Financial markets are good at raising capital; they are also expert at destroying capital. This is now what is happening. The speed, intensity and breadth of the plunge in asset prices owes nothing to poor values, little to logic and everything to a fierce liquidity squeeze (inadvertently) originated by the central banks, (in their own words) the ‘inflation nutters’, some 18-24 months ago.
We have remarked before on how closely today’s de-leveraging resembles a typical ‘nineteenth century’ financial panic, characterised by overproduction of goods and fragile funding of lenders’ balance sheets. In terms of recent experience, it looks and feels like a wider version of the 1997/98 Asian Crisis. More liquidity is the solution; the liquidity squeeze that started in early 2006 was the problem. But are central banks doing enough?
De-leveraging is dangerously deflationary
How much further it has to go largely depends on the actions of central banks. We measure financial leverage as the ratio of total credit to cash: others tend to use the ratio of total assets to capital. This latter ratio would make sense if the monetary problem centred only on bad bank assets. The resolution, then, is in the gift of shareholders and finance ministries willing to invest public funds. Yet, we figure the key problem concerns more the fragile funding of bank liabilities and rather less asset quality. In this case, the ratio of credit to cash, the ultimate means of settlement, is critical. This ratio is controlled by central banks through their monetary operations.
History is replete with many examples of painful ‘de-leveragings’. Japan saw its financial leverage ratio collapse from around 14 times at its early 1990s peak to around 4 times today as credit demand and provision disappeared. The leverage ratio of UK banks stands at a staggering 50 times.
Crisis-hit Iceland, another country with a banking system bigger than its domestic currency, had a peak leverage ratio of 56.6 times. America’s ratio, recently, reached a high of around 25 times but has since fallen sharply over the past two months to below 20 times at the end of October 2008 (see Fig.1). This is a bare minimum, in our view, and equivalent to the ‘traditional’ cash ratio target of 5%, which proved sustainable during the long post WWII period when ‘trust’ in banks was widespread. Modern money is not gold; it is trust. Trust failed alongside the Lehman bankruptcy. Therefore, we suspect that the leverage ratio must fall further, but its drop is likely to be cushioned by continued central bank support. This is essential because of the sudden and possibly lasting disappearance of the unsecured loan market. This was the source of much of banks’ wholesale funding: with different speeds central banks are re-inventing themselves and stepping into the gap.
Perhaps the most important fact taken from October 2008 data is that net liquidity inflows are now rising?
Net liquidity adjusts for cash hoarding. This absorbed a lot of past liquidity injections but it is likely to have peaked, indicating an improving investor mood. End October 2008 US credit data show both a surge in new credit supply and a drop in institutional cash hoarding. These cash hoards, which swelled by US$1.3 trillion from July 2007 to August 2008, have since dropped by US$250 billion. This partly fuelled the near US$1 trillion jump in US net credit supply in September and October. On top, US lending leapt by US$180 billion in September and by a further US$500 billion in October.
Admittedly, the high October number largely reflects a massive drawdown of pre-arranged credit lines from banks, but the much-maligned shadow banks still managed to advance a further US$100 billion of new credit, largely through a pick-up in securitisation!
Rising liquidity will, ultimately, fuel a rebound in financial markets and an easing of credit tensions, as signalled by slimmer spreads between both private and public debts along the yield curve. On top, the close correlation between rising liquidity and a steepening interest rate yield curve is the clearest indication we know that the monetary ‘transmission mechanism’ is working. Past financial crises were unambiguously resolved by three policy responses:(1) massive liquidity injections; (2) a G7 yield curve slope of 200 bp minimum, and (3) at least 2-3 years running this policy mix.
Yet fears persist that the world economy faces a depression because the traditional monetary policy levers are broken. A quick review of what happened in Japan in the 1990s is worthwhile on two counts: (1) Japan did not strictly experience ‘proper’ deflation until the late 1990s, or almost a decade after the stock market bubble burst and (2) deflation was heralded by a preceding slowdown in monetary growth and, most importantly, in high-powered money growth. Specifically, Japanese central bank money leads credit and broad money supply by around 3-6 months, and these, in turn, lead consumer prices by around 18 months. Thus, the late 1990s price deflation reflected the mid 1990s monetary slowdown, which, in turn, is explained by the failure of central bank money to grow. Weak and inconsistent Japanese liquidity flow, in turn, explains why the Japanese yield curve remained inverted until 1992 and then, after steepening aggressively for 3-4 years, flattened decisively from 1996. Thus, Japan’s deflation, like America’s in the 1930s, was the result of a series of policy errors and was foreshadowed by weak and negative monetary growth.
