Cycle paths

Credit conditions in the developed world can perhaps be seen through two stories. First, there is the long-term macro ‘big picture’ – the overhang of debt from the past, the apparent ‘low-growth, high-debt trap’, and ongoing deleveraging. On the other hand, investors are looking keenly for signs of short-term recovery in the banking sector, money supply and flows of credit. Ben Hunt reports.

Money and credit growth numbers have traditionally been important indicators for investors. Followers of the Austrian School of economics or monetarism have especially connected them to movements in the business cycle.

The turn in the credit cycle ushered in by the financial crisis has laid down a real challenge to those studying credit today, however.

At the ‘big picture’ level, the key emerging challenge has been to assess what changes in the long-term cycle mean for recovery prospects going forward. In the short-term the environment has been rapidly evolving with the ongoing crisis of banks – the institutions at the heart of the cycle.

According to Matt King, credit strategist at Citi, the US financial services firm, there is a divide between some economists who “feel that nothing has changed, that we can recover, and the existing deleveraging is encouraging”, and those who “place emphasis on the long-build up of credit and believe that we cannot just continue the same way now”.

For him, “the real shock is the discovery that what we thought was a sustainable growth rate for the last 30 years was largely based on a bubble in credit, which now needs to be repaid”.

The basic change in the macroeconomic environment is vividly illustrated by graphs on debt.

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For example, total credit market debt for the US – a measure of all issued debt in the system, including public, private and foreign debt – grew to $52tn in 2008 (it is now $55tn).

Expressed as a percentage of GDP, the only downturn it has had, since 1952, has been in the last three years, going from 385 per cent to 353 per cent [see chart].

Many commentators have flagged such charts as reflecting highly significant changes – although not everyone is convinced, and others point to nuances.

“We are embarking on a very long-term phase of deleveraging,” says King.

However, so far “there is really no overall progress to date”, he says.

All that has happened is that “we have moved from unsustainable private borrowing to unsustainable public borrowing. The little private sector deleveraging that has been done has been offset by the leveraging up of the public sector – for which the pain will come in the future”.

In that sense there has been little change in the overall levels of indebtedness for the developed world. This has prompted many to believe that there is very little chance that the bulk of the debt will be paid back. The basic consensus is that nobody knows when it will be paid back at the present rate either, although there are many estimates of numbers of years floating around.

One basic link is with economic growth. If economic growth has been overly dependent on debt-fuelled consumption, asset price bubbles, and government borrowing, rather than say income growth and more productive investment – then with such a drastic change in the credit cycle, and the heavy debt burden, what kind of growth can we expect now?

This has implications for the global macroeconomic economy given that the US was the epicentre of credit creation and drove the world economy – the ‘consumer of last resort.’

The economic historian Richard Duncan has analysed this transition extensively and in this context has talked about a longer-term paradigm shift from ‘capitalism’ to ‘creditism’.

Simon Ward, the chief economist at Henderson Global Investors, says that there was ahuge credit bubble, but that should not be seen as an inevitable cyclical phenomenon.

He says it was largely the result of central banks keeping monetary policy too loose after the recession of the early 2000s – a “major mistake”.

Reduced borrowing and spending will be a drag on growth, he says.

“It is possible that trend growth rates were inflated by the credit bubble, so future growth will be lower.”

James Ferguson, the chief strategist at Westhouse Securities, says “we are in the same place as Japan, but we are not doing all the same things that we told them do – particularly in terms of realising non-performing loans and recapitalizing banks”.

The reason, he says, is that “we realise that, now we have the same problem, they are actually too unpleasant”.

Japan is used as the classic case study for where the government has had to borrow, largely from its own population, essentially to spend in an economy – which refuses to spend. It is also seen as the classic case of ‘muddling through’ – although today the phrase could also be applied to any one of many western nations.

The result has been the build-up of the biggest government debt-to-GDP ratio in the world, currently standing at 212 per cent.

Economist and Chair in International Banking at Southampton University, professor Richard Werner, however has essentially argued that the key problem in Japan has been a lack of private credit creation, in relation to its boom and bust cycle of the late 1980s/early 1990s [see box below for monetary policy proposals].

Losses in Europe could be so large as to start a chain reaction effect.

King says: “Spain is to my mind insolvent – it has too much debt, in too many sectors across the board, and little chance of growing out of the problem. Italy by contrast is essentially solvent – it has lots of government debt, offset by lots of net household assets. In other words, provided someone somewhere is prepared to lend money to Italy in sufficient quantity for a long-enough period, they ought to be able to grow out of it.

“But if Spain defaults, the question becomes, will there be the political will to lend enough money to Italy, for long enough, for it to grow out of the problem? On the other hand, if you fail to address Spain, confidence does not return. Losses continue and everyone remains wary.”

