BIS chief fears fresh Lehman from worldwide debt surge
Jaime Caruana says investors are ignoring prospect of higher interest rates in
the hunt for returns
The world economy is just as vulnerable to a financial crisis as it was in
2007, with the added danger that debt ratios are now far higher and emerging
markets have been drawn into the fire as well, the Bank for International
Settlements has warned.
Jaime Caruana, head of the Swiss-based financial watchdog, said investors were
ignoring the risk of monetary tightening in their voracious hunt for yield.
“Markets seem to be considering only a very narrow spectrum of potential
outcomes. They have become convinced that monetary conditions will remain
easy for a very long time, and may be taking more assurance than central
banks wish to give,” he told The Telegraph.
Mr Caruana said the international system is in many ways more fragile than it
was in the build-up to the Lehman crisis. Debt ratios in the developed
economies have risen by 20 percentage points to 275pc of GDP since then.
Credit spreads have fallen to to wafer-thin levels. Companies are borrowing
heavily to buy back their own shares. The BIS said 40pc of syndicated loans
are to sub-investment grade borrowers, a higher ratio than in 2007, with
ever fewer protection covenants for creditors.
40pc of syndicated loans are to sub-investment grade borrowers
The disturbing twist in this cycle is that China, Brazil, Turkey and other
emerging economies have succumbed to private credit booms of their own,
partly as a spill-over from quantitative easing in the West.
Their debt ratios have risen 20 percentage points as well, to 175pc. Average
borrowing rates for five-years is 1pc in real terms. This is extemely low,
and could reverse suddenly. “We are watching this closely. If we were
concerned by excessive leverage in 2007, we cannot be more relaxed today,”
he said.
“It may be the case that the debt is better distributed because some
highly-indebted countries have deleveraged, like the private sector in the
US or Spain, and banks are better capitalized. But there is also now more
sensitivity to interest rate movements."
The BIS warned it is annual report two weeks ago that equity markets had
become "euphoric". Volatility has dropped to an historic low.
European equities have risen 15pc in a year despite near zero growth and a
3pc fall in expected earnings. The cyclically-adjusted price earnings ratio
of the S&P 500 index in the US reached 25 in May, six points above its
half-century average. The Tobin's Q measure is far more stretched than in
2007.
Volatility has dropped to an historic low
“Overall, it is hard to avoid the sense of a puzzling disconnect between the
markets’ buoyancy and underlying economic developments globally,” it said.
Mr Caruana declined to be drawn on when the bubble will burst. "As Keynes
said, markets can stay irrational longer than you can stay solvent,” he
said.
The BIS says prolonged monetary stimulus in the US, Europe, and Japan has led
to a leakage of liquidity, contaminating the rest of the world. The rising
powers of Asia are no longer able to act as a firebreak – as they did after
the Lehman crash –and may themselves now be a source of risk.
Tobin's Q shows the difference between an equity's market value and
the cost to replace the firm's assets.
Emerging markets have racked up $2 trillion in foreign currency debt since
2008. They are a much larger animal than they were during the East Asia
crisis of the late 1990s, so any crisis would do more damage. “The
ramifications would be particularly serious if China, home to an outsize
financial boom, were to falter," it said.
The BIS is the doyen of world’s financial institutions, created in Basel in
1930 to clean up the mess left by German reparations payments under the
Versailles Treaty. It has since evolved into the bank of central banks, and
lately the bastion of monetary orthodoxy. It issued a crescendo of warnings
in the build-up to the Lehman crisis, implicitly rebuking the US Federal
Reserve and others for holding interest rates too low, which in their view
robs economic growth from the future.
The BIS was vindicated, though not everybody agrees that it was right for the
right reasons. Monetarists argue that the Great Recession was due to
over-tightening into the downturn. This caused M3 broad money growth to
collapse months before the banking crisis.
The BIS backed QE as an emergency measure in early 2009 to avert a
deflationary spiral but has long since called for a return to sound money,
and even rate rises. "The predominant risk is that central banks will
find themselves behind the curve, exiting too late or too slowly," it
said.
This has earned BIS a reputation for Austrian School ideology , accused of
encouraging crude liquidation. The bank denies this, tracing the bank’s
doctrines to the pre-Keynesian Swedish economist Knut Wicksell.
Wicksell posited a “natural rate of interest”. Holding rates too low creates a
host of problems. While his model looks like the modern “Taylor Rule” used
by the Fed and other central banks, it is different in crucial respects.
Confident in its cause, the BIS more or less indicts the central bank
establishment of malpractice. "Policy does not lean against the booms
but eases aggressively and persistently during busts. This induces a
downward bias in interest rates and an upward bias in debt levels, which in
turn makes it hard to raise rates without damaging the economy – a debt trap."
"Systemic financial crises do not become less frequent or intense,
private and public debts continue to grow, the economy fails to climb onto a
stronger sustainable path, and monetary and fiscal policies run out of
ammunition. Over time, policies lose their effectiveness and may end up
fostering the very conditions they seek to prevent," it said.
Basel's lonely call for discipline pits it against the Fed, the Bank of Japan,
the Bank of England, and even Frankfurt these days. It prompted an unusually
piquant riposte from London earlier this month. "Has monetary policy
aided and abetted risk-taking? I hope so. That's why we did it," said
the Bank of England’s chief economist Andy Haldane.'
"It is good to have the debate,” said Mr Caruana gamely. Yet he refuses
to back down. “There is something strange about fighting debt by
incentivizing more debt."
He is now skirmishing on a fresh front, questioning the Fed's new enthusiasm
for macro-prudential curbs as a first line of defence. "On their own
there is little evidence that they can constrain financial imbalances. We
don’t think macro-pro can serve as a substitute," he said.
Mr Caruana said the US recovery is not a vindication of monetary stimulus, but
evidence that the best answer to "balance sheet recessions" is to
clear away the dead wood and unlock resources for new technologies. “The
Americans were quite aggressive in forcing recognition of losses and there
was a very rapid recapitalisation of the banks. This is why it was
successful. The role of quantitative easing is an open question.”
Mr Caruana dismisses the global deflation scare as alarmist, even though
Sweden's Riksbank has just abandoned his camp and slashed rates to near zero
to avert a Japanase-style trap. Deflation is very unlikely to happen in the
West, he insists. Gently falling prices are typically benign in any case. "We
should not exaggerate the role of deflation in history," he said.
The Great Depression is the exception, not the rule. Welfare systems and
unemployment insurance now make such an outcome almost impossible. "In
the 1930s the stabilizers were very different," he said.
Critics are unlikely to accept this assurance since Spain, Greece, Portugal,
Ireland, and Latvia have all gone through depressions over the last six
years, and Italy, France and Holland are all close to debt-deflation. The
concern is what would now happen to parts of Europe if there were a fresh
downturn or an external shock. Debt ratios are higher than they were in the
19th Century. The "denominator effect" of deflation is therefore
more destructive today.
The International Monetary Fund has hinted that it might be best for the world
to chip away its debt mountain with a few years of inflation, as the US did
in late 1940s and early 1950s, armed with financial repression.
Asked whether he would support this form of loss recognition for creditors, Mr
Caruana came close to choking. “It must be clearly resisted,” he said.
Amid
all the talk of recovery by politicians, economic officials and big
business leaders, the fundamental numbers behind all the propaganda tell
a starkly different story.
