At $3.2Tn, US Treasury (UST) net issuance YTD (end of June) is running at more than 3x the whole of 2019 and is more than 2x the largest annual UST issuance ever (2010). At $1.4Tn, US corporate bond issuance YTD is double the equivalent last year, and at this pace would easily surpass the largest annual issuance in 2017. According to Renaissance Capital, US IPO proceeds YTD are running at about 25% below last yearâs equivalent. But taking into consideration share buybacks, which despite a decent Q1, are expected to fall by 90% going forward, according to Bank of America, net IPOs are still going to be negative this year but much less than in previous years.
Net issuance of financial assets this year is thus likely to reach record levels but so is net liquidity creation by the Fed. The two go together, hand by hand, it is almost as if, one is not possible without the other. In addition, the above trend of positive Fixed Income (FI) issuance (both rates and credit) and negative equity issuance has been a feature since the early 1980s.
For example, cumulative US equity issuance since 1946 is a ($0.5)Tn. Compare this to total liquidity added as well as issuance in USTs and corporate bonds.*
The equity issuance above includes also financial and foreign ADRs. If you strip these two out, the cumulative non-financial US equity issuance is a staggering ($7.4)Tn!
And all of this happened after 1982. Can you guess why? SEC Rule 10b-18 providing âsafe harborâ for share buybacks. No net buybacks before that rule, lots of buybacks after-> share count massively down. Cumulative non-financial US equity issuance peaked in 1983 and collapsed after. Here is chart for 1946-1983.
Equity issuance still lower than debt issuance but nothing like what happened after SEC Rule10B-18, 1984-2019.
Buybacks have had an enormous effect on US equity prices on an index basis. It’s not as if all other factors (fundamentals et all) don’t matter, but when the supply of a financial asset massively decreases while the demand (overall liquidity – first chart) massively increases, the price of an asset will go up regardless of what anyone thinks ‘fundamentals’ might be. People will create a narrative to justify that price increase ex post. The only objective data is demand/supply balance.
*Liquidity is measured as Shadow Banking + Traditional Banking Deposits. Issuance does not include other debt instruments (loans, mortgages) + miscellaneous financial assets. Source: Z1 Flow of Funds
Fed is now probably considering which is worse: a UST flash crash or a risky asset flash crash. Or both if they play their hand wrong.
Looking at the dynamics of the changes in the weekly Fed balance sheet, latest one released last night, a few things spring up which are concerning.
1.The rise in repos for a second week in a row – a very similar development to the March rise in repos (when UST10yr flashed crashed). The Fed’s buying of Treasuries is not enough to cope with the supply hitting the market, which means the private sector needs to pitch in more and more in the buying of USTs (which leads to repos up).
This also ties up with the extraordinarily rise in TGA (US Treasury stock-piling cash). But the build-up there to $1.4Tn is massive: US Treasury has almost double the cash it had planned to have as end of June! Bottom line is that the Fed/UST are ‘worried’ about the proper functioning of the UST market. Next week’s FOMC meeting is super important to gauge Fed’s sensitivity to this development
2.Net-net liquidity has been drained out of the system in the last two weeks despite the massive rise in the Fed balance sheet (because of the bigger rise in TGA). It is strange the Fed did not add to the CP facility this week and bought only $1Bn of corporate bonds ($33Bn the week before, the bulk of the purchases) – why?
Fed’s balance sheet has gone up by $3tn since the beginning of the Covid crisis, but only about half of that has gone in the banking system to improve liquidity. The other half has gone straight to the US Treasury, in its TGA account. That 50% liquidity drain was very similar throughout the Fed’s liquidity injection between Sept’19-Dec’19. And it was very much unlike QE 1,2,3, in which almost 90% of Fed liquidity went into the banking system. See here. Â Very different dynamics.
Bottom line is that the market is ‘mis-pricing’ equity risk, just like it did at the end of 2019, because it assumes the Fed is creating more liquidity than in practice, and in fact, financial conditions may already be tightening. This is independent of developments affecting equities on the back of the Covid crisis. But on top of that, the market is also mis-pricing UST risk because the internals of the UST market are deteriorating. This is on the back of all the supply hitting the market as a result of the Treasury programs for Covid assistance.
The US private sector is too busy buying risky assets at the expense of UST. Fed might think about addressing that ‘imbalance’ unless it wants to see another flash crash in UST. So, are we facing a flash crash in either risky assets or UST?