If the wider long-term trends are challenging, however, many are looking to the shorter-term picture for at least signs of recovery and progress.

Eyes are keenly trained on trends in the money supply and credit, and reasons for major blockages; the recovery of the banks, in the different geographical contexts; the actions of central banks; and much more.

In terms of short-term prospects, Ward places more importance on the measure of narrow money supply rather than credit, finding that the former leads economies by six months, and that credit tends to lag.

If households or firms are planning to increase their spending, they move savings into more liquid assets, which show up as an increase in the money supply.

“It is a good early-warning signal of increased or reduced spending.”

Ward says the rise in global money and money in the eurozone has shown “a huge turnaround in the last six months. Real money growth in the last six months has been the fastest since 2010. So you could see a bottoming of the recession in the fourth quarter this year, and a recovery next year”.

Werner says we are seeing a contraction of credit in Europe and the UK, a 1.5 per cent rate in Japan, but 5 per cent growth in the US.

The composition of credit also matters, he says.

“A high proportion of US credit growth before the crisis was financial. Now it is manufacturing, which is generally healthier for GDP growth.”

The US “is already in a stronger position than Europe because at least there is one area of credit growth,” says Ferguson.

Loans to corporates and small and medium-sized enterprises – probably more the former than the latter – are growing.

This is bucking the historical trend because typically banks have had zero losses on mortgages and high losses on corporate and SMEs, and favour the former.

However, “for banks and the private sector, several areas are still contracting, and there are hidden losses on residential mortgages and commercial real estate,” says Ferguson.

This reinforces some of the broader analysis of the US economy, which notes that the smaller goods sector has been leading the recovery over the recent period – responsible for 80 per cent of it, according to one analysis.

The much larger services sector by contrast – which tends to rely on consumer spending and consumer credit – is in the meanwhile experiencing its worst recovery for several decades. One vulnerability here, however, is that the US could be more exposed to the downturn in the global economy, with overreliance on manufacturing and exports.

Faster rates of credit growth in the US relative to elsewhere, however, do tend to suggest that banks have had the most success in repairing balance sheets.

“What we do know is that credit goes into reverse when banks repair the balance sheet,” says Ferguson.

“You have grown assets too fast compared to what you need for liquidity and solvency, and you have to get back to solvency. That can take five to six years.”

Ferguson says that a measure of the banking crisis is that the US banking system started out with $560bn in 2007 in terms of tangible common equity, and today it has nearly $1tn. However by the end it probably will have its capital wiped out perhaps twice over.

One main reason is that “the average borrower finds it hard to repay if the economy goes into stall speed. And ironically the economy has gone into stall speed precisely because the banks have not loaned.”

Second, while non-performing loans are usually no problem for the banks as long as they are collateralised, the problem is with the collateral.

If all banks try to sell their collateral and nobody wants to buy, then prices collapse.

Ferguson says: “It is one thing not being paid back, but to find your collateral worth half of what you thought is something else. When you are taking hits to capital that you never really had enough of in the first place, it becomes a nasty feedback loop. Again it can take six years to get out. Banks however do generate huge cash flow, and can get back to solvency even though they are leveraged, given enough time.”

The biggest losses for US banks says Ferguson have been consumer credit, ($230bn), and residential mortgages, ($165bn).

Commercial real estate is $115bn, and C&I (Commercial and Industrial) is $92bn.

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“We are not done yet – losses on residential mortgages and commercial realty are likely to be a lot higher.”

Losses on “boring old loan books” are already more than twice the losses securities were at their peak, which were $275bn, he says.

In other words, he says, this was never really a sub-prime securities crisis, as many have made it out to be – but “an over-leveraged banking sector crisis.” In many cases securities losses have been written back up, he adds.

Werner says the key reason why banks have been able to repair balance sheets and return to strength has to do with the Federal Reserve’s policies.

US monetary policies have been the most successful he says precisely because they have employed a more careful concept of quantitative easing.

“The Bank of Japan has been doing the plain old-fashioned monetarist approach of monetary base expansion, which means cash and bank reserves with the central bank. However, reserve expansion has virtually zero impact,” he says.

“The Bank of England has been better – they have tried to inject via bond purchases to non-banks such as pension funds. That has had a positive monetary impact. However, much of the financial sector money is not reaching the real economy.”

In the US, the Federal Reserve followed “a more constructive definition of QE, something I proposed for Japan, which is that the central bank can help credit creation by buying up non-performing assets at face value, not at market prices. Through this, a stronger banking system is more likely to create credit again.”

King at Citi says the Anglo-Saxon banking sector is closer to what Sweden and Finland did with their crisis, to write assets down to the point where confidence returns and lending can grow again.

In Europe, King thinks the banking system would be generally ok – with the possible exception of Spain – providing that sovereigns are not insolvent. If they are, a large part of the European banking system is insolvent.

