Is Financial Repression Here to Stay?

Howard Davies

JUN 24, 2015

businessman thinking

LONDON – There are several definitions of financial repression – and the repressors and the repressed tend to see things differently. But what financial repression usually involves is keeping interest rates below their natural market level, to the benefit of borrowers at the expense of savers. The borrowers are often governments, and in many emerging economies the state has funded its extravagances by paying bank depositors derisory rates of interest.
But in the last seven years, since central banks in developed countries pushed down their base rates almost to zero, we have seen a First-World version of financial repression. A recent research report from the insurer Swiss Re describes who has won and lost as a result, and questions the sustainability of the policies pursued by institutions such as the United States Federal Reserve, the European Central Bank, and the Bank of England.
The report’s argument is that while the stated motivation for ultra-loose monetary policy might be to guard against deflation and promote economic growth at a time when demand is weak, low interest rates also help governments fund their debt very cheaply. Moreover, as we enter the eighth year of aggressive easing, unintended consequences are starting to appear – notably asset-price bubbles, increasing economic inequality (as wealthier investors able to hold equities benefit at the expense of small savers), and the risk of higher inflation in the future.
The jury may be out on the last point, but the first two are well established. Many countries now have over-heated property and equity markets; in the US, the S&P 500 index since 2009 has closely tracked the expansion of the Fed’s balance sheet. As a result, price-earnings (P/E) ratios, which reflect investors’ enthusiasm for equities, are now high by historical standards (Swiss Re has a Financial Market Excess index, which has returned to its 2007 level).
Moreover, according to the Swiss Re report, “monetary policy and central bank asset purchases have aggravated economic inequality via equity price inflation.” The top 1% of US households have enjoyed a 50% gain in their financial wealth, while the bottom 90% have registered only a 12% profit. The bottom 20% have probably not benefited at all.
Not surprisingly, central banks do not like this argument. Fed Chair Janet Yellen insists that years of near-zero interest rates and quantitative easing were not intended to make it easier for the US government to fund its deficit. She argues that focusing on asset prices ignores the role – helpful for all income groups – of the Fed’s monetary policy in maintaining growth and thus warding off the threat of a wholesale depression.
But central banks accept that their policies have led to distortions in financial markets. For example, institutional investors, especially insurance companies and pension funds, have suffered badly. They are major holders of fixed-interest securities, and their investment income has fallen sharply. The returns they can provide to investors and pensioners have similarly fallen. Logically, therefore, individuals need to save much more to guarantee their income in retirement.
That in itself may have a depressing effect on the economy, partly offsetting the monetary stimulus. Indeed, it may be one reason why highly expansionary policies by the Fed and other central banks have taken so long to generate growth.
A further distortion stems from the prudential regulation adopted in reaction to the global financial crisis. The imposition of higher capital requirements on riskier investments has pushed financial institutions into holding government debt, which in turn means that they have less money available to lend for productive investment. Most countries have yet to see investment recover to pre-crisis levels.
On this analysis, a return to “normal” interest rates cannot come soon enough. The alternative is further financial repression and, with it, low investment, rising economic and social tensions, and the emergence of a generation of impoverished pensioners. Like Monty Python’s city-terrorizing “Hell’s Grannies,” tomorrow’s elderly will surely make their voices heard.
But can we really expect the old normal – positive long-term interest rates on government bonds – to return? Maybe it is unreasonable for investors to expect positive rates on safe assets in the future. Perhaps we should expect to pay central banks and governments to keep our money safe, with positive returns offered only in return for some element of risk.
One reason is that investment may never reach its previous levels. If a service-based economy simply has less need for expensive fixed capital, why should we expect a return to the days when business investment was a strong component of demand? Apps are cheap.
Furthermore, excess savings could be more than just a cyclical phenomenon. Individuals may have come to value future consumption, in retirement, over current consumption – the reverse of the traditional relationship. We are beginning to appreciate that in our productive years we must work harder, because our retirement years will be longer and healthier, and the income support provided by our governments and employers will be far less generous than they used to be. In other words, it is rational to save more now.
In the long run, such a brave new world might not be an intolerable place. But the transition from here to there will be very challenging for financial firms, be they banks, asset managers or, particularly, insurers. The types of products that the latter offer to their customers will need to change, and the mix of assets in which they invest will be different, too. The question for regulators is whether, in responding to the financial crisis, they have created perverse incentives that are working against a recovery in long-term private-sector investment.

The Capitalist as the Ultimate Philanthropist

The Ford Foundation vows to fight inequality but will have a hard time beating Henry’s example.

By Andy Kessler

June 24, 2015 7:12 p.m. ET

Henry Ford With His Model T.   Henry Ford With His Model T. Photo: Getty Images

On June 11, the $11 billion Ford Foundation announced that it will pour its resources—about $500 million in giving a year—into fighting inequality. “We are talking about inequality in all its forms—in influence, access, agency, resources, and respect,” Darren Walker, the charity’s president, wrote in a letter.