Ironically, but logically, the precariousness of the UST market should have a higher weight in the decision-making progress of the Fed/US Treasury than risky markets, especially as the latter are trading at ATH. The Fed can ‘afford’ a stumble/tumble in risky assets just to get through the supply in UST that is about to hit the market and before the US elections to please the Treasury. Simple game theory suggest they should actually âencourageâ an equity market correction, here and now. Perhaps that is why they did not buy any CP/credit this week?
The Fed is on a treadmill and the speed button has been ratcheted higher and higher, so the Fed cannot keep up. It’s a dilemma (UST supply vs risky assets) which they cannot easily resolve because now they are buying both. They could YCC but then they are risking the USD if foreigners decide to bail out of US assets. So, it becomes a trilemma. But that is another story.
Households have massively deleveraged: sold about $1Tn of US equities and bought about $2Tn of USTs. The have also marginally divested from corporate bonds.
Banks have deleveraged as well: bought about $0.5Tn of UST while
selling about the same amount of equities. The have also marginally divested
from corporate bonds.
Insurance companies have put on risk: bought about $1Tn of
corporate bonds and small amounts of both equities and USTs.
Mix bag for pension funds with a slight deleveraging: bought $0.5Tn
of corporate bonds but sold about $1Tn of equities. But also bought $1.5Tn of
USTs.
Mutual funds have put on risk: bought about $1Tn of corporate
bonds and small amount of equities. Also bought more than $1.5Tn USTs.
Finally, foreigners have also put on risk: bought $1Tn of
corporate bonds, $0.5Tn of equities and $4Tn of USTs.
Overall, the most (disproportionate) flows went into USTs, followed by US
corporates. Demand for equities was actually negative from real money.
What about supply?
Issuance of USTs was naturally the dominant flow followed by US corporates and US equities.
On the US equities side, however, there is a very clear distinction between US non-financial corporate issuance, which is net negative (i.e. corporates bought back shares) and US financial and US corporate issuance abroad, which is net positive. In other words, the non-corporate buybacks (more than $4Tn) were offset by the financial sector (ETF) and âADRsâ issuance.
The opposite is happening on the corporate supply side. Non-financial corporates have done the majority of the issuance while the financial sector has deleveraged (reduced debt liabilities).
In other words, non-financial corporates have bought back their shares at the expense of issuing debt, while the financial sector (ETFs) has issued equities and reduced their overall indebtedness.
No wonder, then that financial sector shares have underperformed the overall
market since 2009.
Putting the demand and supply side together this is how the charts look.
On the equities side, the buying comes mostly from ETFs (in âOthersâ – that is basically a ‘wash’ from the issuance) and foreigners. The biggest sellers of equities are households and pension funds. The rest of the players, more or less cancel each other out.
So, households and pension funds, âsold’ to ETFs and foreigners.
On the corporate bonds side, the main buyers were foreigners, mutual funds
and insurance companies. Pension funds also bought. The main seller were the
banks. âOthersâ (close end funds etc.) and households also sold a small amount.
So, here it looks like foreigners, mutual funds and insurance companies âboughtâ
mostly at new issue or from the banks.
Finally, on the USTs side, everybody was a buyer. But the biggest
buyer by large were foreigners. Mutual funds, pension funds, the Fed and
households came, more or less, in equal amount, second. And then banks, âOthersâ
and insurance companies.
Kind of in a similar way, everyone here âboughtâ at new issue.
Conclusion
Itâs all about demand and supply.
In equities, real money has been a net seller in general, while the biggest buyer has been non-financial corporates themselves in the process of share buybacks. The financial sector has been a net issuer of equity thus its under-performance to the non-financial corporate sector. Equity real money flow is skewed mostly on the sell side.
Real money flow in corporate bonds is more balanced, but with a net
buying bias.
USTs real money flow is skewed completely on the buy side.
Overall, since 2008 real money has sold equities, bought a bit of corporate
bonds and bought a lot of UST: it does not seem at all that real money
embraced the bullish stance which has prevailed in the markets since March 2009.
