Why 2007-08 was only a curtain-riser

What began as a message to my faculty colleagues at IFMR Graduate School of Business was eventually abandoned and it ended up being a ‘long read’ article published in Mint. They had removed many of the hyper links to keep the piece tractable. Fair enough.

Here is the original version. Perhaps, Mint should have titled the piece, ‘Why it feels like the autumn of 2007?’ The original version, below, has more links.

Wall Street Journal recently issued an oxymoron alert. The oxymoron was that high yield bonds had gone negative. “There are about 14 companies with junk bonds worth more than €3 billion ($3.38 billion) that are trading with negative yields, according to Bank of America Merrill Lynch. They include telecom giant Altice Europe NV and tech-equipment company Nokia Corp.” It would have been unthinkable even a few years ago to have high-yield/speculative/junk bonds being sold for negative yields. They were meant to be high-yielding bonds because they carried with a high probability of default. But, to compensate the borrower to buy them means that the logic of higher expected return for higher risk has been upended. This makes investing impossible.

A pension fund manager in a European country was told by his regulator not to hold too much cash because it is risky and was told to invest them in negative yielding bonds, instead! This cannot and will not end well. It is time for investors to baton down their hatches and settle for safety rather than returns because it is a recipe for the elevation of socialist policies in America to a historically unprecedented level, after the next Presidential elections in 2020.

Globally, about USD 13.0 trillion of debt is trading at negative yields. Two US companies that issued leveraged loans have quickly seen their bonds lose value. Obviously, lenders chasing yields have ignored risks. The companies recycle printer ink cartridges and another one is a beauty company! – Clover Technologies and Anastasia Beverly Hills! See here.

Amidst all this, what is funny or tragic (depending on your lens) is that investors, according to Schroders, have upped their return expectations for 2019 to 10.7% from 9.9%. This is based on a survey of 25,000 people across 32 countries. In other words, the survey respondents plan to make riskier investments (some of which now yield negative returns!) and that they expect central banks to underwrite their risks with ultra-low interest rates or negative rates or nominal GDP targeting into eternity.

Who is responsible for this upside-down world of investing?

Let us start with the Federal Reserve. Its monetary policy committee is meeting on July 30-31. Donald Trump is putting tremendous pressure on the Federal Reserve to ease monetary policy aggressively. Check out his four tweets on the Federal Reserve including and starting from this one. Although the Federal Reserve strenuously denies complying, it is behaving as though it is complying. The Federal Reserve is ready to cut interest rates by 25 basis points at the minimum in its meeting in July. One should not be surprised if the pre-emptive ‘vaccination’ is 50 basis points. The American economy does not need it. William Dunkelberg of the National Federation of Independent Businesses marshalled data to show that no real business – including small ones – is being starved of credit.

All else being equal, a besieged Federal Reserve would have made the US dollar a sitting duck for speculators and for the world, in general, to fall out of love with the greenback. But, it won’t happen in a hurry because others are far worse off. So, the story of the world finally getting out of the dollar standard has to wait. That is because other central banks are again talking of cutting rates aggressively. European Central Bank is fully prepared to outdo the Federal Reserve. Eurozone countries have selected a ‘tainted’ politician to replace Mario Draghi as the President of the European Central Bank. She will be more populist and ‘bolder’ than him with monetary policy experiments. That will be music to financial markets, hedge funds, PE investors who place bets with a high degree of leverage.

The crisis of 2008 was supposedly due to excessive debt carried by different financial institutions – some visible and some hidden. But, the answer from central banks has been to incentivise even higher gearing of balance sheets. In America, the number of companies with increased risk of becoming financially distressed  – companies that either generated negative EBITDA or have net debt to EBITDA over 3x – has grown noticeably this cycle (53% as 6/30/19) versus last cycle (32% as of 6/30/2007). It gets worse.

Central banks deliberately avoid thinking about why their decade-long policy of ultra-low interest rates have failed to mend economies. In less than a year after proclaiming the return to normalcy, central banks are priming themselves to become even more adventurous with their monetary policies. All that their policies have engendered is reckless risk-taking in financial markets, more leverage, greater inequality and tremendous stress on savers, bank deposit-holders and pensioners. Think of the clients of the pension fund mentioned earlier.

Another important consequence of such remarkable persistence with such ill-advised policies is the diversion of capital for unproductive ends and personal aggrandisement. Loss-making start-ups are carrying on without a concern for profits because cheap money means private equity investors blanket them with funds. ‘Wework’ is a technology unicorn in the office rental space. The company has filed for an IPO but it had the temerity to issue USD 4.0 billion debt before that and its co-founder has cashed out USD 700.0 million in the last year! It is valued at USD 47.0 billion. Softbank wanted to invest USD 16.0 billion in that company with USD 6.0 billion in new money. Its partners protested and the investment was pared back. IWG, the owner of Regus, another office space rental company, is valued at USD 4.0 billion and it is making profits. I had blogged on it here.