To argue, as many do, that we are now paying the price for a past period of ‘too low’ interest rates is just plain wrong. They are muddling the low rate of interest with the low rate of profit. This is not a cyclical ‘savings glut/bad bank assets’ crisis as most investors assume, but a more fundamental ‘overproduction/fragile funding’ crisis. The essential economic problem has been low profitability not low interest rates, because positive supply-shocks hugely expanded output. Low (marginal) profitability has been forced upon us by the latest and third wave of Asian capital spending. After Japan in the 1980s; emerging Asia in the 1990s, it is now (after the brief interlude of the US tech boom) China’s turn to invest massively and then dump the excess product, so hitting global profits. These weak returns encouraged too many Western institutions to leverage up performance using credit provided by the banks and the rapacious shadow banks. The marginal funding for these lenders increasingly came from central banks via their money market activities, which, ironically, were part of the ‘solutions’ to past crises, such as LTCM, Y2K and 9/11.
Once policy-makers started to remove the punchbowl starting in 2006, credit markets began to implode. Central bankers then compounded their mistakes in not reacting swiftly enough to stop this de-leveraging. Policy-makers erred because they confused relative with absolute price changes; muddling commodity price inflation (relative price change) with general inflation.
An ‘overproduction/ fragile funding’ crisis is 180 degrees different from the consensus ‘savings glut/bad bank asset’ crisis in its time-path and in its implications. If excess Chinese savings were the issue why are they now accelerating into the US and driving up the dollar? If the problem was just bad bank assets why did Iceland and Northern Rock fail: they had few ‘bad’ assets? Surely, if the problem is funding, then all financial institutions are affected? Three important corollaries come out of this world view:
• Chimerica – Two economies will emerge from this overproduction crisis stronger: America and China
They are the future. Both are large economies that have the unilateral ability and the desire to create demand and fill productive capacity. Whereas 1990s’ Japan lacked a ‘young’ consumer base to offset the inevitable capex decline and emerging Asia was too small, China is able to bolster her long-run consumption and infrastructure spending radically. America has the benefit of a comparatively young population, and the current policy off-set of monetary inflation to erode real debt burdens. Near-term China is set for a hard landing. We’ve flippantly suggested thinking of a growth number for China in 2009 and halving it! China is an economy based around capex and exports, rather than consumer spending. The former depend more on growth and particularly on future weak global growth, whereas consumer spending depends more on the level of rising domestic income. But a Chinese hard landing, will provide the solution because policymakers will look to bolster the economy with infrastructural spending and incentives for the consumer.
• King Dollar
The US dollar will become the paramount currency, its dignity restored at least for now. We are not convinced that America has to monetise any more than other nations because this is a widespread funding crisis rather than a specific bad asset problem. China’s RMB will continue to link closely with the greenback. We believe that both the Euro and the Japanese Yen will have to slide if these predominantly capex-related, export economies are to have any hope of keeping pace with China and America. We hold to our medium-term prediction of US$1.20/€ and Y120/US$. We sometimes feel tempted even to make the former target US$1/€, given the slowness of the ECB’s monetary response in the face of Europe’s vast debt and potential bad loan problems.
• Monetary inflation
Look to buy risk and reflation trades over the coming months. The list includes commodities, equities, corporate debt and yield curve steepeners. Our data show that policy-makers, led by the Fed, are desperately trying to add liquidity to aid banks’ funding, bolster purchasing power and stimulate demand. Their success can be gauged from the gold price. Gold is a convenient barometer of monetary inflation and monetary deflation. A rising gold price is needed to convince us that central banks have done enough and monetary inflation has the upper hand. Thereafter, investor pessimism is so widespread that it may not take much for stock prices to rally significantly.
ABOUT THE AUTHOR
Michael Howell founded CrossBorder Capital in 1996 as a London-based independent research firm. Previously, he was Head of Research for Baring Securities and Research Director of Salomon Brothers, the US investment bank.