*Data is from end of Q4â08 till Q4â18, Source for all data is Fed Z1 Flow of Funds
Why do smart people do obviously âirrationalâ things? It must be the
incentive structure, so for them they do not seem irrational. So, I am wrecking
my brain over Chinaâs decision to issue EUR-denominated bonds (and a few weeks
ago USD-denominated ones), in light of its goal of CNY and CGBs
internationalization, 40-50bps over the CGB curve (swapped in EUR).
The rationale China is putting forward is that enables it to diversify its investor
base on the back of the trade tensions! Seriously? Do they really mean that or
are they getting a really bad advice? Wasnât the intention to actually go the
other way as a result of the trade war? Didnât China want to be become more
self-reliant? In any case, China does not need foreign currency funding given
its large, positive NIIP. China has the opposite problem. It has too much idle
domestic savings and not enough domestic financial assets. This, among other
things, creates a huge incentive for capital flight which, despite its closed
capital account, China is desperately trying to prevent.
In that sense, China does need foreign investor but to
invest in CGBs (and other local, CNY-denominated bonds) to act as a buffer to
the potential domestic capital outflow as the capital accounts gates slowly
open up. It is for this reason that BBGAI and JPM have started including CGBs
into their indices this year.
It is for this reason SAFE decided to scrap the quota restrictions on both QFII and RQFII in
September. It is for this reason that Euroclear signed a memorandum of understanding
with the China Central Depository & Clearing to provide cross-border
services to further support the evolution of CIBM. That opens up the path for
Chinese bonds to be used as collateral in international markets (eventually to
become euro-clearable), even as part of banksâ HQLA.
All these efforts
are done to make access to the local fixed income market easier for foreign
investors. And now, what does China do after? Ahh, you donât need to go through
all this, here is a China government bond in EUR, 50bps cheaper (than if you go
through the hassle of opening a Bond Connect account and hedging your CNY back
in EUR).
This not
only goes against Chinaâs own goals regarding financial market liberalization but
also against the recent trend of other (EM) markets preferring to issue in domestic
currency than in hard currency. And while other EMs may not have had the choice
to issue in hard currency from time to time, China does. And while the investor
base for other EMs between the domestic and the hard currency market is indeed
different, and the markets are very distinctive, China does not have much of an
international investor base. Issuing in the hard currency market may indeed âcrowd
outâ the domestic market. Especially when you come offering gifts of 50bps in a
negative interest rate environment.
Credit impacts the real economy in a different way depending
on whether it is to households or to corporates (see Atif Mianâs work, also his
interview here).
Very generally speaking, credit to households affects the economy directly
through the demand-side channel, while credit to corporates â through the
supply-side channel directly, and only then, potentially, indirectly through
the demand-side channel.
Household debt to GDP was flat for two decades between mid-1960s and mid-1980s; and then it doubled; corporate debt for GDP, on the hand, was flat also for two decades after the S&L crisis, and even now it is only a few per cents higher. But the demand-side reduction from the household debt channel post 2008 is rather unique.
Given that the US was running a negative output gap for most of the period post 2008 (and it might still do, even though official estimate is for a small positive), it was the demand-side that needed some catching up to. Instead, the opposite was essentially happening: credit to households was decreasing relative to credit to corporates. As far as credit was concerned, it was primarily the supply side that was getting stimulated (of course, the question is how much stimulus was really created given that a lot of the corporate debt went to share buybacks).
The other theory, one to which I subscribe, is that the modern economy is essentially always experiencing a demand gap. When real wages stopped growing in the 1990s, post the the financial liberalization of the 1980s, household credit experienced a massive run-up. The demand gap left from the stagnation in real incomes was filled with household debt. Until the sudden stop in 2008.
Household debt to GDP did not grow between 1960s-1980s but real household income did, so there was no demand gap either. Post 2008, though, neither of these two options were available which left the US economy in a demand insufficiency. The ‘stimulus’ provided was mostly through the supply side with very little follow through into the demand side which meant lackluster economic growth.
The bottom line is that the type of credit creation matters.
The central bank affects directly only the supply of credit (and in some cases,
even less so) thus, it has limited ability (none?) to decide on whether credit
goes to firms or households. We may get a lot more from lower interest rates if
policy makers start thinking more holistically about the whole process of
credit creation. Banks do not care where credit goes
(why should they?) as long as they get their money back.
But with overall debt in the economy climbing higher and higher, it is essential to think how we can get the most out of it. And if the market can’t do that (it can’t), someone else should step in.