We heard of price-eyeball ratio in the dotcom bubble era of the Nineties. Now, ‘Wework’ presents ‘community adjusted’ EBITDA which strips out “not only interest, taxes, depreciation and amortization, but also basic expenses like marketing, general and administrative, and development and design costs.” No one has heard of this EBITDA before because it is effectively gross revenue and without accounting for costs, it turns into profits, of course.

Not only have promoters benefited immensely from loose monetary policies and funds available on liberal terms from capital markets but they have also profited from the tendency of governments to compete away their tax dollars from companies.

The corporate tax rates in developed world have come down steadily from 38% in 1990 down to 22% in 2018. This has forced low-income countries to lower their tax rates as well as, otherwise, companies will shift their tax bases to havens that still remain in high-income countries. Corporate tax rates in low-income countries have come down from 46% to around 28% in the same period. This data comes from the International Monetary Fund which, officially, has been the cheer-leader for unconventional monetary policies that have played a leading role in precipitating the next biggest crisis after 2008. That will not be just an economic crisis but a socio-political one too.

Capitalism does not need enemies or competing ideologies. Capitalists are doing a great job of destroying it with multilateral institutions like the IMF egging on central banks to stick to policies that would ultimately cause capitalism to implode.

There has been much schadenfreude in Asia at the self-destruction of capitalist western societies. But, if only such sentiment were justified. Asia, if anything, is more vulnerable. The crisis of 2008 has damaged their growth models irreparably. Let us start with China. Beijing is presiding over a shaky economy in China as official growth rate is again overstating true economic growth and global manufacturing supply chains are moving out of China, exactly as intended by the American administration, even if they are not returning to the United States.

In the meantime, China’s Minsheng Investment Trust Corp. is defaulting on its dollar debt. Its parent, Minsheng Banking Corporation is China’s largest private sector bank by assets. In 2015, it did warn of ‘systemic, concentrated financial risk happening in China’ but it has become a victim of it, itself. In Hong Kong, protests against the pro-Beijing government are intensifying.

Smaller Asian nations are faring no better. Japan’s exports have had seven straight months of decline up to June 2019. So has the performance of Korea’s exports been except that its export slump appears to be worse than that of Japan. No wonder South Korean auto industry is in a slump. Singapore’s non-oil domestic exports is a bell-weather for international trade and global economy. It is declining  precipitously and Singapore economy itself appears headed for harder times. Singapore’s overall GDP contracted 3.4% in the second quarter (QoQ, annualised). Of course, this is an advance estimate based on two months’ of data. Preliminary estimates based on three months of data will be released in August. Indonesian exports have declined for eight straight months up to June and Malaysia’s exports have fared slightly better than Singapore’s and Indonesia’s.

In Europe, German investor and economic sentiment (ZEW) is going deeper into negative territory. The same ZEW survey also pointed out that “the indicator for the current economic situation in the eurozone fell 6.9 points to a level of minus 10.6 points in July.”

A survey of the global political landscape confirms our worst fears. Leaders are ill-equipped to face the oncoming economic storm. Worse, they are seeding and nourishing it. Japan and South Korea are back to feuding in which the trade disputes playing a small but significant role in it. The wounds are historical and they were re-opened by a Seoul court ruling last October. Malaysian Prime Minister looks all set to walk back on his word to hand over power to Anwar, again! Such political conspiracies and power-grab have rendered ASEAN irrelevant both politically and economically. It was laid low by the crisis of 1998 and it has not recovered since then.

In the United Kingdom, Boris Johnson looks set to become Prime Minister and Brexit – deal or no deal – looks likely. Its consequences will be unpredictable because the country has now fraught relations with the United States, with European Union, with China and with Iran. But, the English team’s Pyrrhic victory in the Cricket World Cup 2019 is a small boost to national sentiment. In continental Europe, Angela Merkel’s physical health is deteriorating. Turkey, the pivotal Eurasian nation at the frontier of the Western alliance against Russia, is no longer a part of it, de facto, if not de jure. This is historic and has enormous implications.

Elsewhere, Iran has seized a British oil tanker and America has shot down an Iranian drone. Of course, the current expectations are that things won’t spiral out of control. But, a President seeking re-election is increasingly focusing on cementing and consolidating his base. Belligerence towards his domestic and international opponents will be consistent with those political goals.

