Reasons to worry about our addiction to loose money

In spite of central bank ‘petrol’, growth has been lower than economists might have expected

Gillian Tett

Anne Richards, chief executive officer of Fidelity Intl Ltd., speaks during a Bloomberg Television interview ahead of the World Economic Forum (WEF) in Davos, Switzerland, on Monday, Jan. 20, 2020. World leaders, influential executives, bankers and policy makers attend the 50th annual meeting of the World Economic Forum in Davos from Jan. 21 - 24. Photographer: Simon Dawson/Bloomberg
Anne Richards, head of Fidelity International, said 'a flip of [central bank] petrol on the fire can get things going' at Davos last week © Simon Dawson/Bloomberg

Earlier this week, the Japanese government nominated Seiji Adachi to the board of the Bank of Japan. The news made few waves outside Japan, since Mr Adachi is little known.

However, global investors should pay attention.

Mr Adachi is a renowned “reflationist” who favours massive monetary expansion. So his selection suggests that after two decades of eye-poppingly loose monetary policy, the BoJ is set to double down in 2020.

That is remarkable. Moreover, Japan is not alone. This week the Federal Reserve left US rates unchanged, after three cuts last year. However, Jay Powell, Fed chair, gave such dovish signals in his press conference amid a pattern of reasonable US growth that markets expect another rate cut later this year.

The European Central Bank also remains set on an ultra loose course. So do most emerging market countries. Indeed, it is hard to find a central bank today with a tightening mission, other than the Swedes who raised rates from negative to zero in December.

Is this good news? Many investors might shout “yes”.

Most asset prices have soared recently. “Very few people expected 12 months ago that we would see the returns we have seen in the markets in 2019,” Anne Richards, head of Fidelity International, said at the World Economic Forum’s meeting in Davos last week. “A flip of [central bank] petrol on the fire can get things going.”

Measures of financial conditions illustrate the point. Consider the “financial stress” index calculated by the St Louis Fed, from a composite of market rates and credit spreads. Between 2002 and early 2007, this index moved from plus 1.064 to minus 0.618 (a negative number indicates loose conditions).

Then, in the 2008 crisis, it surged above 5, before falling below minus one in 2012, as central banks offered support. Last autumn it sank even further and now stands at minus 1.567, its lowest level since records began in 1994. The Chicago Fed’s financial conditions index, which tracks Main Street conditions, echoes this. This implies that funding is even cheaper today than during the pre-crisis credit bubble.

But before investors feel too jubilant, they should consider two further points. Firstly, in spite of this deluge of central bank petrol, recent growth has been far lower than economists might have expected with this much financial easing. “Why has the loosening of financial conditions not offset more of the growth slowdown?” BlackRock asked in a recent research note that went on to blame geopolitical uncertainty.

Secondly, even as this super-loose policy causes asset prices to soar, it is destabilising the investment strategies of many mainstream investors, including pension funds and insurance companies. “The key question is, ‘how do you make money in an environment of negative rates?’” said Paco Ybarra, head of markets at Citi, adding that falling rates and volatility have tipped the system into “a financial ice age”. 
Line chart of St. Louis Fed Financial Stress Index* showing The absence of market stress indicates that funding is exceptionally cheap

To compensate, mainstream investors are buying assets of longer duration, lower credit quality or in much riskier parts of the world. “We have to pick our risks,” said Ms Richards.

The Fed denies that this poses serious dangers to the financial system. But some financiers are becoming alarmed.

“I don’t see a crunch this year, but this feels like 2005. The music is playing so everyone is dancing, but the risks are piling up,” one hedge fund luminary recently told me. Keishi Hotsuki, Morgan Stanley’s chief risk officer, said this week. “Right now there is so much buying power in the market that it makes me nervous . . . about complacency.”

Indeed, Mr Hotsuki says he would welcome a modest market correction. Puncturing this complacency would “be better long term”. He might get his wish: the spread of the coronavirus in China has already caused a wobble in asset prices.

But here is the trillion-dollar rub: if a shock does occur — from the coronavirus or anything else — investors are likely to expect, even demand, even more central bank support. After all, when US repo markets gyrated last autumn, the Fed rushed to help. Mr Powell may have said he expects to slow down those repo interventions later this year, but few financiers believe this would occur if jitters re-emerged.

We are starting a new decade with a financial system and investor base that is hooked on central bank support to a greater degree than we have ever seen before. Few predicted this a decade ago. But even fewer expect it to end this year, in Japan or anywhere else — even though the addiction is deeply unhealthy, not just for investors, but central banks too.