All this does not mean that US households should get even more indebted! On the contrary, the decline in household debt to GDP is good news only if it were also followed by a similar rise in real household income. And it the private market can’t do that either (it seems, it can’t), then we need to rely on the official sector to take on that burden.
Really interesting the divergence of monetary policy in Norway and Canada, and now possibly, Sweden with the rest of the DM/EM world in the last 12 months*. While pretty much every other central bank in the world has turned dovish, Norges hiked four times since September last year, while Bank of Canada has hiked 5 times since mid 2017. And last week, against all odds and expectations, Riskbank also surprised by pretty much guaranteeing a hike at its December meeting. It’s questionable whether hikes in either country was/is warranted looking strictly at economic activity.
Despite a spike in core inflation in early 2019, something which Norges had actually expected to be temporary, inflation is back below 2%. Both Canada’s and Sweden’s inflation spiked up in mid 2018 and have recently retreated back below 2%. Growth in all three counties has actually been more elevated than in neighboring Europe or US but growth was never the reason their respective central banks cut rates before, so it does not seem to be the reason they are now hiking. In fact, looking at weakening domestic demand and rising unemployment rates in Sweden, there are probably more reasons to cut than hike now.
So why are they hawkish? One theory is that the central banks are worried about rising household leverage with private debt to GDP in each close to the highest in the world. The thing is, other countries in a similar situation have chosen to go the opposite way. Australia, New Zealand, Korea, which also have high household debt ratios, tried to be ‘hawkish’ but have been aggressively cutting over the last 12 months on the back of slowing global demand.
The problem with hiking rates when over-indebtedness is high is that you are âinvitingâ financial instability and when that is one of your mandates, it is probably not such a wise choice. Is that why the Riskbank has said it would hike only once and stop at 0%?
Another theory is that the Riskbank is
preparing to introduce the e-krona and does not want to be dealing with the arb
of negative rates. I find that a poor excuse to hike as well.
And finally, some people are looking for a symbolic meaning of Sweden going back to 0% after being the first modern central bank to go below, 10 years ago. I don’t know. My guess is that it is more likely to be part of the experimentation process, but that ultimately it would turn out to be too early not to be a policy mistake.
*In Israel, the UK and the Czech Republic the last interest rate moves were a hike. However, Israel hiked only once, in November last year (from 0%) and with inflation at 0.5% and below the target range of 1-3%, the central banks has removed any prospect for a further rate increase and confirmed inflation is in a downward trend. UK is a special case of Brexit and deserves a post on its own. The Czech Republic, I have to admit, is a proper outlier here with both growth and inflation bucking all trends in Europe and, therefore, also deserves its own blog post.
When speaking to investors, the two most common questions I get asked, given rather extreme levels and valuations of (most) asset classes, are:
1.Should my
asset allocation change dramatically going forward? and
2.What is
the best risk diversifier for my portfolio?
I have previously
opined on this here.
Very broadly speaking, on the equity portion, one should reduce exposure to US
equities and increase allocation to EM equities (unhedged). On the fixed income
side, one should move completely out of the long end of UST and put everything into
T-Bills to 2yr UST; exposure to EU-denominated sovereigns should also be reduced
to zero at the expense of EM local (unhedged) and hard currency bonds. In the
normally âOthersâ section of the portfolio, one should include soft commodities
(or alternatively, scale everything down to make space for them). Finally, in
terms of FX exposure, apart from EM currencies through the unhedged portions of
the bonds and equities allocations, one should hedge the USD exposure with EUR.
Here I am
adding some more general thoughts on what I consider to be the best portfolio
diversifier for the next 5 years, possibly even longer. To my knowledge, ânooneâ
is invested in any meaningful way in Chinese bonds (I am excluding the special
situations credit funds, some of which I know to be very active in the Chinese credit
space â but even they are not looking at Chinese government or bank policy
bonds).
The big
fixed income funds, the pension/mutual funds, the insurance companies have zero
allocation to Chinese bonds. Some of the index followers started dipping their
foot in the space but most of them are either ignoring Chinaâs weight or are massively
underweight the respective index. Finally, a sign of how unloved this market
is, on the passive/ETF side, the biggest fund is just a bit more than $100mm.
Let me just
say here that we are talking about the third (possibly even the second, by the end
of this year) largest fixed income market in the world. And no one is in it?
