There are many misconceptions about the collateral damages of financial repression. The first one is to believe that Central Banks monitor or react to financial risk accumulation. Policymakers tend to allow excessive risk-taking as a lesser evil side effect in their quest for inflation at any cost (read my paper). If asset valuations are somehow elevated, they expect a moderate correction to solve it. Another misconception is to believe that risks accumulated during periods of monetary expansion can be easily absorbed and mitigated with macroprudential measures and regulation (Steiner et al). The evidence also shows that risk happens fast and the impact across assets and the real economy far exceeds the maximum impact estimated by commercial, investment, and central banks. The failure of stress tests and the inability to see financial bubbles or predict a crisis are a testimony to the mistakes in consensus complacent views of risk.
One of the biggest problems right now is that the most conservative and prudent investments are increasingly adding extraordinary risks for lower yields.
Take one of the flagships of conservative investment, the Norwegian pension fund. In its annual report, it shows that the fund has delivered a net real return of 3.27% and -7.74% in 2018, good relative returns, but what seems most interesting is that the overall performance has suffered just as equity investments rose from 20% to 69,32%. The increase in overall risk imposed by central bank financial repression has made global pension funds reduce bond holdings in favor of riskier and illiquid alternatives (Hentow et al, How do Public Pension Funds invest? From Local to Global Assets).
Not only are pension funds diversifying to riskier countries and assets, but they are also searching for yield in increasingly complex products and issuers with weaker solvency and liquidity quality (OECD Survey Of Investment Regulation Of pènsion Funds, 2018).
Making the lowest risk assets -sovereign bonds in OECD) extremely expensive through liquidity injections, asset purchase programs and cutting rates, is the equivalent of inflating a real estate bubble. An asset that is perceived to be safe and with stable qualities is inflated through demand-side policies and monetary support, and the risk accumulation spreads to other less-reliable and volatile assets.
Some concerning facts:
. Currently, there are only 60 basis points that separate “junk” corporate bonds from the highest quality high-yield ones, according to Morgan Stanley Wealth Management’s global investment committee.
. The amount of negative yielding debt has reached a historic high of $12.5 trillion.
. The number of negative yielding junk bonds in Europe has soared from zero to fourteen in a few months.
. Net inflows into junk bonds soared in June to $10.6bn, the largest increase over any such period since 2017, according to the Financial Times.
. Pension funds hold up to 30% of assets in illiquid products as well as equities. In Europe, demand from Asian -mostly Japanese pension funds- for risky peripheral Eurozone debt has also increased to the highest level since 2008 despite historic-low yields and rising political tension and fiscal imbalances.
The “search for yield” policy is similar to the risk outlined by professor Steiner in his 2014 paper: The persistent accumulation of reserves creates systemic risk. Pension funds are accumulating assets they perceive as safe compared to the inexistent yield of the domestic highest quality bonds, and by doing this, they are also adding into their portfolios the rising uncertainty and systemic imbalances built in other economies.
Most investors look at pension funds as the safest and most conservative option to build wealth over time and protect their savings, but many are probably unaware of the rising layers of risk that are being built into the asset base as managers are forced to move away from high-quality bonds to more volatile, risky, less safe and even illiquid assets in order to get a small yield out of their investments. Policymakers may say that all this is only happening due to market demand, but when the central bank manipulates the cost and amount of money for a lengthy period of time while artificially eliminating the supply of low-risk assets through direct purchases and maturity repurchases, what they are effectively doing is the same as a misguided subsidy on a particular activity where demand is poor, creating a set of bubbles that will not be easily contained when they burst.
The fact that the most conservative investors are being forced to purchase bonds of nearly bankrupt companies for virtually no yield is not a success of monetary policy nor a tool for growth. It is a monumental monstrosity that will ultimately generate a crisis of unprecedented consequences.
The appointment of Christine Lagarde as president of the ECB has been greeted with euphoria by financial markets. That reaction in itself should be a warning signal. When risky assets soar in the middle of a huge bubble due to a central bank appointment, the supervising entity should be concerned.
Lagarde and Vice President De Guindos have warned of the need to carry out measures to avoid a possible financial crisis, proposing different mechanisms to mitigate the shocks created by excess risk. Both are right, but that search for mechanisms to work as shock buffers runs the risk of being sterile when it is the monetary policy that encourages excess. When the central bank solves a financial crisis by absorbing the excess risk that the market once took it does not reduce it, it only disguises it.
Supervisors ignore the effect of risk accumulation because they perceive it as necessary collateral damage to the recovery. Risk accumulates precisely because it is encouraged.
Draghi said that monetary policy is not the correct instrument to deal with financial imbalances and macroprudential tools should be used. However, it is the monetary policy which is causing those imbalances when an extraordinary, conditional and limited measure becomes an eternal and unconditional one.
When monetary policy disguises and encourages risk, macroprudential measures are simply ineffective. There is no macroprudential measure that mitigates the risk created by negative rates and almost three trillion of asset purchases. More than half of European debt has negative returns and the ECB must maintain the repurchase of maturities, injections of liquidity and even announce a new program of quantitative easing in the face of the lack of sufficient demand in the secondary market for those negative yielding bonds. That is a bubble.
