Why is credit risk priced so low? A new explanation

By: Eurointelligence Publication Reviews

Why Is Credit Risk Priced so Low? A Perspective on Global Liquidity, by Pierre Cailleteau and Aurélien Mali, Moody's International Policy Perspectives, February 2007

One of the great financial puzzles of our time is why credit risk is priced so cheaply. There are a number of theories around, famously Ben Bernanke's global savings glut theory, and others that try to explain this phenomenon in terms of falling global investments. But so far there has been no consensus, as none of these theories appears capable of capturing all the pertinent aspects of this story. For example, while there is clearly a savings glut in China, the same cannot be said for the US, a country with a negative savings rate. This paper tries to expand on Bernanke's savings glut theory, by accounting for intrinsic differences between mature and emerging economies.

This is the gist of their argument:

In our view, the core of the explanation lies in the interaction between the deepening of financial integration on the one hand, and differences in the financial completeness of world economies on the other. Combined with the notable drop in macroeconomic volatility and portfolio preferences for liquid fixed-income assets, this has led to a massive compression of credit spreads.

We know what financial integration means. But what do they mean by financial completeness? Emerging market economies suffer from information asymmetries. Their legal systems are immature, they suffer from political instability and economic volatility. While emerging market economies are capable of generating persistently high growth rates in the production of physical assets, they are not in a position to produce a corresponding amount of high-quality financial assets. Because of this mismatch, an increase in physical output drives up the prices of the underlying capital. A savings glut is the result. So the story so far is consistent with Bernanke's theory.

In a global environment of financial innovation – that affects both the emerging and the mature economies symmetrically – this situation lead to a perverse flow of capital – from the emerging towards the mature economies. The central banks of the emerging market economies, reluctant to allow an appreciation of their own exchange rates, have a preference to invest in mature economy credit and bond markets, thus driving up prices higher, and spreads lower.

In the mature economies, meanwhile, financial innovation has had the well-known effect to drive down savings rates. For example, the housing boom in many economies has been directly linked to financial innovation through the supply of interest-only mortgages or sub-prime mortgages. Furthermore, physical investment has been relatively depressed since 2000 following the bursting of the dotcom bubble in the 1990s. This has led to a slowdown in the growth rates of collateralisable assets as debt securities need to be backed up by physical assets. In an environment of low interest rates, this combination drives up asset prices, the more so the further the country has moved to the financial innovation frontier, for example the US or the UK.

The authors therefore argue that the sustainability of low spreads depends on a conflagration of low macroeconomic volatility, financial innovation and a dearth of physical investment in mature economies, information asymmetries and weak financial markets in emerging economies, resulting in persistent capital outflows.

Now what could go wrong?

The first is obviously unexpected inflation that would end our benign environment of low macroeconomic volatility. Unexpected inflation impacts your future return of your assets. The assumption that an environment of low spreads could be sustained is predicated on the assumption that central banks manage to have a perfect control of the yield curve forever. The second factor would be an abrupt change in the exchange rate policies by Asian and Gulf State countries, as that would lead to a lower preference for investments in the bond and cash markets – and a move into equities. The third factor would be a sudden drop in oil prices, which would also reduce capital flows from Opec countries. In their conclusion, the authors say that official G7 policy could precipitate a crisis – since the G7 has been calling on China to revalue, and on Opec not to hike the oil price. Their message can also be described thus: Be careful what you wish for.

There are more things that could go wrong, of course, not mentioned in this paper. The most likely would be a reduction in the US current account deficit. We have already seen a reverse capital flow, out of the US, in December, and we may well be on the verge of entering a different global environment than the one this model seeks to describe.

Still, this is a useful attempt to capture some of the dynamics of a system that has gotten us to where we are today. The conclusion, however, does not go far enough to address the issue of sustainability. While it is possible to argue that low inflation is desirable both in its own right and as a precondition for low credit spreads, the same cannot be said for global imbalances and unsustainable exchange rate policies. If the present low credit spreads depend on policies that are unsustainable, they are themselves not sustainable either, and this again raises the questions about the role of policy. Should economic policy sit tight and watch the credit market blow up out of proportion until it collapses, or should policy intervene at an earlier stage. This has some parallels to the debate about whether central banks should prick asset price bubbles, though in this case, this is not a matter of pricking bubbles through high interest rates, but through exchange rate policies or banking supervision or credit market regulation. In other words: The fact that low credit spreads may be more rational than we originally thought does not mean that they are more desirable, and even less that they are sustainable.

Email: munchau@eurointelligence.com

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