Chinese bonds merit a rather significant place in
investorsâ portfolios. They offer diversification thanks to their low
correlation and superior volatility-adjusted return relative to other developed
and emerging markets. In addition, Chinese bonds are likely to benefit significantly from
both the passive and active flows going forward: I expect up $3 trillion of foreign inflows
over the next decade on the back of indexation.
Bloomberg Barclays Global Aggregate Index (BBGAI) and JP Morgan Global
Diversified have already confirmed Chinese bonds inclusion in their respective
indices. FTSE Russell WGBI is likely to do that next March. This inclusion is a big deal! It
will have huge repercussions on the global bond industry. It is a much more
important and far-reaching development than a similar inclusion of Chinese
equities in global indices last year. And the market is not only not ready for
this, but it is also underestimating its impact overall.
China is a
highly rated sovereign with a much better risk/return profile than other
high-quality alternatives. Chinese bonds
offer a significant scope for portfolio diversification because they have very low correlation to global interest
rates which means lower return volatility.
Therefore, China sovereign bonds offer a much
better volatility-adjusted return than Global Bonds, EM Hard Currency and Corporate Bonds, US HY and
Equities, Global Equities and Real Estate.
Among the plethora of negatively yielding sovereign bonds, China sovereigns offer a good pick-up over other DM bonds while yielding not too much lower than EM bonds. In addition, they offer much more opportunity for alpha generation than both DM or EM sovereign bonds. This alpha partially comes from the fact that Chinese fixed income market is still not so well developed and partially from the fact that there are not many sophisticated foreign players in it, as access to it is still not that straightforward.
However,
things are rapidly improving on the access side. Bond Connect has already
started to revolutionize the onshore market. Before the setting-up of CIBM, and
especially Bond Connect in 2017, access to the China bond market was extremely
cumbersome through a lengthy process requiring approvals from high authority (QFII
and RQFII). Bond Connect, on the other hand, does not require domestic account
and custody while following international trading practices. In addition, not
long ago, it started real-time settlement and block trading. As a result, Bond
Connect volumes doubled.
Moreover,
in September this year, SAFE decided to scrap the quota restrictions on both QFII
and RQFII, while Euroclear signed a memorandum of understanding with the China
Central Depository & Clearing to provide cross-border services to further support
the evolution of CIBM. That opens up the path for Chinese bonds to be used as
collateral in international markets (eventually to become euro-clearable), even
as part of banksâ HQLA. Such developments are bound to make access to the
Chinese bond market much easier for overseas investors.
September proved
to be a very important month for the China bond market also because the authorities
finally delivered on the interest rate reform agenda. The central bank eliminated the benchmark policy loan and deposit
rates in favor of a more flexible reference rate. This should be positive
for yield curve formation and the continued expansion of interbank liquidity.
China does not have some of the weaknesses typical of emerging markets. On the opposite, it has very little sovereign FX debt, has large FX reserves, and it is a net creditor to the world. Moreover, some of the foreign debt is most likely offset by foreign assets.
Corporate-sector leverage, however, is still high, though default rates, despite lots of recent media focus, are still relatively low. On the other hand, the recovery rates are high, while the official, banking and household sectors are in relatively strong position which, reflects degrees of freedom to deal with these challenges. China has large amounts of debt with implicit state backing and a culture averse to defaults. In effect, the government controls both the asset and the liability side of the domestic debt issue thus a debt crisis is much less likely than in a fully free-market economy. The fact that China has the âfiscalâ space to deal with the private debt issue is one big advantage it has over DM countries with similarly high private debt burdens but which have also already used the option of shifting that debt to the government balance sheet.
The high debt issue and the authoritiesâ attitude to it, the structure of the economy (export-driven) as well as the potential transition from an extremely high growth rate to a more ânormalâ one, makes Chinaâs situation very similar to Japan’s in the late 1980s. Yet, there are also major differences. Chinaâs urbanization rate is much below Japanâs before the 1990 crisis, the real estate bubble is only in the top tier cities as opposed to country-wide as in Japan, the Renminbi is more likely to depreciate going forward than massively appreciate which is what happened to the Yen after the Plaza accord.
