The broken world of finance or Does Capitalism need enemies?

I was startled to read these two stories and contrast them with the picture below.

This image file came via courtesy of this website.

This article in Bloomberg gamely tries but fails to make sense of the craze for negative yielding bonds.

Wework floated a debt before filing for IPO! It has been losing money ever since it was founded and it is valued at USD47.0bn!

In contrast,

Regus owner IWG , founded in 1989, has a similar business. It booked revenue nearly twice as high as WeWork did last year yet it has an enterprise value a bit above $4 billion. [Link]

Wework co-founder has reportedly cashed out US$700 million from the company through stock sale and borrowings against shares of Wework. JP Morgan advised him on his sales and it is also advising the company on its debt offering. His shares hold 10 times the voting rights of standard shares. He has properties that are leased back to Wework and he collects millions in rent from Wework! Source: Link

Evidently, he could cash out so much because the company had the chutzpah to issue USD4.0 billion of debt

What a model of ethical capitalism!

It is into this loss-making company with co-founder cashing out such a large sum before IPO that Softbank decided to invest USD 16.0 billion including USD 6.0 billion of new money! The amount was eventually scaled back after partners opposed it.

Blame central banks and their policies for money losing its value and investors losing their heads and eventually, their shirts and trousers.

The real economy does not need rate cuts

The Federal Reserve will announce its interest rate decision tomorrow (Wednesday). Financial markets expect a rate cut of 25 basis points or even 50 basis points. But, William Dunkelberg, Chief Economist at the National Federation of Independent Businesses, beautifully and in very simple language establishes that the real economy does not need interest rate cuts. If anything, credit availability, cost of loans, unmet credit needs are all at near five-decade lows. Read the whole thing here. It is worth it.

It is clear that the Federal Reserve under Jay Powell has really flattered to deceive in respect of decoupling monetary policy from asset prices. Now, it is fully captured, it appears. One still entertains a faint hope that the Federal Reserve Open Market Committee will surprise us pleasantly with some spine.

In a sense, William Dunkelberg’s article really is a succinct capture of all that is wrong with ‘The Rise of Finance’ that Gulzar Natarajan and I had documented.

Monetary policy transmission in India

In its monetary policy meeting last week, the Reserve Bank of India’s Monetary Policy Committee cut the policy rate – the repo rate – by 25 basis points. This is its third rate cut since December 2018 and it was unanimous. The Committee also unanimously decided to move to an ‘accommodative’ stance indicating further easing down the road. So far, so good.

Transmission from RBI policy rate to the lending rates fo banks remains the big challenge in India. See this article in ‘Business Line’, for example. Some banks have even increased their lending rate since the last RBI policy rate cut!

Everyone – including my friend Gulzar Natarajan – points out that Indian banks have a much higher share of their liabilities in bank deposits. These deposits are fixed in nature. Therefore, interest rates on them are payable at a fixed rate regardless of the movements in the policy rate. Since they cannot come down with cuts in the policy rate, the lending rates too cannot be lowered. Ergo, there is no transmission.

Gulzar even shared a chart with me that showed that Indian banks’ deposits as a % of overall liabilities is higher compared to other developing nations.

But, the truth is that Current and Savings Accounts (CASA) are more than 40% of overall deposits. 41.3% to be precise. The last data point available – in a easy to retrieve manner, that is – is from February 2019. See here.

Current accounts pay no interest and the interest payable on savings accounts is 4% – at the lowest balance between the 11th and the end of the month. That is as low as one can get, in terms of savings account balances. In the first ten days, the balance could be higher due to salary deposits. That is why they are excluded!

Therefore, the argument is somewhat unconvincing. Not untrue but not the total explanation.

The explanation lies in lack of competition with the central bank prescribing a floor for lending rates via its formulaic Marginal Cost of Deposits based Lending Rate (MCLR). I wrote about it in my MINT column last Tuesday.

If one went through the RBI Internal Working Group Report on the MCLR and the previous base rate, published in October 2017, one would realise that these are not MCLR (i.e., not marginal) but that they are also binding floors for lending rates.

Note a key sentence in the report:

One bank included a negative spread under business strategy due to market competition, which was in contravention to regulatory guidelines. (PAGE 47)

Indeed, that should be the case. Banks should have the freedom to take the basic of decisions for a commercial entity – the pricing decision. But, they do not.