Finally, let us examine if India is anywhere close to being a safe haven from the turbulent world. After all, in the elections held in May, its government won a strong mandate with a better majority Alas, its economy is getting deeper into trouble. The slump in the Indian auto sector mirrors that of South Korea and its overall economy has not stopped slowing. The Reserve Bank of India Governor has taken to chiding public sector banks on their non-transmission of his rate cuts. Just as it is the case in the West, monetary policy has no answers to structural ills. Resolving them starts with admitting to them and then being patient without too much anxiety about short-term growth pains. Window dressing only complicates the problem and delays eventual resolution, recovery and strong growth. The budget was incoherent at best and dangerous at worst, for it privileged financial liberalisation and trade illiberalisation. It socked the rich again and that was needless, both politically and economically.

The government announced that it would go for sovereign foreign currency borrowing at a time when India’s export performance is poor and the global growth environment is becoming worse. Dr. Y.V. Reddy, former Governor of the Reserve Bank of India, wrote that a decision on India’s capital account convertibility must precede the decision to issue sovereign dollar bond. But, this is not the best time to liberalise capital account when India’s fiscal health is not at its best and when export performance is sluggish at best and has deteriorated, at worst.

What appeared to be a cleverly disguised (positive) move to divest government stake in public sector enterprises below 51% has been denied, as well. Monsoon is erratic once again and anecdotal evidence points to India being more vulnerable to global climate change than most other nations. India may be sleepwalking into a major and prolonged economic slowdown. Narayanaswamy Jayakumar may have been prophetic here.

As we head into 2020 – the year of American Presidential elections –present trends in financial markets and economies around the world would coalesce into a major storm, convulsing most of them in the process. The Presidential election campaign in America could yet be the most fractious in history searing the nation apart, at a time when the economy may be pushed into a recession by a crash in the stock market or the other way around. That may set off a dollar crisis. The rest of the world, with political and economic problems of their own, will be unable to fill the leadership vacuum left by a politically fractious and economically floundering America.

Once the storm subsides, a new world economic and political order might emerge. To end on a positive note, the destruction wreaked by the storm might mark a true and a lasting bottom for the world economy on which its durable recovery could be built with more sensible policies than the snake oil that central banks have applied.

Which inflation to fight?

The lesson, to me, is crystal clear. Deflation is a threat posed by a critical breakdown of the financial system. Slow growth and recurrent recessions without systemic financial disturbances, even the big recessions of 1975 and 1982, have not posed such a risk. The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk-taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically, the “easy money,” striving for a “little inflation” as a means of forestalling deflation, could, in the end, be what brings it about. That is the basic lesson for monetary policy. It demands emphasis on price stability and prudent oversight of the financial system. Both of those requirements inexorably lead to the responsibilities of a central bank.

Volcker, Paul. Keeping At It: The Quest for Sound Money and Good Government (p. 227). Public Affairs. Kindle Edition.

This is the lesson that central banks in several advanced nations have ignored repeatedly in the last decade and are preparing to ignore again, in 2019

Incentivising malpractice

The mind-bending complexities of the new financial technology combined with the modern practice of incentive payments that reward employees for particular deals practically invites malpractice, whatever the pious institutional statements about the priority placed on client relationships and an ethical culture. In fact, rewards for successful proprietary transactions, inherently speculative and often in conflict with client interests, will tend eventually to color the overall atmosphere and the reward systems in banks, even beyond the trading rooms.

Volcker, Paul. Keeping At It: The Quest for Sound Money and Good Government (p. 216). Public Affairs. Kindle Edition.

The emphasis was mine and that is the key part of that comment.

Wake up, gentlemen. I can only say that your response is inadequate. I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information.”

Volcker, Paul. Keeping At It: The Quest for Sound Money and Good Government (pp. 216-217). Public Affairs. Kindle Edition.

… concerns about regulatory complexity are common and not limited to financial regulation. Pictures of the thousands and thousands of pages of federal regulation are grist for election campaign mills. I cringe, like others. But then I also cringe a bit when I receive, each year, the eighty or so pages explaining precisely my rights and the policy limitations in my “simple” household insurance policy.

Volcker, Paul. Keeping At It: The Quest for Sound Money and Good Government (p. 218). Public Affairs. Kindle Edition.

Volcker-William Sharpe conversation

I found myself sitting in the audience next to William Sharpe, a 1990 Nobel laureate in economics whose “Sharpe ratio” has become a widely accepted measure of risk-adjusted returns for fund managers. I nudged him and asked how much this new financial engineering contributed to economic growth, measured by GNP. “Nothing,” he whispered back to me. It was not the answer I anticipated. “So what does it do?” was my response. “It just moves around the [economic] rents* in the financial system. Besides it’s a lot of fun.” (Later, at dinner, he suggested the possibility of small ways in which economic welfare could be advanced, but I felt I had already gotten the gist of his thinking.) 

Source: Volcker, Paul. Keeping At It: The Quest for Sound Money and Good Government (p. 206). Public Affairs. Kindle Edition.

Here we are, a decade after the crisis, and the scurrying lobbyist chipmunks are nibbling away in the name of efficiency and simplification (good, in itself), but with the ultimate aim of weakening the new safeguards.