Oh, the irony. I won’t join the public intellectuals having hissy fits over how people choose to give away their money, beyond being annoyed that since the Ford Foundation is tax-exempt, we’re all subsidizing it. Here’s the real problem: The foundation is getting exactly backward what its namesake, Henry Ford, understood. Society benefits from making, not giving.

The bulk of the Ford Foundation’s assets came when it received 88% of the nonvoting shares in the Ford Motor F 1.37 % Company, most after Henry Ford died in 1947. Ford hated inheritance taxes, then a punitive 70%. In 1956 Ford Motor went public at $3.2 billion. Most of the shares sold were from the Ford Foundation, about a quarter of its holdings. The foundation’s charter stated the money should go “for scientific, educational and charitable purposes, all for the public welfare.” How times have changed.

This story matters because people have lost sight of where foundations got the money they’re donating. Ford Motor was worth $3 billion 60 years ago because it was profitable and investors had high expectations, not because the company raised wages to $5 an hour, a popular myth.

Ford Motor was profitable because Henry Ford created scalable assembly lines, reduced the cost of the Model T to under $300, and sold 15 million of them.

Model Ts made millions of businesses and workers more productive and created that “public welfare” that the Ford Foundation struggles to achieve. Ford Motor created wealth for society, as well as for Henry Ford, and you can’t do the latter without the former.

Think about it: No one would invest $300 in a Ford unless he thought that he could make at least that much using it—to deliver milk, to get to work, whatever. At least 15 million drivers made that choice, and the rest of Americans benefited from cheaper milk and Corn Flakes. In other words, the Ford Motor company increased living standards, and as a result its owner became fabulously wealthy. This may have increased the perception of inequality, yet everyone was better off.

A company’s profits are the minimum value of the work it does for you and for society. Google, GOOG -0.49 % to take another example, generates huge profits. CEO Larry Page has an estimated net worth of $30 billion. But Google offers you a valuable service, and society benefits to the tune of trillions, yes trillions, of dollars in commerce that happens thanks to Google searches, mail and maps. Similarly, an iPhone 6 is worth a heck of a lot more than $600; you can hail a car, trade stocks, call your mom, all without being chained to a desk.

Everyone should stop focusing on an entrepreneur’s wealth and instead focus on the value the customers gained from his products. I can’t dig for oil, let alone frack, but I am happy to pay Exxon XOM -0.46 % a premium for my high-test gas. Collectively, we are richer because of Exxon. So inequality is not a bug of capitalism; it’s a feature.

The Ford Foundation plans to focus on six areas of inequality: civic engagement and government; creativity and free expression; gender, ethnic and racial justice; inclusive economics; Internet freedom; and youth opportunity and learning. Hard to argue against all that namby pamby. But none are productive, none drive profits, and none will achieve the huge leaps in public welfare that Henry Ford pulled off so long ago.

At the end of the day, there are only four things you can do with your money: You can spend it, pay it to the IRS, give it away or reinvest it. Consumption is on the receiving end of productivity—furthering personal instead of public welfare. Government spending is by definition not productive, as you realize every time you step into a DMV. Same goes for charitable giving—no profit means no measure of value or productivity.

And so the most productive thing someone can do with his money—the only thing that will increase living standards—is invest. If the Ford or Clinton foundations really wanted to help society, they’d work on lowering barriers to business formation and cutting the regulatory chains that inhibit productive hiring in the U.S. and globally. But what fun is that? Better to boast about reducing inequality, public welfare be damned.

Mr. Kessler, a former hedge-fund manager, is the author of “Eat People” (Portfolio, 2011).

June 25, 2015 6:30 am

Shadow lending crackdown looms over China’s stock market


China’s shadow banks, increasingly wary of lending into a slowing economy, have turned to the stock market, fuelling a surge in unregulated margin lending that has driven the market’s dizzying gains over the past year.
Now regulators are cracking down on shadow lending to stock investors, a campaign analysts say is partly to blame for last week’s 13 per cent fall in the Shanghai Composite Index — the largest weekly drop since the global financial crisis in 2008.

“The price of funds has increased, the flow has shrunk, and transaction structures are getting more complicated,” says a Chongqing-based shadow banker who provides grey-market loans to stock investors.

“We’re no longer in a growth period. It’s more like, feed the addiction until you die, earn fast money. No one treats this as their main career.”

China officially launched margin trading by securities brokerages as a pilot project in 2010. It expanded the programme in 2012 with the creation of the China Securities Finance Corp, established by the state-backed stock exchanges specifically to provide funds for brokerages to lend to clients. 

Official margin lending totalled Rmb2.2tn ($354bn) as of Wednesday's close, up from Rmb403bn a year earlier, according to stock exchange figures. Yet this officially sanctioned margin lending, which is tightly regulated and relatively transparent, is only the tip of the iceberg for Chinese leveraged stock investing.
For standardised margin lending by brokerages, only investors with cash and stock worth Rmb500,000 in their securities accounts may participate. Leverage is capped at Rmb2 in loans for every Rmb1 of the investor’s own funds, and only certain stocks are eligible for margin trading.
In the murky world of grey-market margin lending, however, few rules apply. Leverage can reach 5:1 or higher, and there are no limits on which shares investors can bet on.

