If the natural rate of interest is so low,…

This morning, an article in FT caught my attention: ‘Economists fear US is approaching limits of monetary policy’. I read it. These lines were interesting:

Economists puzzle over what has been dragging the natural rate down, and have formulated two explanations. The first is that labour forces in developed economies are growing older — there are fewer workers and a higher savings rate as they prepare for retirement. More savings chasing fewer investments drives down returns. The second is that productivity is not growing as quickly as it used to. People in work are not becoming more efficient, which dampens growth and opportunities for investment. [Link]

If the natural rate of interest is below 1% and if productivity growth rate is abysmal, what explains the remarkable run of returns in the stock market and in private equity deals?

My guess: financial engineering aided by loose monetary policy boosts profitability unrelated to economic activity and two, capital gaining at the expense of other stakeholders, especially workers.

Pillars of financialisation

In my column for Mint on Tuesday (my last column for the year), I wrote that two important and promising developments – although small – have happened recently. One is that the International Monetary Fund has a serious rethink on capital controls and its usefulness. It used to look down upon capital controls. No longer, it seems. See here.

Then, there was the OECD draft proposal on taxation of international companies. One hopes that the developed world would adopt it. It would vastly discourage companies from doing ‘taxation shopping’. I had written on it in a column for Mint.

The pillar that is still holding up financialisation (asset bubbles, executive compensation, stock buybacks, etc.) is central bank policy. The recourse to Quantitative Easing and Negative interest rates without any shred of evidence that it has been beneficial, on balance, is what continues to fan social, political and economic imbalances. The major central banks continue to embrace QE/Negative interest rates without any audit or honest appraisal of the costs and benefits. See this article and the second chart embedded.

In that sense, it is good that Swedish Riksbank, thanks to public pressure is turning its back on negative interest rates.

If 2020 sees a rethink on the part of major central banks, if they return to normalcy, the world can avert a bigger replay of 2008. Or, is it already too late?

Paul Volcker: 1927-2019

The legendary chairman of the Federal Reserve (1979-87) passed away few days ago on 8th December 2019. He was 92. I had read his book, ‘Keeping at it’ this year and blogged on it here, posting some extracts from it. It was a good book but not a very exciting one. I read few of the tributes posted for him. The Financial Times stuck to the theme of using the occasion to bash the curent American President. John Taylor was conventional too. I found Greg Ip’s tribute somewhat interesting.

While praising Volcker, he held out the possibility that Volcker was not as austere nor dogmatic/rigid/doctrinaire as often made out to be. Therefore, he would have taken the same decisions that his successors like Greenspan Bernanke and Yellen took in their years at the helm of the Federal Reserve Board. That is quite tongue-in-cheek. He cites this observation once made by Mr. Volcker as support for his conjecture:

In 1989, two years after stepping down from the Fed, Mr. Volcker attended a conference of economists in Cambridge, Mass., on financial crises. Mr. Volcker warned the attendees that policy makers, by repeatedly intervening, could be “reinforcing the behavior patterns that aggravate the risk in the first place.” Then, revealing how he felt torn between the urgency to act and the avoidance of moral hazard, he related that as head of the Fed’s New York district back in the 1970s, “I often said to myself, ‘What this country needs to shake us up and give us a little discipline is a good bank failure. But please, God, not in my district.’”

This episode does not prove that Mr. Volcker would have succumbed to the moral hazard and would not have allowed a shake-up to happen, discipline to be instilled through a bank failure, even if he wished that it would not, happen in his District. That is par for the course for human nature. We are capable of holding two contradictory thoughts in our heads.

Paul Volcker clearly did not mind engineering two recessions – nearly back-to-back to quell inflation. As we have learnt over the years, taming inflation is easier than stoking it, for there is no ceiling to raising the interest rate but there is a floor and that is 0.0%. Of course, breaching this floor has brought with it unintended and often unpleasant consequences. We have not seen the end of them yet.

Mr. Volcker did not give an exalted place to financial innovations. He called the ATM the best financial innovation ever. That said, ironically, his taming of inflation and allowing the long-term bond yield to commence a secular decline paved the way for financialisation. As interest rates declined, so-called financial innovations deploying leverage flourished.

All that being said, the world is poorer for his demise. One upright man – a man who combined integrity with competence – less in this world.

Be sure of what you want. You may get it.

Based on the current repo rate of 5.4 per cent, the impact on SBI’s profitability is compressed to 10 basis points (bps). Home loans offered by the bank now start at 8.1 per cent. However, we are in a declining repo trajectory.