Goldman Sachs

How the mighty Goldman has fallen

The bank’s search for a new identity captures the changes in global banking

In its prime Goldman Sachs was exceptional. Fifteen years ago, just before the global financial crisis, the bank easily outshone its Wall Street rivals—winning the most lucrative deals and making the most profitable trades.

It printed money, both for shareholders and employees. Although the crisis imperilled the firm along with the rest of the banking industry, it navigated the chaos relatively well. Success allowed it to be haughty—while other banks engaged in the grubby game of sucking up to investors, Goldman remained secretive and enigmatic.

How times have changed. This week the firm held its first investor day, led by David Solomon, who took over as chief executive last year. It comes after a long period of underperformance. A dollar invested in Goldman in 2010 would be worth just $1.60 today. A dollar wagered on the s&p 500 would be worth $3.60, and on JPMorgan Chase, $4.10. Goldman has become a laggard.

Its predicament reflects two big changes in Western banking. One is the declining profitability of capital-markets activity, in large part the result of tighter rules, including higher capital requirements for riskier activity, penalties on lenders that rely on debt markets to fund themselves and tighter compliance regimes.

The second is the rising importance of technology in the industry, as consumers and corporate borrowers shift to digital banking. This appears to give an immediate advantage to very large lenders that can support huge it budgets, and to big tech platform firms that have vast numbers of customers who can be sold financial products, as is already the case in much of Asia.

Goldman has been on the wrong side of these trends. Consider its performance relative to JPMorgan Chase, a giant full-service firm. Goldman is still wrestling with past compliance mistakes—it is expected to pay billions of dollars in penalties for the 1mdb scandal in Malaysia. Its funding costs are higher than JPMorgan Chase’s (1.95% compared with 1.25% in 2018). Its ratio of expenses to revenues is worse.

Not surprisingly, its return on tangible equity, a measure of profitability, was just 11% in 2019, compared with 19% for its rival. For Goldman’s shareholders the only consolation is that it has done better than Europe’s flailing banks—in the most recently reported quarter Barclays managed 10%, Credit Suisse 9%, and Deutsche Bank made a loss.

Mr Solomon’s new plan is, in part, to become more like JPMorgan Chase, with a broader range of services and funding. Goldman wants to expand Marcus, its fast-growing consumer arm, and also to build out its transaction-banking division that ships money around the world for companies.

It plans to attract more deposits, which are typically the cheapest way to fund a bank. It has hired an army of tech experts. All this, Goldman hopes, will raise its return on tangible equity to 14%.

Goldman says it recognises the need for fundamental reform. It boasts of transforming its macho culture with a more diverse intake of recruits. But you can question how much it has really changed. It continues to allocate half its capital to its once-famed trading operation, despite its drab returns.

And it still spends a lavish $12bn a year on rewarding its staff, even as the firm earned only $8bn for its shareholders in 2019. So far investors remain sceptical, with its shares priced at their book value.

If Goldman’s reinvention fails it may ultimately have to do a deal. Uniting Wells Fargo and Goldman, for example, would create something more like JPMorgan Chase (and with a similar-sized balance-sheet). In America regulators and some politicians are sceptical about bigger banks.

In Europe, where the industry is more desperate, the mood has already changed, with matchmaking now encouraged. At least Goldman’s mergers-and-acquisitions advisers will be in on any action.

Belarus: When the US Calls, Russia Listens

By: Ekaterina Zolotova

U.S. Secretary of State Mike Pompeo is on a tour of Ukraine, Belarus, Kazakhstan and Uzbekistan that will last until Feb. 4. His visit to Belarus will be the first of its kind since 1994 – just a few years after the Soviet Union to which all these states once belonged collapsed.

Pompeo will meet with the president and the foreign minister to foster ties with a country that is perpetually susceptible to – and sometimes welcomes – Russian influence. Geostrategically, Belarus is an indispensable buffer between Russia and the West, so maintaining a footprint there is a high priority.

The Kremlin understands that the visit will not change much in the short term; prying Belarus away from Russia will take a long time, thanks in no small part to obstacles to U.S.-Belarus relations such as sanctions, but the Kremlin is wary of any visit that could woo Belarus away from Russia, however long it may take.

For Belarus, the feeling with the U.S. is mutual. Minsk tried to improve relations with Washington throughout 2019. In fact, several senior U.S. officials, including former National Security Adviser John Bolton and Undersecretary of State for Political Affairs David Hale, visited Belarus.