The money for these leveraged bets comes mainly from wealth management products sold by banks and trust companies. WMPs, a form of structured deposit that banks market to customers as a higher-yielding alternative to traditional savings deposits, also spurred China's original shadow banking boom beginning in 2010.
Traditional WMPs are backed by credit assets such as bonds, loans and money-market instruments. Ultimately much of the funds have flowed to property developers and local government infrastructure projects. 

But with China's property market suffering a slowdown and the central government focused on curbing the rapid run-up in local-government debt, this form of shadow banking has receded.
Meanwhile, monetary loosening has fuelled an equity boom, attracting WMP funds into the market.
“Money has abandoned the real [economy] and entered the fake [financial assets],” Haitong Securities analysts led by Jiang Chao wrote in a recent report.

“The flourishing of financial markets has caused ‘ersatz fixed income’ products that invest in secondary markets to become the preferred target for wealth management funds.”

There is no reliable data on “umbrella trusts” — the most prevalent structure — but Haitong estimates that between Rmb500bn and Rmb1tn in margin lending from trust companies has flowed into the stock market.

With a touch of financial alchemy, trusts transform an equity investment into a structured product that yields a fixed return — that is, unless something goes wrong.

In the case of umbrella trusts, banks purchase the senior tranche, which guarantees a fixed return. They then slice up this tranche and distribute it to clients as WMPs. 

Hedge funds, brokerages and other institutions subscribe to the subordinate tranche, which absorbs the first losses from stock investments but also enjoys all profits once the senior tranche holders have received their fixed return.  

Subordinate-tranche investors are effectively borrowing money from senior tranche-holders to make leveraged stock bets. The interest that subordinate tranche-holders pay on the margin loans comprises the fixed returns paid to the senior tranche.

If institutional investors were the only ones making leveraged bets outside the standard margin trading framework, analysts say the risk would still be relatively limited. In reality, other types of investors are also accessing margin finance through umbrella trusts and similar channels.

A universe of so called “fund matching” companies, known in Chinese as peizi, has sprung up over the past year to provide margin funding to virtually anyone who asks. Officially registered as consulting companies, these groups also subscribe to the subordinate tranche of umbrella trusts.

After opening a securities account at a brokerage, fund-matching companies use a software program produced by Shanghai-listed Hundsun Technologies — controlled by Alibaba founder Jack Ma — to divide the account into multiple sub-accounts that enable peizi clients to trade independently. The peizi company, as the official accountholder, maintains ultimate control and can liquidate any sub-account if the investor racks up heavy losses.
In mid-April China’s securities regulator told brokerages to stop working with umbrella trusts. On June 13, a Saturday, the agency followed up with rules explicitly forbidding them to co-operate with fund-matching companies by offering them direct access to their electronic trading systems. The country’s stock markets began their tumble the following Monday.


By Jon Hilsenrath

Thursday, June 25, 2015

Richard Drew/Associated Press

Fed watchers can mark their calendars with the following dates: July 2, July 8 and July 15. During that span of 13 days next month, the Labor Department will release its next jobs report, minutes of the Fed’s last policy meeting will be released and Fed Chairwoman Janet Yellen will begin two days of testimony presenting the central bank’s semiannual report to Congress. The sequence of events could provide the makings for important disclosures on the central banking beat.

The jobs report will be released on a Thursday rather than the traditional Friday because of the July 4 holiday. As the Fed gets closer to raising short-term interest rates, these jobs reports take on more significance. Confirmation of continued progress and reduced slack in the labor market is central to the Fed’s decision on raising interest rates. Another batch of monthly payroll gains of 200,000 or more and a reduction in the jobless rate will move the Fed closer to a September interest rate increase.

Minutes of the Fed meeting – the next batch released July 8 – are an increasingly important signaling device for the central bank as liftoff approaches, as they are likely to reveal the contours of the Fed’s discussion about rates. The April minutes provided the key clue for the June meeting: “Many participants … thought it unlikely that the data available in June would provide sufficient confirmation that the conditions for raising the target range for the federal funds rate had been satisfied.” Minutes from the June meeting, likewise, are likely to set the tone for the July and September meetings.

On July 15 Ms. Yellen begins two days of testimony before Congress. She will start out before the House Financial Services Committee. By then she will be armed with more information on the economy’s performance – including that earlier jobs report — and could provide the next big clues on where the Fed is heading. Much of her first day before combative House Republicans will likely be consumed in questions from lawmakers on ongoing investigations into leaks from the Fed. It will be a test of her composure. Because Ms. Yellen is not attending the Fed’s annual retreat in Jackson Hole, Wyo. in August, it will also be one of her key moments in the spotlight this summer.