“We need to focus not on ‘quantitative easing’, the quantity of liquidity, but on ‘credit easing’”, he says.

“You need the economy to gets its ‘mojo’ back, to get risk flowing through the system again.”

That seems unlikely to happen unless “the assets which have turned out to be riskier than investors initially thought – be they US securitisations, or peripheral government bonds – can be made safe again. Yet doing so – for example by the Fed buying real estate, or the ECB relaxing collateral requirements and buying large amounts in peripheral government bonds – would require a blurring of fiscal and monetary policy which we are still reluctant to undertake.”

Elsewhere, King says that lowering interest rates does not address the real problems.

“For example, in the US, the Fed wants to lower the interest rate on mortgages perhaps to 3 per cent from 3.6 per cent. But is the interest rate really the main barrier to buying a house?”

This action “does not address the subprime borrower who wants a loan but will struggle to get another one because of the credit risk.”

At the same time, “it does not address the good credit risk who can get a loan, with banks falling over themselves to lend, but does not want one because of lack of confidence in the future.”

There are also other contradictory circumstances in the UK says King – a desire for more lending to SMEs, but also a desire for banks to have stronger balance sheets.

“But one cannot have it both ways”.

One of the ongoing risks discussed for the West since the crisis has been deflation and depression.

“If you want to prevent a deflationary depression – and who does not – QE plays a role” says Ferguson.

“If you get a contraction in the broad money supply, that is the very definition of deflation, and deflation is the difference between a recession and a depression.”

Europe’s periphery – which has experienced contraction in broad money, as commercial banks contract loans – after all is in depression now, with extremely high rates of unemployment.

“Central banks usually cause recessions when they raise rates to quash inflation. But that can be reversed with policy – lowering rates.

But central banks do not cause depressions – so they cannot easily reverse them with policy.”

You need QE to counteract the negative GDP effect from the government running less of a deficit, or fiscal austerity, he says, in the context of the private sector running a surplus.

“I am open-minded on the prospects for either growth going forward, or a new depression, because it depends entirely on monetary policy. We can do 20 years of two ‘lost decades’ like Japan or we can have steady growth. It depends on how credit is created, and allocated,” says Richard Werner.

Ward says that there is a greater risk of “inflationary resolution”.

He says that in history there is strong evidence for a long-term inflationary Kondratieff cycle.

Today, we are in the early stages of a long-term upswing, he adds.

“The policies of central banks are sowing the seeds for an upswing to develop over the next 10 years,” says Ward.


Innovations in Monetary Policy to boost growth

James Ferguson of Westhouse Securities says that many now claim that we have used up all the monetary policy options. The conclusion is that fiscal policy is the only thing left.

He argues this is wrong, and tends to serve special interests. Monetary policy should be still on the table but “we need new channels”.

His proposal is that we use fiscal channels to deliver monetary policy.

That is, trade finance, working capital lines, or plain-vanilla owner-occupier mortgages can be provided through state institutions such as the post-office. The state becomes an intermediary to provide credit to those firms that are currently starved.

The ‘state bank’ could issue government-guaranteed bonds with maturities that matched the loans (long-dated for mortgages, or very short-dated for working capital, trade finance, and the like.)

They could also deposit fund if there was a branch network like the Post Office, or set up an internet bank account or issue tax-free or inflation-indexed National Savings certificates.

Ferguson says the options are endless.

“There is no shortage of funding – look at how low short-dated gilt yields have been bid down. The problem is that all the funds want risk-free, so there is none searching for the risks in illiquid term loans to the private sector. A ‘risk-free’ entity (for example a country with its own printing press) needs to intermediate.”

Professor Richard Werner of Southampton University proposed in the first half of the 1990s that the Bank of Japan should use central bank credit creation to buy up real-estate in central Tokyo, including that held by banks as collateral on defaulted loans, and simply turn the land into ‘BoJ parks’.

The measure would inject money into the economy, support the real estate market (which had tanked by 80 per cent), help banks, and improve quality of life for Tokyo residents.

He has also proposed ‘baby premiums’ in Japan – payments of £200,000 for the choice for parents to have children, to address the ‘demographic timebomb’.

For debt write-offs more generally, Werner suggests that “non-performing debt should be purchased at face-value from the banks by a 100 per cent central bank subsidiary, funded by the central bank. Then the debt is cancelled.

Those who have performing debt, and those who do not have debt, get the aggregate amount of cancelled debt, divided among them, paid out as a citizens’ dividend (reverse tax), by the central bank.

So the book value cost of the write-off would be double the bad debt, but funded not by the tax payer, but the central bank. The central bank does not have to mark the shareholding in its subsidiary to market, so no losses are realised on its balance sheet. The subsidiary is effectively a ‘bad bank’, but funded by the central bank.”