India needs genuine competition in lending rates between banks. Neither the owner nor the regulator must intervene. It will also enable the owners to figure out which of them are worthy of further capital infusion, growth and which of them deserve to be merged, consolidated or weeded out.

Of course, the second thing is the Small Savings Interest Rate. Check out the table in page 26 of the said report (Table II.8).

Interest rates offered on bank deposits are lower than that of the interest rates on small savings and these interest incomes are tax-free too. The Government-announced interest rates on these Small Savings Schemes are higher than that of the rates that would be offered if the government sticks to the formula that it promised – linking the interest rate to the 10-year Government bond yield. It has not. On top of it, there are tax benefits.

That is the second (or, even the first) biggest hindrance to transmission. That is why I felt that the usually meticulous Indira Rajaraman quite did not get it right in her column on the topic of transmission. She is right with her conclusion, of course. The multiple strands that link the funding of government budgets (of the States and the Union) to the National Small Savings Fund (NSSF) need to be broken. She is right on that one.

But, more than that, the idea of offering a higher interest rate on a product that is even safer than a bank deposit and with tax benefits is a sure-fire killer of the banking system profitability and of transmission of monetary policy.

Some politically unpopular decisions need to be taken. They will be unpopular in the short-term. But, a government with its back to the wall on the banking system and with such low actual economic growth (more on that in a separate blog post) has to take some decisions and face up to the tradeoffs. There are no costless choices here.

Surjit Bhalla had got this one right. One of the most important decisions ever taken by a FM was taken by Yashwant Sinha when he lowered the interest rate on Small Savings Deposits. That did play a big role – among many other things – in India’s post-2002 economic boom.

Surjit Bhalla had got this one right. One of the most important decisions ever taken by a FM was taken by Yashwant Sinha when he lowered the interest rate on Small Savings Deposits. That did play a big role – among many other things – in India’s post-2002 economic boom.

Who makes recessions in America?

I stumbled upon the website of CMG and Mr. Steve Blumenthal’s weekly missive called ‘On my radar’. He had penned one of his recent letters based on David Rosenberg’s presentation at the John Mauldin’s Strategic Investment Conference. Must attend one of them soon. At least, an impressive array of speakers.

One thing one has to like, admire and envy about David Rosenberg is that in 2011 or so, he switched to being an equity market bull and rode the wave all the way up to 2018. He has again turned bearish now. Full credit to him for such intellectual openness. It requires a lot of discipline and intellectual integrity to be able to switch.

This is a clear case of seeing things as they are likely to be rather than as what one likes them to be. Not easy at all.

The presentation and the slides are, as usual, very informative and perceptive. I have a minor/major quibble about the causality attributed to Federal Reserve tightening for economic recessions in America. That is a false framework, in my view.

Recessions happen not because the Fed hikes interest rates. The Federal Reserve tightening merely confirms that the cycle had run its course. The Fed’s mistake is not that it overtightens but that it does not tighten enough and early. Indeed, what it does is to tighten too late and even then it does too little only. But, that is enough to topple the apple cart of the economy because, by then, it had accumulated so many excesses that it does not need too many excuses to topple over.

So, who makes recessions in America? It is the Federal Reserve and financial institutions that pay little heed to accumulating risk and passing them on to the rest of the society. The Federal Reserve is still the villain but not with its ‘restrictive’ or ‘normalisation’ stance but with its ‘low and easy for long’ stance.

‘Blaming the Fed’ for recessions plays into the hands of politicians and the financial market types who would prefer a perpetual flow of funds at cheap rates. They can earn the returns and pass on the risks to the broader society and taxpayers.

In response to the criticisms that the Fed tightenened and precipitated a recession, the Federal Reserve eases aggressively and keeps rates too low for too long in the next cyle. That is what the Federal Reserve did in 2001-07. The result was 2008. Again, the Federal Reserve has repeated 2001-07 between 2009 and 2017 and the result is likely far worse.

Did the Fed overtighten?