The countries have been somewhat estranged for years – they even recalled their ambassadors in 2008, something Pompeo is expected to rectify during his trip – and so President Alexander Lukashenko has had to balance (mostly) between Moscow and Brussels, since Russia would feel threatened by signs of life from U.S.-Belarus relations.

It appears as though the U.S. is trying to change that. Washington seems to want better ties with the Eastern European nation and, by extension, more distance between Minsk and Moscow. But there are limits to what each can do. It will take more than high-level diplomatic visits to reset their relationship. If the United States is really ready to normalize its relations and “protect the sovereignty of Belarus,” both countries will have to resolve a host of issues that have kept them apart for years.

One of which involves oil, the vast majority of which Belarus receives from Russia. However, when Minsk and Moscow negotiated fuel supplies at the end of 2019, they failed to reach an agreement, so on Jan. 1 Russia suspended the supply of fuel to Belarus. Instead of making concessions to the Kremlin, Lukashenko began to look for alternatives to Russian supplies.

Belarus is reportedly especially interested in buying Bakken oil from the United States. Just last week, Lukashenko said Minsk was negotiating oil supplies with the United States, Saudi Arabia and the United Arab Emirates, and that they promised to supply Belarus with as much raw material as it needed. There are even rumors that the first tanker may arrive in Odessa in February with oil arriving in Belarus through Ukrainian pipelines.

But buying U.S. oil is complicated. Washington levied sanctions against a variety of Belarusian officials and companies as punishment for what it saw as a sham presidential election in 2006.

The U.S. eased the sanctions, including those that hit oil companies, in 2015, after Lukashenko released some political prisoners and invited observers to the presidential election, but didn’t lift them entirely. Then in June 2019, President Donald Trump extended sanctions against a number of Belarusian officials, including Lukashenko, but would just a few months later extend the suspension of sanctions against energy companies for another one and a half years.

That doesn’t mean trade and economic relations will be easy to establish. The presidential election will take place in August, and it seems unlikely that the U.S. will completely lift sanctions before then, since doing so would undermine the point of imposing them in the first place – to show that, by Washington’s account, Belarusian officials pose a threat to the interests and foreign policy of the U.S. and that Belarusian elections are not democratic.

Moreover, upcoming military exercises in Europe, known as Defender Europe 2020, will hinder a U.S.-Belarus reconciliation. During these exercises, the United States will conduct the largest redeployment of troops to the Continent in the past 25 years. Some 40,000 soldiers will take part, nearly three-fourths of which will come from the U.S. Eighteen countries – 17 NATO members plus Georgia – will participate in drills that will span several countries, including those on Russia’s border and those close to Belarus. Lukashenko has repeatedly expressed concern about the drills and has since begun to conduct unexpected and multidimensional readiness checks of the armed forces.

He sees the drills as a threat to his country, and because it’s a threat shared by Russia, it only brings them closer together. (Indeed, despite the turmoil between the two, Belarus and Russia continue to discuss security cooperation. On Jan. 29, Russia’s ambassador attended a meeting of the Security Council of Belarus, during which Belarus reaffirmed its commitment to the strategic partnership, strengthening contacts and developing joint security projects.)

For the U.S. and Belarus to fully cooperate, Minsk will have to make some concessions. For one, Washington wants Lukashenko to invite it to the Normandy talks on the resolution of the Ukraine conflict. For another, it wants Belarus and Poland to settle their territorial disputes. (Poland hasn’t said much about this recently, but Belarus is always vigilant. For these and other reasons, relations between the two run hot and cold.)

Lukashenko will probably agree to none of this. He is using Pompeo’s upcoming visit mostly as a signal to Russia that he is ready to deal with the U.S., something that could give him leverage in future negotiations. In that sense, the meeting is more important to the Kremlin, which someday may have to ask itself if instead of having an allied buffer state it dominates, what if it had a neutral neighbor capable of devising its own foreign policy without taking into account Russian interests?

The latter runs counter to Russia’s plans to integrate the countries that used to comprise the Soviet Union. So far, the Kremlin has yet to comment on Pompeo’s visit, though President Vladimir Putin has unexpectedly invited Lukashenko to meet in Sochi. Clearly, the issue is something Putin can’t ignore.

Brazil’s Biggest Economic Risk Is Complacency

This year can be a decisive one for Brazil’s transition to a more robust and sustainable growth path – but only if the government commits to fiscal and structural reform. If Brazil’s leaders fail to take this opportunity to lay the foundations for long-term prosperity, it may not be long before the economy stalls again.