Volcker, Paul. Keeping At It: The Quest for Sound Money and Good Government (p. 209). Public Affairs. Kindle Edition.

I am sure Tim Geithner and Larry Summers would have been content if I disappeared. The potential for conflict in policy approaches was real.

Volcker, Paul. Keeping At It: The Quest for Sound Money and Good Government (p. 212). Public Affairs. Kindle Edition.

In my view, ‘Keeping at it’ was a good book but not a great book. He is a master of understatement. Mr. Volcker’s transparent sincerity, simplicity, impeccable integrity came through. But, he was not going to make scathing statements or judgements on any one. That is a testimony to the man’s character but that also makes the book somewhat duller. One has to pierce through his statements to understand what he left it for readers to figure out. One example is the comment on Geithner-Summers above.

The ‘expert’ problem

The biggest problem with experts is not that they can be wrong but that they think they have answers for all the problems or that others think they have. Human history proves otherwise.

Read this blog post of mine from last year in which I quote from Sir Martin Rees’ ‘Final hour’ on how little scientists were able to predict the developments that were going to happen in the second half of the twentieth century, in 1937!

At best, experts and governments can ‘nudge’, if they know how and where to ‘nudge’. More often, the best outside help is not to make problems worse. That takes humility on the part of experts to accept. Admittedly, it is trickier for politicians not to act because they have been elected to act.  So, they act in wrong ways. It is because expert advice, for the most part, falls short because experts fail to factor in the law of unintended consequences and second, experts simply forget that ‘ceteris paribus’ is only a starting assumption and not a reflection of reality. 

Politicians have to find a way to be seen to be acting without causing harm and without worsening the situation. Experts need to become more rigorous and more humble as well.

This may seem like standard ‘expert bashing’ which has become fashionable and even trite. But, an expert, George Akerlof, had written himself about the ‘limitations’ of expert wisdom, inasmuch as expert wisdom is perceived as wisdom that can emanate only from hard science.

In a paper that is about 20-page long, footnote no. 8 caught my attention. So much for wisdom and rationality among economists who routinely consider themselves as experts:

Two papers—one by Brock and Durlauf (1999), the other by myself and Pascal Michaillat (Akerlof and Michaillat (2018))—show that beliefs in a scientific field will converge if its practitioners have a desire for conformity. In Brock and Durlauf, scientists continually adjust their beliefs to reduce the distance between their thinking and the beliefs of others. In Akerlof and Michaillat, evaluators of candidates for tenure are biased in favor of those with similar beliefs and also against those with different beliefs. In both cases, the beliefs converge. Furthermore, that convergence will not necessarily be to the Truth (or to best practice). On the contrary, because of Reason 1 (the role of Hardness in the scientific pecking order) and Reason 2 (its facilitation of agreement), following from the comparative statics of equilibrium in Akerlof and Michaillat, those uniform beliefs are likely to have Hardness bias in turn.

These theoretical findings of belief convergence under rather general conditions accord with Kuhn’s (2012) view that scientists base their work on commonly-held paradigms. Those paradigms do not just pertain to subject matter; they include, as well, beliefs about appropriate methodology for the respective field. [Link]

G-2 to G minus 2

My friend Rohit Rajendran forwarded the ‘Project Syndicate’ piece written by Arvind Subramanian and Josh Felman. The article is, in short, about global leadership vacuum. Calling it ‘G minus 2’ is smart.

The points made about China’s lack of soft power, it not being a benevolent hegemon are well made. I would be blunter: I would call it a predatory hegemon.

US, wrongly, for the most part, thinks that it has been too benevolent a hegemon. That is convenient excuse to deflect problems which defy easy answers.

Taking a step back or rising above these, we should expect these kinds of long cycles to keep coming in a 30-year rhythm. 

We have just begun the long journey of turbulence. 2008 was a decent-enough warning. Our central banks applied monetary balm and politicians were happy to go along with it.

The truth – which most humans do not accept – is that some problems do not have answers. Or put differently, the problems will have to solve themselves, through sheer passage of time and through participants realising the folly of their ways. 

In the current global context, it is going to take rather long, I am afraid.

India’s banking trilemma

Notwithstanding the controversies that dogged his tenure at the Reserve Bank of India as its Governor, Urjit Patel has made an important and interesting presentation at the Stanford-India conference in June on India’s banking sector problems. As Urjit Patel frames it, the ‘Impossible Trinity’ of Indian banking is this: Dominance of government-owned banks in the banking sector, independent regulation and adherence to public debt-GDP targets. India can have only two of the three.

But, in fact, political economy considerations dictate that India follows only the first of the three. In the presence of the first, the other two are impossible, except in terms of appearances.

India’s banking crisis is a huge opportunity missed.

His presentation is worth going through and storing for reference. Lots of good tables and charts.