Transcript Are We Sowing the Seeds of the Next Financial Crisis

Dr Robert Gay
Fenwick Advisers
November 2013
….risk that originates within, or spreads through, the financial sector (e.g., due
to insufficient solvency or liquidity buffers in financial institutions), with the
potential for severe adverse effects on financial intermediation and real output.
The objective of macroprudential policy is, therefore, to limit system-wide
financial risk (IMF, 2011a) by enabling policymakers to know better when to sound
the alarm and implement policy responses.
from IMF Working Paper 13/168 “Systemic Risk Monitoring Toolkit—A User Guide”, July 2013
Are financial crises unavoidable?
Are (well-intentioned) policies aimed at mitigating past financial crises merely
setting the stage for the next one?
Can regulators and central banks limit the downside of the next crisis?
What can investors do to protect portfolios and outperform in crises?
2
I.
Buildup phase

Asset price bubbles are a signal that something is running
amok.
II.
Warning signs

Follow the hidden risks – shadow banking, subsidies, debtors
and unsustainable policies
III.
Crises, contagion and policy responses

Fighting the last war?
3
1.


2.


3.


4.

SIFIs (bank and nonbank) and trading platforms
Maturity and FX mismatches
Credit transformation
Shadow banking
Same bank risks without public backstops or oversight
Systemic because of links to other financial institutions
Asset Values
Risks builds in environments of low volatility and easy credit.
Abrupt reversals transmit losses to the financial system.
Real economy
Transmission mechanism - excessive leverage.
Source: “Financial Stability Monitoring”, presentation by Tobias Adrian, Daniel Covitz and Nellie Liang of the
Federal Reserve, September 2013.
4

Basel III – capital adequacy, liquidity ratios, leverage ratios – will
create safer buffers and will force deleveraging by global banks.

“Too big to fail” – crisis resolution procedures for SIFIs, bail-ins and
stress tests

Regulatory oversight – exchange-traded derivatives, spread of ‘best
practices’

Central banks - financial stability monitoring, expanded swap
agreements (esp. RMB), ECB supervisory authority over SIFIs and
monetary union.
Key question: Are we mistakenly attributing the global financial crisis
to flaws inherent in the monetary system rather than to identifiable
and correctable policy errors?
5

Rising costs of new regulations incentivize banks to move activity
off balance sheets and into shadow banking sectors.

Advances in trading technology and complexities of regulations are
pushing transactions onto private trading platforms (40% of US and
UK equity trades are off-exchanges).

Financial nationalism is on the rise, especially ring-fencing of the
cash and capital of global banks during crises.
Conclusion: Tighter regulation of global banks focuses on crisis
resolution and deleveraging but is not likely to preclude the
buildup of new financial market risks.
6
“Central banks need to step up their game in getting their arms
around shadow banking.”
George Osborne, Chancellor of UK Exchequer, 2013
“The more troublesome the times, the worse does a laissez-faire
system work.”
John Maynard Keynes, 1923
Do central banks lack authority or is shadow banking an inevitable
byproduct of rising costs of regulation?
7
Outstanding Debt of Euro Area Financial
Institutions (% of GDP)
Credit Market Debt Outstanding of U.S.
Financial Sector
250%
200%
150%
100%
50%
0%
Sources: Federal Reserve Flow of Funds, ECB
8
Monitoring Shadow Banking:
Financial Sector Liabilities
Sources: Federal Reserve Flow of Funds, Note: Bank Holding Company liabilities include the liabilities of Broker Dealers.
9
Root causes
 Paucity of outlets for Asia’s savings glut
 Rising wealth/income inequality
 Government subsidies, especially for property, and regulatory
loopholes (often are sources of the most pernicious bubbles)
 Fraud
Are QE policies and EU bailouts merely postponing sovereign debt crises?
Are Western central banks willing and able to prick asset price bubbles?
Will China internationalize the RMB fast enough to recycle its saving glut?
10

A deleveraging cycle is deflationary.

Deleveraging favors creditor nations and their currencies. Debtors
are vulnerable.

The winners will be those who control their debt and improve
competitiveness.

