December 10, 2013 6:51 pm

Asset managers could blow us all up

When funding conditions turn, relying on cheap dollars to finance local assets can be lethal

The most sobering lesson of the global financial crisis was that developments expected to increase resilience – in that case, the “originate and distributemodel of finance turned out to reduce it. Does a similar danger now threaten stability? Yes. The next round of global illiquidity might derive from foreign currency bonds of non-financial companies of emerging economies. The centre would be asset managers, not banks.

Last summer’s taper tantrum” was a foretaste. The indication by the US Federal Reserve that it was considering a reduction in the rate at which it would expand its balance sheet had a dramatic effect on emerging economies. As the International Monetary Fund noted in its October World Economic Outlook: “Expectations for earlier US monetary policy tightening and slowing growth in emerging market economies prompted major capital outflows from emerging markets during June 2013.” The results included a widening of risk spreads, equity market falls and big declines in exchange rates against the dollar.

Why did turmoil follow the mere possibility of a twitch towards tightening in Fed monetary policy? At a conference on Asia at the Federal Reserve Bank of San Francisco, Hyun Song Shin of Princeton University, among the world’s foremost financial economists, suggested an answer: the growth of demand for the private sector bonds of emerging economies.

To enlarge graph click here

In booms, finance floods the market, driving excesses; in busts, finance dries up, causing slumps. This phenomenon is known by the loose termglobal liquidity”. Before the global financial crisis, banks were the main providers of liquidity. Since 2010, a locus has been the bond finance of non-financial corporate sectors of emerging economies

Asset managers (BlackRock, Vanguard, Fidelity, State Street, Pimco and so forth) drive the flows. This, then, is the “second phase of global liquidity”. It is also why portfolio flows to emerging economies reversed last summer.

External finance of emerging economies has changed in two ways: non-banks have become bigger borrowers, relative to banks; and debt securities have largely replaced loans. Much borrowing is done abroad. An indication is the widening gap between borrowing by place of residence and by nationality: Chinese companies, for example, issue foreign currency bonds in Hong Kong, not the mainland (see charts).

The purchasers of these bonds search for yield in a low-yield world by lending longer and riskier. Borrowers take advantage of the lower cost of foreign-currency bonds. But in the process, they assume a currency mismatch: foreign currency debt against domestic currency assets

These borrowers are speculating on their domestic currencies. Students of the Asian financial crisis of 1997-98 will find this disturbingly familiar. Non-financial companies have taken on a “carry trade”, by financing local assets with apparently cheap dollars.

When funding conditions turn, such trades can become lethal. As the Fed is expected to tighten, the dollar will rise, prices of dollar bonds will fall and dollar funding will reverse. As the bonds they issued lose value, borrowers will be forced to post more domestic currency as collateral. That will squeeze their cash flows and trigger a downturn in corporate spending. A fall in the exchange rate will exacerbate the squeeze upon them. Highly indebted non-financial corporations may even go bankrupt, imperilling domestic creditors, including the banks.

Such a pattern of currency and risk mismatches partly explains the volatility last summer. That stress eased, but the Fed will tighten at some point. Then the doom loop is set to restart: a brutal unwinding, with attendant corporate distress and even sharp recessions.

Thus, even asset managers may be a source of cyclical instability provided they, too, behave pro-cyclically, just as leveraged lenders do. The two fundamental problems, in this case, are the lack of long-term holders of the debt and the currency mismatches inside borrowers. Indeed, non-financial corporations are behaving more like banks, with rising financial assets (in domestic currency) and liabilities (in foreign currency). They are more like financial intermediaries than conventional companies. This makes them vulnerable to bank-like risks.

The case that the development of this new pattern of financing could be a source of vulnerability and volatility seems strong. The story underlines a point that emerged in previous crises in emerging economies: national balance sheets matter. Currency mismatches emerge whenever borrowers find it attractive to borrow in apparently cheaper foreign currencies. They have repeatedly proved devastating to emerging economies, whether they have occurred in the government sector, the banking sector or the non-financial corporate sector.

Yet it is hard to know how big such risks are without better data. The meticulous monitoring of build-ups of mismatches is an essential part of better financial housekeeping. Focusing on the financial sector’s leverage and mismatches is, alas, insufficient

One must track the debt issuance of domestic financial and non-financial corporations – both onshore and offshore – and the build-up of domestic currency deposits of non-financial corporations. These are, as Prof Shin argues, in part the counterpart of their foreign currency borrowing. The dollar value of the deposits of the non-financial corporations of emerging economies has been volatile, partly because of swings in exchange rates, but has also been rising rapidly (see chart).