The high debt issue is a problem China shares not only with Japan but also with most advanced countries in the world. Similar to them, China is fully sovereign (the government has full control of the overall economy balance sheet; the currency peg is a âquestion markâ, not a real issue given Chinaâs large positive NIIP). Of all these advanced economies with similarly high non-financial debt to GDP, only China has not reached the zero-bound*. It is, therefore, likely for the Chinese policy rate to continue to move lower until it eventually hits 0%.
Similar to Japan, it has a high household savings rate and a rapidly ageing population. Yet, Chinese households have relatively low exposure to financial assets and especially to bonds. Given the policy agenda of financial market reform and the life-cycle savings behavior (i.e. risk-aversion increases with age), Chinese householdsâ allocation to bonds is bound to increase manifold. Moreover, with the looming of the property tax law (sometime next year), I expect the flow into bonds to start fairly soon.
This
flow aspect makes the case for investing into China bonds much stronger. Given the size of the Chinese fixed income market, its
rapid growth rate and the reforms undertaken most recently, global bond indices had ignored
Chinese bonds for too long. However, last year BBGAI announced that it would
include China in its index as of April 1, 2019. Purely as a result of this, China bond inflow is expected to reach
$500Bn by 2021 as the weights gradually increase from 0.6% to 6%. By then
China will be the 4th largest component in the index (after US,
Japan and France â and bigger than Germany!)
Before
BBGAIâs inclusion, there had never been a bond market that large, that was not
included in an index, as the Chinese bond market. In fact, China already represents the third largest bond market in the world,
growing from $1.6 trillion in 2008 to over $11 trillion now.
And even after these
inflows, China bonds are still likely to remain relatively under-owned by
foreigners as they would represent just 5% of Chinaâs total bond market (currently foreign ownership of the overall bond market is around 3%,
PBOC expects it to reach 15%). Foreign ownership of China sovereign bonds (CGBs)
is slightly higher, but even at around 6%, it is materially lower than in other
major sovereign bond markets. This under-ownership is even more pronounced relative
to the emerging market (EM) universe (the ranges there are between 10% and 50%).
Finally,
foreign investors are expected to continue to get very favorable treatment from
the Chinese authorities. The government has an incentive to make things easier as they need
the foreign inflows to balance the potential domestic outflows once the current
account is liberalized. For example, the tax changes implemented last year allowed
foreigners to waive the withholding tax and VAT on bond interest income for a
period of three years.
I am still
frankly shocked how little time investors have to discuss these developments
above but, at the same time, how eager they are to discuss the Chinese economy
and the trade tensions. From one hand, they acknowledge the importance of China
for their investment portfolio, but on the other, they continue to ignore the
elephant in the room being the Chinese bond market. I understand that this choice
is perhaps driven by investorsâ inherent negative bias towards any Chinese
asset, but the situation between asset and asset is much more nuanced.
In the
fixed income space, one can be bearish select corporate credit and bullish CGBs
or bank policy bonds (in fact, the more bearish one is on corporate credit, the
more bullish sovereign bonds one should be). Finally, I do acknowledge that the
big unknown here is the currency. But even there, the market has become much
more sophisticated: one can now use a much longer CNY/CNH forward curve to hedge.
Bottom line is that if you are still looking for a fixed income alternative to diversify your portfolio and you are not looking at Chinese sovereign bonds as an alternative, you are not being fiduciary responsible.
*For more details, see JP Morgan’s economics research note, “China’s debt: How will it evolve?”
In the current debt-backed system,
the majority of money is still loaned into circulation at a positive interest rate.
Even in Europe and Japan, where base interest rates and sovereign bond yields
are negative, the majority of private debt still carries a positive interest
rate. This structure inherently requires a constantly growing portion of the
existing stock of money to be devoted to paying solely interest. Thus, the rate
of growth of the money supply has to be equal to or greater than the rate of
interest, otherwise more and more money would be devoted to paying interest
than to economic activity.
The long-term average growth rate of US money supply is around 6%, which is only slightly higher than the average interest rate on US government debt but it is below both the average US corporate interest rate and US household debt. While I have used the UST 10yr yield as the average yield on US government debt (the average maturity of US debt is slightly less than that), the estimates for both US corporate debt and US household debt are very generous. For the former, I used the average yield on Aaa and Baa corporate bonds, and for the latter I used a weighted average interest rate between mortgage debt and auto loans (I have used 2/3 and 1/3 weights). I have not included the much higher yield on US corporate junk bonds which comprise a growing proportion of overall corporate debt. I have also not used credit card/consumer debt, which has a much higher interest rate than auto loans, and also student loan debt which carries approximately similar interest rate to auto loans. Just like for BBB and lower rated US corporates, credit card and student loan debt are a much higher proportion of total US household indebtedness compared to before the 2008 crisis.
