Placebo Effects: Part 1

By: Satyajit Das

Mixed Metaphors…

Botanical commentators are finding ‘green shoots’. The astronomically minded have seen ‘glimmers’. The meteorologically minded have spoken about the storms ‘abating’. Strong rallies in equity and debt markets have confirmed the recovery for the ‘true believers’. The Global Financial Crisis ("GFC") crisis is over!

It is useful to remember Winston Churchill’s observation after the British expeditionary force’s escape from Dunkirk: "[Britain] must be very careful not to assign to this deliverance the attributes of a victory". There may be confusion between ‘stabilisation’ and ‘recovery’.

The ‘green shoots’ theory is based on a slowdown in the rate of decline in key economic indicators, improvements in the financial system, unprecedented government support for the banking system, near-zero interest rates and large fiscal stimulus packages. The recovery of emerging markets and a renewed belief in Decoupling (Release 2.0) also underpin hopes of a swift return to growth.

Receiving the Messengers…

The puzzling thing is that real economy indicators continue to be poor. Growth forecast for 2009 have steadily deteriorated with world growth expected to be negative 2.00 to 3.00% with especially poor prospects for Japan and the Euro Zone. Industrial output, employment, consumption, investment and global trade continue to be weak. Even China expected to grow between 6% and 8% in 2009 experienced a fall in exports of over 20% over the last year.

The ‘wealth effects’ of the GFC on economic activity are unclear. In the U.S. alone $30 trillion of value has been destroyed. Combined with declines in housing prices and reduced dividends and investment income, the sharp decline in wealth may not be yet to fully flow through into consumption.

The financial system has stabilised but not returned to the ‘rude good health’ that current executive compensation levels within banks would suggest. Asset quality remains vulnerable to more bad debts from the normal recessionary credit cycle that is working through the economy.

Profitability is patchy and reliant on risky trading income and large underwriting revenues from capital raisings by financial institutions and companies who are de-leveraging aggressively. Bank risk levels have returned to near pre-crisis levels.

Capital remains scarce and bank balance sheets are at best not growing and at worst shrinking. Some estimates suggest that the bank capital shortfall could be in range of $1 to $2 trillion, equivalent to a credit contraction of around 20-30% from previous levels. Proposed bank regulations, primarily the increased levels of capital and lower permitted leverage, will also affect the ability of the financial system to extend credit.

The link between debt and economic growth is well established. The global economy probably needs around $4 to $5 of debt to create $1 of GDP growth. IMF researchers Tamin Bayoumi and Ola Melander, in a study of the economic impacts of an adverse shock to bank capital ((2008) "Credit Matters:Empirical Evidence on U.S. Macro-Financial Linkages" IMF Working Paper 08/169) found that in the U.S. a 1% point fall in Tier 1 risk-weighted capital ratios reduces real GDP by 1.5%. This means that global bank capital shortage may restrain credit creation thereby reducing economic activity and sustainable growth levels.

The impact of fiscal stimulus packages has been variable. In some jurisdictions, the payments have been saved or applied towards debt reduction rather than consumption. Targeted measures, such as the ‘cash for clunkers’ deals (cleverly packaged as ‘green’ environmental initiatives) have boosted immediate demand for cars but the long-term demand effects are unclear.

The multiplier effect of the fiscal initiatives is likely to be low. Major infrastructure initiatives will take time to implement. Few projects are ‘shovel ready’. The rate of return on government spending programs, some of which are politically motivated, is unclear. Government spending increasing capacity is likely to create problems in a world where many industries are operating with surplus capacity. Government bailout packages for various industries, such as the auto and housing industries, however well intentioned, are delaying much needed capacity adjustments and risk prolonging the problems.

The phoenix-like recovery in emerging markets is primarily driven by panicked government spending and loose monetary policies increasing available credit. Estimates suggest that around 6% of the growth of around 8% is attributable to government spending and increased bank lending.

