One of the causes of the financial crisis is finally being tackled

The collapse in the price of energy and other commodities has seen current account surpluses slashed

An advertisement poster promoting China's renminbi (RMB) or yuan , U.S. dollar and Euro exchange services is seen outside at foreign exchange store in Hong Kong, China
China's foreign exchange reserves have fallen from a gigantic $4 trillion in the first half of 2014 to around $3.2 trillion today Credit: Photo: Reuters

Slowly but surely, a key weakness at the heart of the global economy is being tackled. For years, countries including China and the oil-rich Middle East had been accumulating foreign exchange reserves, mostly in the form of US government bonds. This huge build-up pushed up bond prices and depressed yields over the past 15 years, contributing to the secular reduction in the cost of credit that began in the 1980s and fuelling the boom of the late 2000s.

That era has now come to an end. The collapse in the price of energy and other commodities has slashed the export revenues of countries that specialise in extracting them, reducing or reversing current account surpluses. China’s current account surplus is still around 3.1pc of GDP, hitting $73bn in the second quarter; but Beijing has devalued the renminbi and is now intervening heavily in the markets to try to retain control of its value.

The decline in the renminbi’s exchange rate against the dollar – from around 6.10 a year ago to closer to 6.35 today – would have been far larger had Beijing not thrown so much foreign cash at its currency. As a result, it is thought that its foreign exchange reserves have fallen from a gigantic $4 trillion in the first half of 2014 to around $3.5 trillion today.

One reason why so many countries decided to accumulate such large stashes of foreign exchange was the havoc wreaked by the Asian crisis of 1997, as well as the Russian default of 1998: after that, many emerging economies’ governments swore that they would make sure their central banks would never run out of reserves again. Another factor was an improved attitude from Middle Eastern nations towards their petrodollars: they looked back at the 1970s and 1980s, and realised that the billions they had made during Opec’s heyday had been squandered. They were determined to do better, and started to divert oil money into investment vehicles, which snapped up real and financial assets.

A worker of Gujarat State Petroleum Corporation checks oil flow of well PK-2 during its inauguration at Ingoli village, about 40 kilometers (25 miles) southwest of Ahmadabad, India

Massive demand for Western government bonds from current account surplus nations have had a large impact on the world economy and on the long-term cost of borrowing. Budget constraints faced by Western nations softened: it has sometimes felt in recent years that somebody would be found to buy gilts, bunds and US Treasuries – regardless of how many IOUs states were printing and almost regardless of the interest rate on offer. There were other reasons for the absence of bond buyers’ strikes, including the fact that central banks have become big buyers of bonds, but purchases from China and the rest were a key part of the process that led to the demise of the bond market vigilantes.

The fact that bond yields could be so low and yet still the buyers came helped lull the political left into a false sense of complacency. Why bother with “austerity” if the cost of government borrowing could fall even as the budget deficit grew? Yet this wasn’t a case of the laws of economics ceasing to apply – merely that a new category of not-for-profit buyers had appeared. These official investors weren’t especially interested in returns – though many were eventually able to book vast capital gains, on paper at least, as yields kept being pushed down globally – their real aim was to accumulate forex in a relatively risk-free manner. Nothing else really mattered to them.

The global economy turned into a giant recycling device: Western nations bought commodities or Chinese goods; many of the dollars, euro and pounds handed over were then used to purchase Western assets; this flood of cash meant that the price of buying a future cash flow went up, and so the yields and long-term interest rates required to attract capital fell, seemingly permanently.

In theory, a lower opportunity cost of capital is great news for entrepreneurs: it means that far more projects are viable. In practice, the shift was translated into lower mortgage rates, helping to fuel property bubbles around the world, and in easier and looser credit, including cov-lite loans and a private equity and mergers and acquisitions boom. A few economists correctly argued that the “global imbalances” at the heart of the world economy were one of the key drivers of the financial crisis. But most wrongly chose to downplay this, incorrectly blaming only domestic monetary policies or the banking industry.

Demand for sovereigns has remained remarkably strong, with quantitative easing the biggest factor

Since the crisis, demand for sovereigns has remained remarkably strong, once again triggered in part by non-commercial concerns. Quantitative easing was the biggest factor; banks and insurers have been forced to stock up as a result of new capital and liquidity rules. These factors haven’t gone away – but the great forex reserve accumulation is over. All other things being equal, this will put upwards pressure on yields. Austerity-deniers will have a much tougher job on their hands. The great normalisation of interest rates and bond yields is finally upon us. As economic stories go, this one could hardly be any more significant.

Steel in crisis

The loss of jobs in Britain’s steel industry is a tragedy for the workers concerned. The demand for their products has slumped and the competition is fierce. But the Government is right to reject protectionist calls: given the extreme anti-carbon measures introduced during the past decade, the only surprise is that so many players survived for so long.

demand for sovereigns has remained remarkably stron

A slump in demand and intense global competition are the proximate causes for the job losses – but we should never forget the role of environmental policy in hastening the demise of Britain’s heavy industry.

allister.heath@telegraph.co.uk