What, finally, are the policy implications, beyond the well-known fact that the combination of today’s hyper-aggressive central banks with the private sector’s reach for yield is bound to create fragility? One is that controls on capital inflows count for next to nothing if companies can borrow offshore. Another is that currency adjustments, albeit vital for managing our volatile world, will expose such mismatches. Above all, managing a return to normal monetary conditions without further large-scale instability is going to be quite difficult.

Emerging economies must be aware of such perils. So must the institutions charged with helping them.

Copyright The Financial Times Limited 2013.

America’s Partisan Peril

Mohamed A. El-Erian

DEC 9, 2013

Newsart for America’s Partisan Peril

NEWPORT BEACHThe United States’ reputation for sound economic policymaking took a beating in 2013. Some of this was warranted; some of it was not. And now a related distorted narrative one that in 2014 could needlessly undermine policies that are key to improving America’s economic recovery – is gaining traction.

The 2008 global financial crisis left the US economy mired in a low-level equilibrium, characterized by sluggish job creation, persistently high long-term and youth unemployment, and growing inequalities of income, wealth, and opportunity. Many Americans started 2013 with high hopes that congressional leaders would overcome, even if only partly, the polarization and political dysfunction that had slowed recovery.

Expectations of less political turbulence were enhanced at the start of 2013 by a bipartisan agreement that avoided the so-called fiscal cliff (though at the last minute and with much rancor) and a deal reached later in January to raise the debt ceiling (albeit temporarily). With expectations of less political brinkmanship and lower policy uncertainty ahead, consensus projections foresaw faster, more inclusive economic growth.

In turn, faster growth was expected to revitalize the labor market, counteract worsening income inequality, mollify concerns about debt and deficit levels, and enable the Federal Reserve to start normalizing monetary policy in an orderly fashion. It would also facilitate a return by Congress to more normal economic governance – whether passing an annual budget, something not accomplished in four years, or finally taking steps to enhance rather than impede growth and job creation.

But optimism foundered over the course of 2013, and frustration soared.

Growth has again fallen short of expectations. With another year of uneven job creation, the problems associated with long-term and youth unemployment have become more deeply embedded in the economy’s structure. Inequalities remain too high, and continue to grow. Congressional paralysis has reached levels unparalleled in recent history. And, again, lawmakers have not enacted an annual budget.

This is not to say that there has been no economic or financial progress in 2013. After all, economic growth, while unnecessarily held below potential by Congress (and vulnerable to decline if Congress is not careful), has again outpaced that of Europe. The budget deficit has fallen markedly, while companies and households, too, have continued to strengthen their balance sheets. Many segments of the equities market have bounced back strongly, with price indexes hitting record highs. And Americans are on the verge of obtaining much better access to health care.

What is frustrating is that the country could have – and should havedone a lot better. Recognizing this, Americans are not hesitant to blame a Congress that seems more eager to manufacture problems than to enable the economy to reach its considerable potential.

Rather than building on some of the fledgling bipartisanship from earlier in the year, Congress decided to produce a mid-year government-financing drama. Even immigration reform – a bipartisan pro-growth issue with considerable support from much of American society – has languished unnecessarily. More broadly, Congress took no significant action to avoid headwinds that impose a drag on growth and discourage companies and individuals from investing in their future.

According to a survey based on data from the Office of the Clerk of the US House of Representatives, the current 113th Congress has delivered the lowest legislative activitysince at least 1947, when the data collection began.” And Americans know it. According to Gallop, the 9% approval rating for Congress is the lowest level in the survey’s 39-year history.

Partisan polarization in Congress has also undermined the executive branch, unduly blocking government appointments – including routine and essentially uncontroversial ones – and placing unwarranted obstacles in the way of implementing even the most sensible and seemingly bipartisan legislative proposals. The resulting sense of political drift and dysfunction has been exacerbated by the poor rollout of the Affordable Care Act (Obamacare) – a massive, avoidable distraction that has been allowed to cast doubt on this landmark initiative.

Yes, 2013 was not a good year for public-sector decision-making, especially given that most of the slippages were “own goals.” In the process, the US damaged the reputation for effective economic management that it had earned during the global financial crisis, when bold and timely measures prevented a period of reckless private risk-taking and financial leverage from ending in Great Depression II. The Congress-imposed government shutdown and near-default in October were particularly harmful to the country’s global standing.