Deleveraging and income inequality reduce potential economic
growth.
Key Issue: Do asset price bubbles amidst deflation and deleveraging
pose an inescapable conundrum for central banks, especially
those of debtor countries?
11
“If confirmed by the Senate, I pledge to do my utmost to keep the trust and meet the
great responsibilities that Congress has entrusted to the Federal Reserve — to
promote maximum employment, stable prices and a strong and stable financial
system.”
Janet Yellen, Vice Chair and nominee for Chair of Federal Reserve, highlighting the Fed’s ‘third
mandate’ of assuring the safety and soundness of the financial system.
“I must confess to a sense of discomfort on whether the current dominant view on
‘one target, one instrument’ will survive the test of time…”
Former Governor Jalan of the Reserve Bank of India in 2003 as quoted in The Rise of the People’s
Bank of China, Stephen Bell and Hui Feng, 2013.
Western Central banks may be forced to reconsider administrative tools to contain
shadow banking and asset bubbles, especially with respect to property lending.
12
In times of peace,
prepare for war.
Variation of Roman motto “Si vis pacem, para bellum” from 4th century BC.
Often misattributed to Chinese military strategist Sun Tzu.
13

Shadow banking
 “…it is everywhere…” – senior global banker

Asset price bubbles
 Key signal – but are they the root cause of crises?

Suspended disbelief in a burgeoning credit event
 E.g. US default on GSE preferred shares in 2008

Central bank policies
 Are unsustainable policies sowing the seeds of the next crisis?
14
Potential growth is slowing almost everywhere.
1.



US 2%; EU 1%; UK 1%; Japan 0.6%; China 5%
Key warning signs: real interest rate (r) > potential growth (g)
Relative productivity performance
In a still-leveraged world, debtors and their currencies are most vulnerable to
external crises.
2.

Key warning signs: net foreign liabilities(NFL) > 50% of GDP, abrupt changes in NFL/GDP
and significant changes in current account balances (see IMF WP13/113 External Debt
and Crises). Also NFL of the banking sector/international reserves.
Property markets and their financing
3.

Key warning signs: Excessive credit growth for > 5 years
Sovereign debt crises
4.

Warning signs: Net debt > 150% of GDP and primary budget deficit
15
Source: Stratton Street Capital LLP calculations (2011) and extended version of the External Wealth of Nations Mark II database developed by
Lane and Milesi-Ferretti.
16
Fed procrastination in exiting unsustainable asset purchases
1.


UST purchases ($45bn/month > new issuance in 2014)
Lingering misperceptions about future rate hikes (2015?) and the
neutral fed funds rate (= 2% to 2.5%?)
Disappearance of US current account deficit and the coming
shortage of US dollars (now 85% of trade transactions, 62% of
international reserves)
2.


Cheap energy exports and reindustrialization are transforming the
world’s largest deficit.
Emerging world will shift to RMB for trade transactions (now 8th most
used currency)
17
U.S. Output Gap and Inflation
6%
4%
4%
2%
2%
0%
0%
-2%
-2%
-4%
-4%
-6%
-8%
-6%
Dec 1981 Dec 1984 Dec 1987 Dec 1990 Dec 1993 Dec 1996 Dec 1999 Dec 2002 Dec 2005 Dec 2008 Dec 2011
Core Inflation (lhs)
Proj Core Inflation High (lhs)
Proj Core Inflation Low (lhs)
Proj Output Gap High (rhs)
Output Gap (rhs)
Proj Output Gap Low (rhs)
18
Fed Funds Effective Rate
10
8
6
4
2
0
Actual
High Projection
Sources: Federal Reserve and Fenwick Advisers’ model estimates.
Jan 16
Jan 14
Jan 12
Jan 10
Jan 08
Jan 06
Jan 04
Jan 02
Jan 00
Jan 98
Jan 96
Jan 94
Jan 92
Jan 90
Jan 88
Jan 86
-2
Low Projection
19
US nominal GDP (% yoy)
Mar 13
Mar 12
Mar 11
Mar 10
Mar 09
Mar 08
Mar 07
Mar 06
Mar 05
Mar 04
Mar 03
Mar 02
Mar 01
Mar 00
Mar 99
Mar 98
Mar 97
Mar 96
Mar 95
Mar 94
Mar 93
Mar 92
Mar 91
Mar 90
Mar 89
Mar 88
Mar 87
Mar 86
Mar 85
Mar 84
Mar 83
Mar 82
Mar 81
Mar 80
18
16
14
12
10
8
6
4
2
0
-2
-4
US 10-yr bond yield (%)
20
Sources: US Bureau of Economic Analysis and Fenwick Advisers

Deficits are fast shrinking and growth
will strengthen thanks to oil and
reindustrialization.

USD is cheap against major
currencies.

Fed’s exit from QE will be
asynchronous with ECB, BOJ,BOE.