Risk builds up slowly and happens instantaneously. That is what the central planner does not seem to want to understand and the reason why stress tests and macroprudential measures fail in the midst of monetary stimuli. Because they start from a fallacious base: Ceteris paribus and that the already accumulated imbalances are manageable.
When most Eurozone countries finance themselves at negative rates for up to seven to ten years, there is no reason to maintain current rates and stimuli.
The central planner can say that bond yields are low due to market demand, but when the Central Bank supplants the market by injecting, repurchasing maturities and announcing more monetary stimuli, the placebo effect in the real economy is imperceptible and the risk in financial assets is huge. The huge injection of money supply goes to other risk assets in search of a diminishing yield.
The eurozone has been in stagnation for several months, with many leading indicators worsening, and it is not due to lack of stimulus, but due to excess.
1.- 64% of the sovereign debt of the eurozone hs negative yields. Five trillion euros . Completely unjustified looking at solvency, liquidity or growth ratios.
2.- Junk bonds are at the lowest yield in thirty years, while the rating agencies warn that the solvency and liquidity ratios have not improved. The BIS warned of the increase of zombie companies, eternally refinanced at low rates despite not being able to cover their interest expenses with operating profit. Meanwhile, companies on the verge of bankruptcy are financed at rates of 3.5-4%.
3 .- The multiples paid for infrastructure assets have soared in little more than half a decade and now no one is surprised to see 19 times EBITDA paid for assets driven by low rates and cheap debt.
4.- Excess liquidity reached 1.2 trillion euros. It has multiplied sevenfold since the launch of the repurchase program.
5.- The debt of non-financial companies in the eurozone remains above 78% of GDP, according to Standard and Poor’s, above the cycle maximum of the fourth quarter of 2008.
Many say that nothing has happened yet, although it is more than debatable, according to bankruptcies of financial entities and increase of zombie companies. However, the fact that there has not been a massive financial crisis yet does not mean that the bubble is not being inflated. And when that bubble is in several assets at once, there are no macroprudential measures to cover the risk.
The problem of central planners is one of diagnosis. They think that if credit does not grow as much as they think it should grow and investment and growth are not what they estimated, it is because more stimulus is needed. Many ignore the effect of overcapacity, excess debt and demographics while carrying out the greatest transfer of wealth from savers and the productive economy to the indebted.
Calls for prudence and risk analysis measures would be much more effective if misallocation of capital was not encouraged by the policy itself. We must be aware that lower rates and more liquidity will not improve the economy, but they may generate a dangerous boomerang effect on risk assets.
Lagarde faces two difficult options. On one side, continue with negative rates and liquidity injections which perpetuate overcapacity, make governments avoid structural reforms and stagnate the economy. On the other side, normalizing monetary policy would show the artificially low yields of sovereign debt as unsustainable. She needs to face reality. The Eurozone does not need more monetary stimulus or government spending, it needs less interventionism.
The defeat of Tsipras in Greece is the loss of those who came to power promising that two plus two would equal twenty-two, of paper promises and policies that harm those that they pretend to protect.
The example of Greece is very useful to other European nations.
First. Marxist populism is not defeated by whitewashing it. The main reason why Syriza came to power was that the social democratic and the conservative parties implemented the wrong policies for years. Between 1976 and 2012, public employment multiplied by three while private employment increased by only 25%. More than 70 loss-making public companies while government spending stood at an average of 49% of GDP since 2004. Greece, faced with the failure of Keynesian policies, embraced populism that, instead of correcting previous mistakes, promised a lot more of the same.
Second. Populism arrives promising wealth for all with policies of misery. Syriza promised all kinds of magic solutions, from not paying the debt to threatening to leave the euro when not a single Greek citizen would accept depreciated drachmas. What they delivered was a bank run and sending the country into a deeper recession. Syriza´s fantasy and arrogance, coupled with the childish promises of Tsipras, were confronted by reality. If Greece had abandoned the euro it would have become a European Venezuela.
Third. They promise taxes to the rich and raise taxes to everyone. Tsipras and Syriza leave Greece with unemployment of 18.1%, a debt of 176.1% and a deficit that rise again. But, above all, they leave tax increases for average workers. Under Tsipras, the tax wedge for workers has risen to the thirteenth place in the world. A single worker pays 40.9% of taxes. Even the farmers of the country were demonstrating after the tax assault that the Tsipras government imposed. A farmer who earns 5,000 euros a month has to pay up to 4,000 in taxes and social security, according to the Greek Union of Farmers. The Syriza government increased income tax by 70% to farmers and raised it to 44% for those who earn 40,000 euros or more.
Syriza has raised taxes to the middle class to subsidize its political cronyism, something that even the finance minister ended up recognizing and led Tsipras to promise (late) tax cuts to attract investment and employment and to promise not to lower pensions again.
Fourth. Goodbye pensions. Syriza has carried out the largest pension cuts in Greek democracy. Today the Greek pensions are between 25% and 40% lower than those before Syriza arrived … And Tsipras expected to be voted again saying that he was not going to lower them anymore.
Fifth. The country is fed up the populists blame everyone except themselves. A few will say that the above-mentioned policies were imposed on Tsipras yet he did not resign, he stayed in power, implemented massive tax increases and pension cuts and expected everyone to thank him for continuing to rule the country.
Marxist populism, as always, promised heaven and delivered hell, has devastated pensioners and the middle class and has not cut a single euro of political spending.
Someone will say that next time will be different.