I estimate the long-term average economy-wide interest rate as a weighted average of government, corporate and household debt – with the weights being their portions of the total stock of debt. That rate currently is about 7%, still higher than the average money supply growth rate since the early 1980s. Over the last four decades, US money supply has not only not grown enough, on average, to stimulate US economic growth, but has been, in fact even, below the overall interest rate in the economy. Needless to say, this is not an environment that could have persisted for a long time.
Indeed, if one calculates the above
equivalent rates for the period 1980-2007, the situation would be even more
extreme (see Chart below). In fact, until the late 1990s, money supply growth
had been pretty much consistently below the economy-wide interest rate. Only
after the dotcom crisis, but really after the 2008 crisis, money supply growth
rate picked up and stayed on average above the economy-wide interest rate.
What is the situation now? The current money supply growth rate is just above the average economy-wide interest rate; respectively above the government and corporate interest rates but below the household interest rate (data is as of Q1’2019).
It is also still below the combined average private sector interest rate.
So, even at these low interest
rate, US money supply is just about enough to cover interest payments on
previously created money. And that is assuming equal distribution of money.
Reality is that it is only enough to cover interest payment on public debt. And
even in the private sector, money distribution is very skewed: corporates have
record amount of cash but it is only in the treasuries of few corporates. The
private sector, overall, can barely cover its interest payment, let alone
invest in CAPEX, etc.
The deeper question is whether money creation should indeed be linked to debt at positive interest rate. In fact, we have already answered that question, and gone beyond, with some portion of money creation in Europe and Japan actually happening at negative interest rate. In effect, the market is trying to correct for all those decades when money creation substantially lagged interest payments: money there is starting to decay.
Demurrage money is not unusual in history. Early forms of commodity money, like grain and cattle, was indeed subject to decay. Even metallic money, later, on was subject to inherent ânegative interest ratesâ. In the Middle Ages, in Europe, coins were periodically recoiled and then re-minted at a discount rate (in England, for example, this was done every 6 years, and for every four coins, only three were issued back). Money supply though, did not shrink, as the authorities (the king) would replenish the difference to find his own expenses. In 1906, Silvio Gesell proposed a system of demurrage money which he called Freigeld (free money), effectively placing a stamp on each paper note costing a fraction of the noteâs value over a specific time period. During the Great Depression, Gesellâs idea was used in some parts of Europe (the wara and the Worgl) with the demurrage rate of 1% per month.
The idea behind demurrage money is
to decouple two of the three attributes of money: store of value vs medium of
exchange. These two cannot possibly co-exist and are in constant âconflictâ
with each other: a medium of exchange needs to circulate to have any value, but
a store of value, by default, ârequiresâ money to be kept out of circulation. Negative
interest rates in effect split these two functions.
Seen from this point of view, negative interest rates may not be a temporary phenomenon just to spur lending. On the opposite, negative interest rates may be here to help reduce the overall debt stock in the economy and to escape the deflationary liquidity trap caused by the declining marginal efficiency of capital.
At presentations you will see the blue line below.
How many times have you seen the red line?
Pension funds unfunded liabilities have indeed been on the rise, especially after 1999. But so have pension funds assets. So much, that the ratio between the two has been declining (which is the natural, long-term trend) since 2008.
In fact, for the whole period between WW2 and 1984, unfunded liabilities were always bigger than funded liabilities. In 1999, unfunded liabilities hit an all time low of 25% of funded liabilities and even though that ratio has risen since then to 75%, it is still much closer to the bottom of the whole period since 1945.
So, is there a pension fund crisis?
Maybe, but it is not obvious to me that it is anything
bigger than at any other point in history before the 1990s.
Could there be a pension fund crisis?
Of course. But you know what is going to happen (as long as
the US is fully sovereign), the Treasury will bail out the pension fund
industry just as it bailed out the fund management industry in 1988 following
the Asian/Russia crisis, and the banking, insurance and auto industry following
the 2008 financial crisis.