Therefore, if the central bank announces another rate cut anywhere between 25 and 40 bps — in October or later — profitability or net interest margin (NIM) may take a huge knock. At 3 per cent in the June quarter, numbers have just about started firming up and looking better.”

Source: “Linking loans to external benchmark may delay SBI’s profit revival – Profitability may take further hit on policy rate cut of 25-40 bps [Link]

The Chinese proverb I have used in the header is a very profound one.

The shrill case for rate cuts with a tasteless header

My young friend Karan Bhasin urged me to wait until I read his full piece in Swarajya when I told him that I was disappointed with the header of his article. He said that the header was not his choice. Fair enough. Then, I have to protest to the editors of the magazine strongly at that tasteless pitch for RBI rate cuts.

In a balance-sheet constrained economy, rate cuts seldom have positive effects and may have effects in areas where we don’t want. Now that the government had cut the corporate taxes aggressively, companies might be willing to borrow and invest for the tax cut might have shifted the sentiment in the commercial sector more decisively.

That, in fact, proves the point that rate cut works only when certain pre-conditions are present. It is a limited tool. Its omnipotence is overstated in the West and now, it seems, in India too.

With the benefit of hindsight, RBI was too reluctant to cut rates in 2017. It should have dropped them more as liquidity tightened. It dropped the repo rate only by 25 basis points throughout 2017. It began the year at 6.25% and dropped it to 6.0% in August. 2017. It raised rates twice in 2018 because, by then, the Federal Reserve was raising rates and the rupee was weakening.

Official statistics for real GDP growth in 2016-17 and in 2017-18 is 8.0%. So, may be, was RBI that wrong in maintaining a real repo rate of around 2.0% then?

Karan writes:

This suggests that the RBI believes that the economy overheated in 2017 and 2018 while the exact opposite happened thanks to their policy choices.

8% growth rate (official print) was an overheating economy. One cannot have an official growth print of 8% and then call for aggressive rate cuts. More useful to tell the government to come clean on the actual growth rate.

Growth began to slow in the second half of 2018-19. RBI could have cut rates aggressively then. But, with foreign currency loans repayments (check out the net international investment position data every quarter on dollar amounts falling due for repayment) and an aggressive Federal Reserve (that did a about-face only in December 2018), a central bank has to have its eye on the currency too, even if it is not a policy objective.

Interest rate cuts may help but to suggest that it is guaranteed to work or that it is the only game in town is to let the government off the hook for its acts of omission and commission that contributed to the economic growth slowdown. [To be sure, the Supreme Court and the private sector had big roles too in the slowdown].

Also, it follows the fashion of placing monetary policy at the heart of economic cycles. It is far less potent that it is made out to be and it works only under rather specific conditions. Else, it gives rise to excessive risky lending, asset bubbles and deprives savers of their income.

In India, with banks reluctant to lend and companies still saddled with debt in their balance sheets (check out the interest coverage ratio of Indian non-financial corporations), low rates flow to consumers.

In the last eight years, household debt growth has far outpaced nominal GDP growth:


The table above depicts percentage growth rates (not annualised) over two-year windows in India’s household debt (nominal and in rupees), based on BIS Quarterly data on non-financial credit.

Further, the compounded annual growth rate of credit card outstanding (one of the categories of personal loans) over the last four and quarter years has been 29.6%. This is available from Table 171 of RBI Handbook of Statistics on the Indian Economy. Data available up to July 2019 at the time of writing this and goes back to April 2007.

This is what happens when the commercial sector is constrained by its own balance sheet from borrowing further. Money flows to the easy but not necessarily the most ideal borrowing segment of the economy. Bankers’ risk aversion to lend to even eligible borrowers must be fixed. That requires not just recapitalising banks but an enabling environment that does not punish them for commercial decisions going wrong. These are in the realm of the government.

The government had been slow to recognise the problem of bad debts and even slower to find answers. This dates back to 2015. To blame the RBI alone for the economic slowdown is way off the mark.

The way the Goods and Services Tax had been implemented (may be, that is what was feasible in a federal and large polity like India) could not have but induced uncertainty among businesses. Insolvency and Bankruptcy code is a good and essential game-changer but it has had short-run consequences for economic growth.

The obsession over tax revenue growth was another major growth dampener. Relative to RBI, the government has been, by far, the biggest contributor to the economic growth slowdown.

Without accounting for these and fixing some that need to be fixed- which are in the realm of government, an uni-dimensional call for RBI to cut rates is not only wrong but also dangerous.