Stronger growth and tighter
monetary policy will mean…

… USD will strengthen against
western currencies taking Asians
with it.
21
1.
PBoC’s sterilization of capital inflows is unsustainable. (Has sterilization
reached a tipping point that now jeopardizes monetary control?)
2.
Internationalization of RMB has become inevitable. (Will it come too late?)
3.
Local government debt, creation of bad banks (Will China ‘socialize’ bad
loans?)
4.
Overinvestment, overcapacity in steel, cement, aluminum, glass,
shipbuilding, solar panels (Will excess capacity be closed down?)
5.
Negative real deposit rates (Will PBoC end financial repression?)
6.
Inflation (Is the economy already operating above potential?)
7.
Experiment with Shanghai Free Trade Zone (Is this the first step toward
yuan convertibility and a relief valve for capital flight?)
22
A monetary authority of a country with an open trading regime can
achieve only 2 of the following 3 basic macroeconomic objectives:
1.
2.
3.
A fixed exchange rate
Control of domestic interest rates (or monetary aggregates)
Open cross-border capital flows
Any two of these conditions ultimately will dictate the third.
23
Capital Flows (in billions of US$)
600
Money Growth and Inflation
30
Growth In M2 (%)
500
Inflation (%)
25
400
300
20
200
15
100
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
-100
1998
0
10
5
-200
0
-300
2003
Trade surplus ($bn)
FDI ($ bn)
2005
2007
2009
2011
2013
Hot money'
Soaring capital inflows has forced the PBoC to intervene by raising reserve requirements on bank
deposits to sell PBoC bonds to absorb excess liquidity. Nonetheless, M2 now > 200% of GDP and
rapid real money growth is no longer sustainable.
Sources: Peoples Bank of China, Federal Reserve, Trading Economics
24
People’s Bank of China
Assets
Federal Reserve
Liabilities
Assets
Liabilities
(in trillions of US$)
Total
of which:
$5.0
Total
$5.0
Intl. reserves $4.1
Deposit $3.0
reserves
Non-gold
reserves
PBoC
bonds
$3.66
(in trillions of US$)
Total
of which:
$0.7
$3.8
Total
$2.1
Reserve $2.4
balances
Mortgages $1.5
FRB notes $1.5
UST
$3.8
Currency $1.0
Cost of PBoC sterilization = interest on deposit reserves and PBoC bonds LESS return on intl. reserves
= 3.6% ($3.0 + $0.7tr) - 1.5% ($3.66tr) = $78 billion (1% of GDP)
The cost of sterilization and waste in lending are beginning to outweigh the benefits of stabilizing
the RMB.
Sources: People’s Bank of China, Federal Reserve, Fenwick Advisers estimates.
25
Chinese economy already is
operating above potential.

Interbank Market Rates (%)
Inflation is rising (CPI 3.1%; food
6.1%; core 1.7%).

Cost-push inflation is stubborn and
resistant to monetary restraint.

Property price bubble compounds
cost problems.

PBoC has been forced to resume purchases of foreign currency inflows
(US$21b in September).


PBoC is leaning against inflation with higher market rates (see chart).

Cost of sterilization is rising and unsustainable.
26
Liberalizing lending and deposit rates are key to keeping savings at home
12
10
8
6
4
2
0
-2
-4
-6
1997
1998
1999
2000
2001
2002
2003
2004
Prime lending rate
2005
2006
Deposit rate
2007
2008
2009
2010
2011
2012
2013
Real deposit rate
27
Yen (then) and RMB (now)
28
1.
Australia’s vulnerabilities:

58% - net foreign liabilities (%GDP)

A$200/hr – high cost producers of commodities

85% - proportion of mortgages with floating rates
2.





3.
Risks
Balance sheets of resource companies
Bank lending mismatches
US energy exports
Steeper yield curve
Protracted QE
Remedies

Lower A$, administrative restrictions/tighter standards on property
lending, full-employment budget, flat sovereign yield curve
29
What is unlikely to protect portfolios in crises?

CDS (contemporaneous)

Shorting bank stocks (stress tests will identify weak banks)

Cash (ring-fencing may preclude deploying it)

Liquid assets including large cap equities (there are no remedies for
forced selling)
30
Hypothetical Portfolio Allocations
Core holdings (40% to 70%)
Tactical (10% to 30%)
Opportunistic (0 to 20%)
Tail hedge (5 to 20%)
31
1.
Know the underlying risks in portfolio (credit, liquidity,
covariance, volatility, concentration, etc)
2.
Maintain a defensive or hedge position that mirrors your
portfolio risk yet can withstand the worst consequences of a
financial crisis. In today’s context, that hedge position should
focus on creditors, not debtors.
3.
Scale the defensive position according to your macro assessment
of the likelihood of a systemic risk event in the near future.
32
This document is for information only and does not constitute an offer
or recommendation to buy or sell any investment, or subscribe to any
investment management or advisory service. Past performance is not
necessarily a guide to the future. Whilst all reasonable care has been
taken to ensure that the stated facts are accurate and opinions are fair
and reasonable neither Fenwick Adviser LLC nor any of its partners or
employees shall be responsible in any way for the contents of this
document. It is not, under any circumstances, intended for distribution
to the general public.
33