Rosie focused on the Fed overshooting the neutral rate, actually tightening as we go into recession with a combination of balance sheet reduction and interest rate increases (something I’ve also been ranting about).  [Link]

That was from the John Mauldin weekly missive, ‘Thoughts from the Frontline’ published on May 17, 2019 (‘Takeaways from the SIC’). Rosie is David Rosenberg of Gluksin Sheff, formerly North America Investment Strategist (or, Chief Economist?) of Bank of America – Merrill Lynch. That was quite a while ago. He has been with Gluskin Sheff for quite a while.

Look at the very chat (below) that David Rosenberg has presented at the Strategic Investment Conference (SIC) that John Mauldin conducts annually in May:

Financial Engineering and Fed Rates

Source: https://www.mauldineconomics.com/frontlinethoughts/takeaways-from-the-sic

On this basis, how can one say that the Fed overtightened? In fact, it is fairer to say that it left rates too low for too long. So, despite acknowledging that the crisis of 2008 revealed the flaws of a monetary policy framework that ignored the financial sector, how can one pass judgement on Fed monetary policy under Powell, again ignoring the financial sector?!! Beats me.

In fact, the U-turn that Powell made in December 2018 has once again made the financial sector riskier, more unstable and hence, more vulnerable to a downturn.

The two theorems of Lacy Hunt

First, federal debt acceleration leads to lower, not higher interest rates. This is because the economic stimulus effectiveness ends quickly, but the debt overhang causes weaker business conditions that reduce loan demand.

Similarly, monetary easing eventually leads to lower, not higher interest rates. Debt productivity falls, making the velocity of money decline so monetary policy becomes asymmetric and inefficient. [Link]

He has charts to show that. Notice that they are all ‘hard currency’ countries. Therein lies the clue to the relevance and applicability of his theorems:

Federal Debt and interest rates

Source: https://www.mauldineconomics.com/frontlinethoughts/why-debt-wont-spark-inflation

Between economic pessimism and market optimism

Through Andrew Batson’s blog (yes, I caught up with quite a bunch of his posts today), I chanced upon this Greg Ip article written in January 2019 at the time of the meeting of the World Economic Forum. Greg Ip concludes that central bankers have to acknowledge that the world economy was not strong enough to withstand the return to a normal level of real interest rates and therefore, must do the following:

Nonetheless, central banks need to proceed carefully: in a low-growth world, a little bit of monetary tightening can go a long, and painful, way. [Link]

Yesterday, while searching for something on the net, I stumbled upon the ‘Weekly Global Economic Update’ put out by Deloitte. The latest edition (14th May 2019) is here. It highlights an important financial stability risk that raises questions over Ip’s preferred monetary policy:

The US Federal Reserve has warned about the risks to the financial system from the sharp increase in corporate debt.15 In the Fed’s periodic report on financial stability, it noted that “borrowing by businesses is historically high relative to [GDP], with the most rapid increases in debt concentrated among the riskiest firms amid signs of deteriorating credit standards.” It drew attention to the fact that, although the volume of corporate debt increased 4.9 percent in 2018, leveraged loans increased by 20.1 percent, thereby boosting the risk profile of the corporate sector. It also said that asset values are relatively elevated and that investors continue to exhibit a high appetite for risk.  ….. It said a downturn could hurt the financial system because of “the rapid growth of less-regulated private credit and a weakening of underwriting standards for leveraged loans.” [Link]

They have quoted from the ‘Financial Stability’ Report of the Federal Reserve Board.

This is the all-important question that monetary policymakers have avoided confronting. If one keeps policy loose for the sake of real economy vulnerabilities, how does one prevent that from feeding through to irrational financial market optimism that does not really square with the real economy weakness or stagnation?

Financial markets do not worry about the numerator (cashflows). They are happy if the denominator (discount factors) is low. In other words, it will worry about the numerator if stock markets are discounting mechanisms. They are not. In casinos, fundamentals do not matter. Only luck and liquidity matter.

With their ostensible purpose of supporting the real economy – for which there is very little long-term evidence – central banks end up lowering risk premiums in financial markets. That, in turn, boosts asset prices, turn them into bubbles, stoke wealth and income inequality (one way to boost short-run stock prices is to cut wages to pay interest on debt taken to finance share buybacks!) and makes the economy even more vulnerable. Then, commentators again call for low interest rates while all that it has done is to boost the financial economy while doing zilch to the real economy.

When will this farce end? It is inconceivable that either commentators or policymakers are unaware of the reality. Are they captured or what else is the reason?