As I had mentioned in my column in Mint today (not my original idea – I am citing someone else), with RBI and the Government asking banks to link their lending rates to external benchmarks while rates on liabilities (deposits) are fixed, banks’ net interest margins will be substantially affected. If aggressive rate cuts are made, this problem will get far worse, making banks chase aggressive and riskier loans (they will carry a higher lending rate) and paving the way for a future cycle of non-performing assets.

Finally, to keep up the shrill attack on the central bank week after week, ignoring its record open market operations (pumping money into the economy) in the last one year which then enabled a record dividend payout from RBI to the government, with strong language (bordering on abuse) is an exercise in losing friends and turning people away.

The magazine too deserves to be reprimanded for its rather tasteless and wrong header.

Over-rated and fallible

While monetary policy is a powerful tool that works to support consumer spending, business investment, and public confidence, it cannot provide a settled rule book for international trade. Our challenge now is to do what monetary policy can do to sustain the expansion.

Remarks attributed to Jerome Powell, made at Jackson Hole Central Bank Symposium in August. This is my source. Monetary policy is not a powerful tool that helps any of the above. It is a limited tool that works under very specific circumstances. Experience has taught us that.

After so many years of egging on central banks to go negative, etc., Summers has found religion. He says central bankers are powerless. It is too late and he may well be abandoning a sinking ship. A tweet-storm or tweet thread on this is here (HT: Niranjan Rajadhyaksha). Tweets 18-24 under this thread are the important ones:

In contrast under the secular stagnation view we have outlined – what might be called “new old Keynesian” economics – interest rate cuts, even if feasible, may be at best only weakly effective at stimulating aggregate demand and at worst counterproductive.

There is the further point that reducing interest rates may degrade future economic performance for any of the following reasons.

First, financial instability. The financial crisis had roots in bubbles & excessive leverage caused by efforts to maintain demand after the 2001 recession. Japan’s late 1980s bubble had roots in a low interest rate tight fiscal environment after the 1987 stock market crash.

Second, risks of zombification of firms. Firms that do not face debt service payments are like students who do not have to take tests. They can drift along complacently & ultimately unsuccessfully. And low rates may contribute to increased monopoly power and reduced dynamism.

Third, risks of bank failures. Low rates crowd bank profits and franchise value, making them more vulnerable to adverse shocks at any given level of regulatory capital.

Fourth, risks of further reducing monetary policy effectiveness. To the extent to which rate cuts now “borrow” demand from the future as firms and consumers bring forward investment and durable purchases, low rates now may imply less effective monetary policy in the future.

The right issue for macroeconomists to be focused on is assuring adequate aggregate demand. We believe it is dangerous for central bankers to suggest that they have this challenge under control – or that with their current toolkit they will be able to get it under control.

I hope the last tweet is not the harbinger of more hare-brained approaches. Summers (and his friends in the academia in the United States who still swear by monetary policy effectiveness) would do well to reflect on this speech by Graeme Wheeler, former Governor of the Reserve Bank of New Zealand made in October 2015. It is not secular stagnation in aggregate demand. It is secular stagnation in trend growth. That is the nature of the game. The answer to the question of where inflation is, if trend growth is weak as well is that inflation is driven by wage dynamics. Labour has been stifled and its pricing power emaciated for last four decades. It has not come back. As long as that is the case, conventional inflation rate (CPI index change) is the wrong place to look for deficient or excess aggregate demand. That was the mistake pre-2008 and now post-2008 too.

Summers’ formal piece in ‘Project Syndicate’ is here.

Summers’ ‘revelations’ carry no trace of him having preached something very different all these years. Some acknowledgement of the errors of his past world view would be the intellectually honest thing to do. In fact, as recently as in June, he was urging the Federal Reserve cut rates aggressively.

In the meantime, four Governors of the Federal Reserve wrote a joint op.-ed., urging the American President to respect the independence of the Federal Reserve. Not quite directly but that was the intention. Their effort was undone by an op.ed., by William Dudley (a Goldman Sachs Alumni), former President of the Federal Reserve Bank of New York in which he urged the Federal Reserve not to offset the damage President Trump might be causing the American economy with his ongoing dispute with China and also to tweak policy to thwart his re-election chances! It is unclear as to whom he is batting for. It was clear whom he was batting against.

Best response to William Dudley came from Michael Lebowitz:

Dudley really has some nerve. The Fed, with Dudley’s help for ten years, lays tons of economic tinder for economic troubles and then he places blame on the potential spark (Trump). [Link]

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.