As a result, the popular narrative is shifting to the danger of “government failure.” More and more Americans are being led to forget how, just a few years ago, a united US government reacted decisively to “market failures” and thus helped to avoid a global economic meltdown that would have devastated millions of lives and undermined future generations’ prospects. Now, as the pendulum swings back, it risks overshooting the optimal combination of private and public activity and ending up at a simplistic view of government as the problem and the private sector as the solution. If this occurs, the outlook for faster, more inclusive growth would be weakened further.

Government has a long pro-growth to-do list heading into 2014. The top priorities include modernizing the country’s transport and energy infrastructure, reforming an underperforming education system, improving the labor market, bringing order to an overly-fragmented fiscal structure, enhancing the provision of public goods, and safeguarding America’s interests abroad.

It is tempting for politicians and analysts to overplay simple narratives that place the blame entirely on one side or the other. The truth is more nuanced and complex. America is in desperate need of a Congress that encourages, rather than impedes, better partnerships between the public and private sectors.

Constantly pitting one side against the other may make for entertaining roundtables on cable television and energizing political rallies. But it comes at the cost of undermining an economy that could – and therefore should – be performing much better.

Mohamed A. El-Erian is CEO and co-Chief Investment Officer of the global investment company PIMCO, with approximately $2 trillion in assets under management. He previously worked at the International Monetary Fund and the Harvard Management Company, the entity that manages Harvard University's endowment. He was named one of Foreign Policy's Top 100 Global Thinkers in 2009, 2010, 2011, and 2012. His book When Markets Collide was the Financial Times/Goldman Sachs Book of the Year and was named a best book of 2008 by The Economist.

Markets Insight

December 9, 2013 6:20 am

A weak EU banking union risks deflation

Barely one year after agreeing to build an integrated banking union, Europe is on the verge of meeting its promises to create a single supervisor and rule book for banks, a common resolution fund and harmonised national deposit insurance mechanisms.
But it has failed miserably in its primary objectives: to sever the vicious link between sovereigns and banks, to protect the European Central Bank’s independence, and to jump-start a genuine process of cross-border mergers and acquisitions to create a single European banking market.
The outcome, which resembles a weak confederation rather than a strong union, increases the odds that the euro area slips into deflation.

Banking union will fail to break the sovereign-bank feedback loop. In the event of resolution, banks will remain dependent almost entirely on national funding sources. The first port of call will be equity and subordinated debt holders (and eventually senior unsecured creditors under the new Bank Recovery and Resolution Directive).
Domestic creditors, a subset of domestic taxpayers, will still probably have to pick up the tab, not least because most national resolution funds will not be pre-funded. Sovereign loans from the European Stability Mechanism (ESM) will be next in line, but there is little euro area capital set aside as a backstop: at the end of the rainbow lies a paltry €60bn in ESM funds dedicated to direct bank recapitalisation.

For a group of 130 banks that carry a mountain of €25tn in assets, the common backstop looks like a pebble. Meanwhile, common deposit insurance is nowhere in sight.

The result? With sovereign and private sector debt levels high and growth low, foreign creditors will stay away from any whiff of a capital problem.

Entrenched fragmentation

This will force banks to be “national in life as well as in death”, entrenching fragmentation in the European banking system.

Banks will continue to hold primarily national assets and their size will be constrained by their resident deposit bases. Any reconvergence of funding costs comes not as a function of greater confidence, but from the forced reimposition of national financing constraints.

Loan pricing, on the other hand, will remain highly differentiated amid elevated periphery default risk, as highly indebted economies will be unable to grow their way out of a debt trap. A complete banking union would remove these national financing constraints and promote a greater flow of credit to viable entities.

Fragmentation along national lines is reinforced by myriad regulatory changes designed to make the global financial system safer – that create powerful financial disincentives for cross border acquisitions.

Basel III and related regulation generally work against building scale. Larger capital charges based on size, leverage and complexity, and a bias toward ringfenced subsidiaries, may make for a safer global banking system, but applied across euro area countries, and in the absence of a strong banking union, they constitute a recipe for less efficiency and greater fragmentation.

Independence compromised

Finally, given the lack of common fiscal backstops for the banking sector, the ECB’s independence is compromised. Indeed, without a credible backstop, supervisory responsibilities cannot be separated, giving rise to conflicts between monetary policy and financial stability objectives.

