income, as well as appetite or ability to acquire assets.

Nothing in the recipe is necessarily surprising, because for months it had been clear that the problem of inflation was getting out of hand: from a target close to 2 percent per year in the industrialized world, the reality shows that prices are rising by nearly 8 percent. a hundred. However, diagnosing disease is one thing, and initiating treatment with trauma treatments that leave and will leave more than one victim is one thing, given the certainty that eradicating the disease will be more difficult than was thought until recently.

Thus, there is more evidence of a stalemate on both sides of the North Atlantic. Both consumer demand and the pace of business investment appear to be running out, which could lead to a recession in the next half year.

Economists hope the slowdown will not weaken employment levels significantly. With the US unemployment rate at 3.6 per cent and a job market full of vacancies, the impression of specialists is that calm will be desirable.

Although the truth is that no one knows for sure how to adjust the case’s controls to limit damage. Just as the long-awaited soft landing can occur, a “belly bump” is also possible where the country is left with the sin of inflation and without that kind of growth.

Back in Uncle Sam’s land, the way things go will be decisive in the November legislative elections that could give the Republican opposition control of both houses. Having Congress against it will make life more difficult for Joe Biden, whose administration has been criticized as ineffective.

And in other parts of the world, politicians are concerned with the way their authorities are facing challenges that were off their radar for most of the past few months. While some prefer orthodoxy, others will try to ease some measures and others will choose to fish in a turbulent river.

Expected tail clicks

Such scenarios will exist in the most diverse latitudes, but the biggest concern is how the emerging countries will deal with the situation. The reason is that there is no shortage of parallels with what happened in the 1970s, when there were also elements similar to those that exist today: high inflation, war between commodity producers, economic slowdown, and turmoil in stock markets. and monetary policy tightening.

Although at the point of raising interest rates, the United States and others will end up cutting rates, they have sowed the seed of another unpleasant crisis in Latin America. This consisted of the explosion of the “debt bomb”, as Time magazine called it, the same bomb that caused the loss of the 1980s in the region.

On paper, there are now more elements of concern. And when measured as a percentage of their GDP, the claims of developing countries are about six times greater than they were at the time.

It is true that the weight of China in the above calculations is very important, which is why it is not necessary to jump to make generalizations. It is also true that the control mechanisms are more sophisticated, that the central banks have more reserves and that the technical capacity is greater than half a century ago.

It is also true that the basis for comparison is very different. Adjusted this week, the US federal funds rate is at a maximum of 1.75 percent annually and will reach 3.5 percent by the end of 2022, a historically moderate level.

As a result, it is important that the fire is controlled relatively quickly, something in which a series of uncontrollable things play a role. The duration of the war in Ukraine and the problems with the supply of raw materials are largely unknown, to which are added the expectations of consumers and the behavior of international trade.

For Colombia, the wake-up call deserves to be heard. According to Banco de la República, the country’s external debt at the end of the first quarter of this year amounted to $175,106 million, 58% of which is to the public sector and the rest to the private sector.

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In the case of the government segment, 52 percent of bond issuances and 36 percent of loans came with multilateral banks. For non-financial companies, nearly 80 percent refer to loans with the financial sector offshore.

Outside of the described configuration, it is expected that at least a portion of these credits will become more expensive due to the new conditions in force. And if there is a devaluation of the peso, the payment will be more difficult.

On the other hand, the local currency debt will also reflect the above conditions. To point out just one case, 10-year Treasuries — known as TES — are already yielding more than 11.5 percent annually, four points more than they recorded 12 months ago. And this upward trend will continue, depending on what happens with domestic inflation and the international context.

And we cannot forget that an important part of the holders of TES in peso are foreign investors. If the perception of risk deteriorates, leading to a collapse in said bond sales, the impact will be enormous and incidentally will put the exchange rate against the wall.

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According to Banco de la República, the country’s external debt at the end of the first quarter of this year amounted to $175,106 million.

As Juan Pablo Espinosa, Director of Economic Research at Bank of Colombia points out, “The huge dual deficits – fiscal and external – that have emerged in this recovery make Colombia particularly vulnerable at this time when the world’s cheap and plentiful money is ending.” “Financing is already getting more expensive, but this trend could intensify,” he adds.

In addition, the expert warns that “the volume of capital flows that we receive from abroad can shrink.” He concludes, then, that “this is why issuing signals that reassure investors and highlight the country’s attractions as an investment destination is, at this juncture, particularly important.”

The will is equally valid in a larger environment. Although the publication of the Medium-Term Fiscal Framework this week brought positive news regarding deficit and debt behavior that gave the incoming government some slack, by not making the need for tax reform imminent, the easing caused by the largest oil prices is temporary.

That is why, sooner or later, the next administration will have to gnaw at the reality of state finances, with the aim of making them sustainable. On the contrary, if you take decisions that lead to its deterioration, the consequences will appear quickly, because not only will it be more difficult to borrow, but the interest account will rise.

For Colombians, the risk starts with being forced to pay more for imports and continues as the economy may slow down and start to falter, after a good start to the first semester. Going from a virtuous circle to a vicious circle is something that is likely to happen because of faulty selections in which mistakes are paid so dearly.

Which is that when there was abundant and cheap money in the world, the margin for tolerance of risk was greater. Today this space is gone.

In conclusion, we do better if the winner of the presidential election understands what is at stake and knows how to send reassuring messages, while the time comes to take power in the midst of the most challenging global circumstances of the past forty years.

Ricardo Avila Pinto
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