The extraordinary growth in lending in China is fuelling unsustainable growth. In the first half of 2009, new loans totalled over $1 trillion. This compares to total loans for the full 2008 year of around $600 billion. Current lending is running at around three times 2008 levels and at a staggering 25% of China’s GDP. The combination of government spending and bank loanshas resulted in sharp increases in fixed asset investments (over 30% up on 2008). Government incentives, in the form of rebates for purchases of high value durables such as cars and white goods, have also increased consumption (up 15% on 2008). Even Chinese government officials have admitted that the recovery is "unbalanced".

The increase in industrial production in the absence of real end demand for products could result in a rapid build up in inventory. The availability of credit is also fuelling rampant speculation in stocks, property and commodities.

The price rise in emerging market shares, debt and currencies also reflects a blind belief that anywhere must be safer and more promising than the U.S., Japan or Europe. This misses the point that these markets have a strong trading and export orientation or are external capital dependent. While some have bright long-term futures, they will need to make difficult and slow adjustments to their growth models to return to trend growth.

The recovery in emerging markets has, in turn, underpinned the recovery in commodity prices and economies dependent on natural resources. A significant part of this is inventory restocking but there is a speculative element. Availability of abundant and low cost bank finance combined with a deep seated fear of the long term prospects of U.S. Treasury bonds and the dollar has encouraged speculative stockpiling of certain commodities artificially boosting demand.

In reality, the global economy has, in all probability, entered a period of stability after a fairly big decline. Market sentiment seems to be shaped less by facts than the Doors’ song: "I've been down for so long, it feels like up to me."

Government Largesse…

A key risk remains the ability of governments to finance their burgeoning government deficits. A wretched combination of declining tax revenues, increased government spending to cushion the economy from recession and bailout packages for banks and other ‘worthies’ means that many countries face large and continuing budget deficits.

Even countries with relatively healthy ‘balance sheets’ such as Australia do not anticipate balancing their books for many years. If the problems of an aging population and unfunded liabilities such as public sector pensions, healthcare and social security arrangements are included, then the budgetary position looks considerably worse.

In 2009, total sovereign debt issues are expected to total over $5 trillion of which the U.S. alone will need to finance around $3 trillion. The increases in sovereign debt issuance are astonishing – U.S. around 300%, U.K. over 400%, Euro Zone around 50%. Government debt-to-GDP ratios for many developed countries are projected to reach and remain at levels in excess of 100%.

Overall government deficits in major economies through the recession are estimated to total around $10 trillion (around 27% of GDP of these economies). The work of economists Kenneth Rogoff and Carmen Reinhart on previous recessions suggests that the deficit estimates are conservative and the amount that will need to be financed will be between $15 trillion (40% of GDP) and $33 trillion (86% of GDP).

As a comparison, the total amount of global investment assets under management, according to one estimate is around $120 trillion. This provides some idea of the funding task ahead.

To date, sovereign debt issuance programs have been successful. There have been some auction problems (in Germany, U.K. and U.S.) but these have been manageable.

Long-term interest rates have risen sharply reflecting supply pressures. The U.S. 30 year rate has increased by around 1.50% p.a. since the start of 2009. Maturities have also shortened increasing the re-financing challenges ahead. Participation of central banks in the U.S. and the U.K. bonds, under their quantitative easing mandates, has helped keep interest rate rises down creating a somewhat artificial market.

A key issue over the coming months is the continued demand for increased sovereign debt issues. China, Japan and Europe historically have been major buyers of U.S. Treasury bonds. As their own fiscal position changes and their current account surplus shrinks, the ability of these investors to absorb the increased supply is unclear. China’s foreign exchange reserves are growing more slowly than before. China has continued to purchase U.S. Treasury bonds but some purchases represent a switch from U.S. Agency paper. As the U.S. has increased its issuance program, China’s purchases are now a smaller portion of the total.

In the best case the government debt issuance programs is accommodated but squeezes out other borrowers. In the worst case, governments find themselves unable to finance their deficits setting of a new stage of the GFC.

The markets ability to avoid consideration of these issues reflects Mark Twain’s observation that: "Ignorance more frequently begets confidence than does knowledge".

 

 

© 2009 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

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