The likely agreement on a weak Single Resolution Mechanism echoes a broader banking union theme that eschews centralisation of powers in favour of one where national governments and regulators still have significant veto power. The link between persistent fragmentation, unstable periphery debt dynamics and corresponding risks of deflation draws the ECB ever closer to quantitative easing policies that are indistinguishable from the underwriting of fiscal policy.

The optimistic view of Banking Union 1.0 is that a confederation regulated by a single supervisor marks an irreversible step towards fiscal integration.

In Banking Union 2.0, all countries might belatedly accept stronger supranational authority over resolution and recovery as the price of a healthy, growth-enhancing single market for European banks. But by then, it may be too late.

The risk is that weak confederations create more, not less, conflict, and delay allows deflation to seep through the cracks in the current configuration. A stronger union is needed now as the price of a healthy, growth-enhancing single market for European banks.

Gene Frieda is a global strategist for Moore Europe Capital Management


Copyright The Financial Times Limited 2013.

December 10, 2013, 3:43 PM ET

Brazilian Central Banker Says Not to Fear the Fed Taper

By Paulo Trevisani

Brazilian Central Bank Governor Alexandre Tombini has a message for the worldFederal Reserve tapering is good and governments that do their homework shouldn’t fear it.

Of course, he thinks Brasília’s homework is already done, while critics say the country is bound for a credit downgrade.

In scheduled testimony before a Brazilian Senate committee Tuesday, Mr. Tombini re-iterated his view that “Brazil is ready to make the global transition without any trouble.”

The central banker was referring to the expected reversal of the Fed’s easy money policies used to jump start growth in the U.S. and Europe.

Among other things, “easy moneyfueled capital flows to emerging countries such as Brazil, in Brazil’s case leading to an unwanted strengthened of the currency, the Brazilian real, which damaged exports. Earlier this year, however, when Fed Chairman Ben Bernanke hinted that the easy-money policy was about to end, the real went into a tailspin that stopped only when Brazil’s central bank launched a program of daily market interventions.

In Mr. Tombini’s view, the fact that the Brazilian real floats freely against the dollardespite central bank interventions–“is the first line of defense” against potential ripple effects in currency markets from Fed tapering, which could come as early as this month.

As for Brazil’s homework,” the central banker cited the country’s $376 billion in foreign reserves, high levels of foreign investment and strong fundamentals in the local banking system.

His views contrast with those of many critics, who think slow growth and deteriorating fiscal accounts make Brazil more vulnerable.Tapering hasn’t even started and the real is already falling,” said Alberto Ramos, a Goldman Sachs economist who has pointed to low growth, high inflation and declining fiscal results as problems Brasília has been slow to confront.

Mr. Ramos and other analysts believe Brazil is heading for a sovereign credit downgrade in 2014, a possibility Brazilian officials often hotly refute.

Mr. Tombini, whose job is at the ministerial level in the Brazilian government, has also shown optimism. Even as the Brazilian economy contracted in the third quarter, Mr. Tombini said that “gradual growth is still occurring.” He said that future growth depends on consumer and business confidence, but that both are already improving.

Pursuing growth is complicated by the fact that, at almost 6%, 12-month inflation is well above the government’s 4.5% target. Mr. Tombini said the target is “reachable.”

The central bank has been raising interest rates systematically since mid-year but the tightening cycle is expected to come to an end at some point in 2014.

“I don’t believe we should accept a little higher inflation in order to have stronger growth,” he said, trying to dispel feelings that the government has abandoned its commitment to inflation control. “There is no such trade-off.”

He said thatany central bank in the world would rather have a strong fiscal result,” answering a senator’s question about Brazil’s deteriorating public accounts. But he stopped short of criticizing the government’s handling of its finances.

Last month, the Brazilian Treasury unveiled figures showing a 12-month primary surplus, as of October, equal to 0.85% of gross domestic product. The primary surplus, or the difference between tax revenues and most government expenses, gives a sense of the country’s readiness to pay its debts.

In the past, Brazil has been able to consistently deliver an annual primary surplus equal to 3.1% of GDP, an important factor in achieving an investment grade rating in 2008.

Brushing away the fiscal results, Mr. Tombini said Brazil will keep on investing in social programs to reduce the country’s infamous income gap. He said that expected private-sector investment in infrastructure and educational programs to boost productivity will drive sustainable growth in the future.

Copyright 2013 Dow Jones & Company, Inc. All Rights Reserved