16 February 2012
The Debasement of the Riskless Rate
Structural causes and effects on world
macroeconomics
1
Finance and the Riskless Rate
• What is Finance?
– The business of borrowing and lending money in the free capital
markets
• What is the Riskless Rate?
– Or risk-free rate of return, is the interest an investor would expect
from a theoretically risk-free investment over a specific period of time
• Why Does the Riskless Rate Matter to Global
Macroeconomics?
– By representing the certainty or near-certainty of principal repayment,
both short-term (CB Repos/Deposits; Treasury Bills; AAA CPs) and
longer-term (AAA Treasury and Corporate Bonds) risk-free rates work
to anchor the credit risk (insolvency) hierarchy; crucial prerequisite to
an optimal allocation of capital
2
When the Riskless Is at Risk
•
During Normal Times Financing and Investment Anchored by Risk-Free Rate
– Traditional foundation is high-grade sovereign (e.g. US, Germany, UK)
– Extends across the maturity spectrum – from o/n deposits at CBs’ to long-term bonds
•
Underlying Source or Cause of Risk– Debt that Cannot be Repaid
– Insolvency or the prospect of insolvency
•
•
•
Responses – A Typology of Sovereign Risk
The Good – Growth, Taxes, and Re-payment
The Bad and the ugly
– Nominal Default
•
Simplest and most obvious – as in Russia 1998 , Argentina 2001, Ecuador 2008, Greece 2012? Actually
pretty common over history
– Inflation
•
Moderate to High Unexpected Inflation – as in most Latin American countries over past 70 years, but
also Europe and the US in the 1970s. Devalues the debt
– Financial Repression
•
•
Restrictions on nominal rates or other financial activities
Current example – US – low rates, negative real rates devalues the debt**
– Currency Revaluation
•
For foreign-denominated debt – equivalent to nominal default
** Expected Positive Real Interest Rate – The Anchor to Economic Growth and Investing
- Key price for decisions on consumption today vs. tomorrow, investing, growth
3
Credit Risk Distorted
• Problems Start when Credit Risk (Insolvency
Hierarchy) is Distorted
• It is Bad Policies, not Financial Markets, that Produce
Long-Term Credit Risk Distortions
– Fed’s monetary policy 1994-2007*
• The Productivity Miracle
• The Y2K
• The “Great Moderation”
– US Congress housing policies: ’00s mortgage democratisation*
• “One mortgage for every American”
• Fanny Mae and Freddy Mac’s balance sheet leverage
• Government implied guaranty on GSEs’ MBS
* See Appendix
4
Current State of Affairs - Riskless Rate
Debasement
• Current Disarray – “Financial Repression” and Negative Real Rates
– Past four years has seen explosion of sovereign debt and increasing sovereign risk
– Shows up in places as explicit default risk – pretty obvious (e.g. Greece)
– More important – although harder to see and far more damaging – is the effect of
financial repression and negative real rates – default by a thousand cuts
• Global Quantitative Easing Distorts Real Rates and Credit Risk Hierarchy
– US, Eurozone, and UK CB short-term funding to banking system provides
emergency liquidity
– But banking system hoarding reserves in anticipation of further funding difficulties
and investors losing confidence in extending credit to indebted governments
– The creeping sovereign risk of financial repression distorts traditional risk-free
benchmarks
• This Leaves Global Markets Looking for “True” AAA Assets
– Borrowers and investors looking for transparency, liquidity, and stable credit
hierarchy
5
Current State of Affairs (cont.)
• Only few Surviving “True” AAA Lenders and Borrowers Globally
– Low sovereign risk requires good growth prospects, low debt, good fiscal
management
– China, Germany, Canada, Norway, Australia,….?
• China, Currently Pursuing the “Bilateral” Way i.e. Investment + Currency
Bilateral Agreement vs Strategic Collateral
– Bilateral convertibility
• Opens to bilateral finance and trading
• By-passes traditional capital markets
– Crucially, China has no Borrowing Needs so no AAA Bond Issuance
• Germany, Trapped in Captive Political Environment, Trading Funds vs
Political/Fiscal Conditionality; Too Small to Fill “True” AAA Assets-Global
Savings Gap
• IMF and EMU’s (EFSF, ESM) Rescue Funds Creating Unprecedented Credit
Seniority Debasement – Crucially, No IMF Issuance; EMU’s not a AAA
• US, Backed by China’s Captive AAA Investor Status, Precariously Extending
Role of Global AAA Liquid Asset Provider
6
Current State of Affairs (cont.)
• Financial Markets Pressing for Credit Standing
Differentiation While Policy Makers and Rating
Agencies Catching up with Reality
• New Ranking of “True” AAA Lenders/Issuers
Emerging
• “True” AAA Lenders/Borrowers Unwilling to Offer
Funds Without Strict Conditionality
• China and Germany’s “Bilateral” Approach
Inadequate to Solve Global Credit Anchoring
Vacuum
7
AAA Debasement: Macroeconomic
Impact
• Global Business Confidence Likely to Remain Low
as Businesses and Individuals Perceive Their
Savings as Unsecured
• CBs Short-Term Lending Provision and QE Likely
to Increase Confusion Between Liquidity and
Solvency Risk Leading to Misallocation of Capital,
Next Financial/Asset Bubble
• Lack of Credit Hierarchy Anchoring and Credit
Differentiation Hampering Private and Public
Sector Financing/Re-financing Activity
8
Desirable Outcomes
• “True” AAA Lender/Borrowers (China, Germany, Canada, etc.) and
C/A Surplus Countries (Russia, Brazil, India, etc.) to Establish
Voluntary Global AAA Fund Which Lends to Countries and Banks
Against Streamlined, Market-Based Conditionality
• Global AAA Fund Resources to be Provided Through Up-front Cash +
Issuance of a Global AAA Bond
• “True” Global Longer-Term AAA Lending, Coupled with AAA
Issuance to Provide Credible Anchor to Global Credit Hierarchy
• Struggling European Countries to Re-acquire Credit Standing
Differentiation
• “Implied” Chinese Capital Market as a By-product of AAA-GlobalBond Issuance Sets off Additional Global Reserve Currency
• US to Compete for Global Savings; Budget Deficit to Be Tackled by
Congress Sooner Rather than Later
9
Greenspan’s Expansionary Mon. Policy
Excess Liquidity
Excessive Leverage
+
US Congress Housing Policies
AAA Pool Expansion
GSEs’ AAA Implied
Rating
Rating Agencies’
Modelling Error
AAA MBS and AAA CDOs Proliferation
Sub Prime Lending Expansion - Real Estate Bubble
Generalised Capital Misallocation - Real Estate, Financial Assets, Commodities
Real Estate Bubble Burst - Sub Prime Derivatives Default
Banking Insolvency Risk Re-pricing
Government Insolvency Risk Re-pricing
AAA Poll Contraction
10