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Getting back to normal -- buckle up

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Stocks worldwide fell after Federal Reserve chairman Ben Bernanke's June 19 statement on U.S. monetary policy. Emerging markets were hit especially hard. The statement, and Bernanke's comments afterward, shouldn't have come as a surprise -- so what's going on? Was the sell-off a meaningless overreaction, or a warning of new financial stresses ahead?

A bit of both. Bernanke said the Fed's program of quantitative easing would be reduced over the next year or so, and probably ended in 2014 -- so long as the economy continued to strengthen as the Fed expects. He also repeated his plan to keep short-term interest rates on the floor for longer than that. Again, none of this was unexpected. It would have been shocking if he'd said anything else.

In that sense financial markets overreacted, as they are apt to do. But Bernanke also focused investors' attention on the challenges of a return to normalcy in global financial conditions -- because that's what the tapering of QE and the (still-distant) prospect of higher short-term interest rates represent. Monetary policy quite rightly went far out on a limb in the aftermath of the recession, and getting off that limb was never going to be easy. Anxiety over this manoeuvre isn't misplaced.

For the past several years, central banks, led by the Fed, have provided extraordinary liquidity to global markets, driving down interest rates and leading investors to search far and wide for decent returns. Capital has flowed into emerging markets. As normal prices and valuations are restored, these flows are bound to be partially reversed, and assets whose prices were bid up will get cheaper. The process had already begun; this week it accelerated.

The danger is the adjustment will be so abrupt it causes collateral damage, or asset prices might fluctuate wildly as the market finds equilibrium. It has long been argued there'd be less volatility if policy-makers made their intentions clearer, but at the moment this doesn't look so plausible. Bernanke has worked hard to provide greater transparency about the Fed's thinking, and it hasn't helped.

To paraphrase the bumper sticker, volatility happens, and there's not much policy-makers can do about it. But they can help their economies and financial systems to take these lurches in stride. Here's the real cause for complaint -- and alarm. Work to strengthen banking systems in advanced and emerging economies alike has barely begun.

Financial systems are still seriously undercapitalized, and their capacity to absorb losses is too thin. This makes volatility much more dangerous than it needs to be -- and it's a vicious circle, because fragile systems are more susceptible to panic, which in turn amplifies the volatility.

In many emerging markets, this danger is compounded by weak and opaque supervision, and by other homegrown policy challenges. Long before sentiment moved further against emerging-market stocks on June 19, investors in China were grappling with signs of a serious slowdown and government moves to slow the supply of credit. India is juggling a limited liberalization of its financial system, a huge current-account deficit and a falling rupee. Emergent middle classes in Brazil, Chile, Russia and Turkey, to name just a few, see their prospects dimming and are demanding action.

Instability in emerging markets -- in financial markets anywhere -- is a given, especially over the next few years. The right thing to ask of governments is greater resilience. That's within their power to deliver.

-- Bloomberg News

Republished from the Winnipeg Free Press print edition June 22, 2013 A17

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