This, sadly, does not prevent that future pensioners might
be exposed to some misguided government attempts to respond to this supposed
pension fund crisis by extending the retirement age.
Bottom line is that 1) pension funds unfunded liabilities are not even close to being in a crisis and 2) any fully sovereign government is in a position to provide all the necessary resources to secure comfortable retirement to its people.
We have advanced as a society to such an extent that the only hurdle to a normal life to all at the moment is our antiquated rules of accounting, not our lack of resources.
*Betteridge’s law of headlines: “Any headline that ends with a question mark can be answered by the word no.”
There seem to be three aspects of the recent debate about China’s private credit build-up:
1) Is it excessive? Yes, but it is not extreme.
2) Has it been misallocated? Probably yes, but not necessarily more than in other countries now or in earlier stages of development.
3) How will the authorities handle the inevitable credit burst? That remains to be seen, but due to its unique political system, China seems to be more in control than other countries which have undergone a similar fate Question is whether this control will result in a positive outcome.
China’s recent credit build-up is indeed big: its recent private credit-to-GDP gap (a BIS indicator measuring the speed of credit creation now relative to its long-term trend) is currently the largest in the world.Â
China’s credit build-up seems to have accelerated especially so after the great financial crisis in 2008.Â
However, private credit creation growth in China reached a top (using four quarters MA of the credit gap as an indicator) sometimes in 2015 and has been decreasing since then.Â
Indeed, Chinaâs absolute private credit to GDP ratio is nowhere near some other countriesâ extremes.Â
It is the corporate sector which has levered…Â
…with households still relatively unlevered.Â
And of the corporate sector, most of the debt is concentrated in the SOEs. Finally, its government sector is unlevered, leaving the total (private + public) credit to GDP even lower relative to majority of other countries.Â
Â
Bottom line is, China seems to have a lot of credit space left, giving it some room for âa beautiful deleveragingâ.
The fact that most of the credit is in CNY gives a lot of flexibility of how that deleveraging is done – on China’s own terms (there is some foreign currency debt but a lot of it is either matched by corporate foreign currency assets or covered by the country’s own FX reserves).
Having travelled extensively throughout the whole country, I can confirm that there are ghost cities but the state of the overall infrastructure, pretty much everywhere, is first class, probably on par, or even better than most of continental Europe while putting US/UK infrastructure to shame. Having travelled also through all of Central Asia and after spending a month in the Philippines and now in Malaysia, I can also attest that the alternative, not spending so much on infrastructure, is infinitely worse.
So, by investing in real estate and infrastructure projects, and given its large population which is emerging from decades of under-development, is China misallocating more capital relative to:
the developed world, particularly, UK and US, where since the 1980s majority of credit created was against existing (unproductive) assets like residential real estate and financial assets for speculative purposes, leaving current infrastructure in a crumbling state? That’s in sharp contrast to the period between WW2 and the 1980s when credit was allocated to the production of goods and services and infrastructure projects like the interstate highway system in the US (a period more comparative to China’s developments now, and one largely heralded as the golden stage of economic growth).
 the developing world, which similar to China now is also in need of massive infrastructure development but instead national capital has been syphoned off to offshore wealth centres? Yes, there has been private capital outflow from China as well but it would have been much bigger had the capital account not remained closed.
It would take time before we know for sure whether the decisions Chinese leaders are making are beneficial for the country or not. It is fairly likely, though, that this credit expansion is not sustainable. Should this boom be followed by a bust, we could be fairly certain that the situation would be carefully managed by the authorities, unhindered by either hostile domestic political opposition, like in the majority of the democratic Western world or by foreign creditors, like in the majority of the developing world.
How would they handle it? If history is any guide, they did a pretty good job both during the Asian crisis in 1997/98 and the great financial crisis of 2008. Third time lucky?
I expect the authorities to continue building up the social safety net – pension and health care system – alongside expanding and improving the financial assets universe. They could simultaneously deflate the real estate bubble, by starving it of additional capital and inflate financial assets by encouraging diversification into them. Unlike, developed world countries where household wealth generally collapses during crises, Chinese households could come out unscathed from this as they are unlevered. In addition, any losses on their real estate portfolio could be offset by gains in their financial assets portfolio. Finally, with the right social safety net in place, they would also feel more secure for their future than before and therefore welcome such an outcome.