Otaviano Canuto

canuto14_Priscila ZambottoGetty Images_brazilmoneyeconomy

WASHINGTON, DC – Brazil’s economy has endured a difficult few years: after a deep recession in 2015-2016, GDP grew by just over 1% annually in 2017-2019. But things are finally looking up, with the International Monetary Fund forecasting a 2.2-2.3% growth in 2020-21.

The challenge now is to convert this cyclical recovery into a robust long-term expansión.

Two problems have undermined Brazil’s economic dynamism: anemic productivity and a bloated public sector. As weak productivity growth has constrained the economy’s overall growth potential, steadily rising public spending has become increasingly unsustainable.

This is not a new problem. But in the first decade of this century, it was obscured by the commodity-price super-cycle, which drove annual growth above 4%. In 2012-2014, pro-cyclical fiscal and (public-bank-driven) credit expansion fueled growth further, but exacerbated imbalances that would come back to haunt Brazil when the commodity boom ended.

Now, Brazil is shifting to a new economic model, in which lower-for-longer interest rates and increased private finance and investment make up for more restrained fiscal policies and reduced public-bank credit. This year could bring substantial progress in this transition, but only if the government remains committed to fiscal and structural reforms.

On the fiscal front, Brazil has already taken significant steps. In 2016, the government passed a 20-year public-spending ceiling. Last year’s pension reform is an important example of this new regimen.

But the pension reform alone is not nearly enough to restore fiscal health, not least because the associated reductions in public spending will be spread out over several years. Meanwhile, other mandatory public expenditure continues to rise.

To enable needed discretionary spending, such as on public infrastructure, all levels of government will have to curb mandatory expenditures. At the federal level, the World Bank has identified two additional areas where significant spending cuts would be possible.

First, Brazil has many subsidies and tax exemptions that bring no macroeconomic or social benefits. Second, the public-sector wage bill is high by international standards, owing not to an excessive number of employees, but to public officials’ disproportionately high salaries, relative to their private-sector counterparts.

Here, progress may be on the horizon. Last year, the government unveiled a reform package – yet to receive congressional approval – that includes sweeping changes to the terms and conditions of federal employment.

If Brazil’s government respects the public-spending cap, real interest rates (now at record lows) do not rise significantly, and annual GDP growth averages around 2%, the public-sector gross-debt-to-GDP ratio could decline from over 77% in 2018 to 66% in 2030.

If GDP growth averages 3%, that ratio could fall to just 49%. The extent to which the government manages to make space for pro-growth discretionary spending will play an important role in determining which scenario prevails.

Financial markets offer further reason to hope that Brazil’s macroeconomic recovery will succeed. Beyond low interest rates, the country’s risk spreads have fallen to their lowest level in nearly a decade. While capital flowed out of the country in net terms in 2019, that mainly reflected the unwinding of the interest-rate premium paid on domestic debt, as well as pre-payment of foreign debt by Brazilian corporates.

Meanwhile, domestic funding to Brazilian non-financial corporates has returned to pre-recession levels, and corporate-debt securities and equities have grown significantly. Capital markets have begun to compensate for the decline in subsidized credit from the Brazilian Development Bank (BNDES), and bank lending to businesses has picked up.

In addressing weak productivity gains, Brazil has a longer way to go. Over the last two decades, labor-force expansion has accounted for more than half of Brazil’s per capita income growth. But as Brazil’s demographic dividend ends, continued progress will require existing workers to become more productive.

Since the mid-1990s, productivity has been increasing at an average annual rate of just 0.7%. Inadequate physical investment has contributed to this inertia, but the main culprit has been a lack of progress in total factor productivity (TFP) – a result of poor education, weak infrastructure, and a challenging business environment.

To spur TFP growth, Brazil’s government should use concessions and privatization to convince the private sector to channel its large savings – now in search of yields – toward infrastructure.

To this end, fine-tuning the regulatory framework governing private investment in areas like transport and sanitation is essential.

At the same time, the government must improve the business environment. Reforms that simplify tax administration, including by harmonizing the tax base across levels of government, are particularly urgent. Moreover, trade-opening measures and agreements – which may run up against political obstacles abroad relating to environmental and other concerns – must be pushed forward.

This year can be a decisive one for Brazil’s transition to a more robust and sustainable growth path – but only if the government commits to reform. If, instead, Brazil’s leaders simply reap the short-term benefits of improved macroeconomic performance without laying the foundations for long-term prosperity, it may not be long before the economy stalls again.

Otaviano Canuto, a senior fellow at the Policy Center for the New South, previously served as a vice president and Executive Director of the World Bank, Executive Director of the International Monetary Fund, and as a vice president at the Inter-American Development Bank.