Reflections: Define Exigent
By John Gilbert
September 21, 2012
The world is relying upon its central banks to work wonders. Having made a mess of their balance sheets, households and governments are faced with the long and unpleasant task of reducing indebtedness. The infinite supply of money in a paper money system is the obvious solution. The question is whether, with very liberal exercise of that privilege, there is some limit to its use.
Central bank behavior has, so far, produced annoying but salutary results. Anybody with any savings is annoyed at the asphyxiation of their yields. But central banks’ vigor in countering further price declines in risky assets is, on the other hand, a happy outcome in its immunization of private investors’ risk of significant loss. The balance is, so far, a standoff. The disappearance of yield in putatively safe assets is offset by the safety provided by the central bank.
But unintended effects are the iron rule of government behavior. In fact, the more vigorous the government behavior, the greater the unintended effects are likely to be. Central bank doctrine holds that this does not matter. Certain asset prices may inflate because of their behavior, but such consequences are incidental for their purposes. Their remit is inflation and, in the U.S., employment. Asset prices are notoriously volatile, incorrect valuations are difficult to prove, bubbles locate themselves in particular assets unpredictably and an unfavorable valuation conclusion may be controversial. But the enthusiastic policies of the central banks are producing distortions that must, in time, have their revenge. The distortions are already growing, and there is a rising risk that unintended effects manifest themselves before developed world delevering is complete. If that were to occur, risk aversion would likely return, and central banks could find themselves under pressure to provide a bid under riskier assets.
We look here at certain examples of inflating valuations. They are sovereign issues of emerging countries, which are particularly meaningful since their overvaluation may have broader significance than those of private issuers. Emerging countries have been a primary driver of aggregate world demand since the 2008-2009 crisis, and if their growth were to slow it would have negative implications for the growth necessary for deleveraging in general.
The attempt to value assets, financial or real, at their correct value is impossible. The future is uncertain, so the proper value of an asset at a given time lies within a broad range. This principle is the basis for central banks’ avoidance of making asset prices explicit considerations in setting policy.
However, while identification of the right value for any asset is futile, recognition of the wrong value is easier. Excess, high or low, may become apparent upon careful analysis. Some excesses are already demonstrable. France does not, at the moment, deserve to trade as a sovereign credit at the yield that it does. But it is less risky than Italy, so that is where the money goes, and French bonds are overvalued (Reflections, August 2012).
Another candidate is emerging country bond yields, which over time has been a reliable canary for air quality in a coal mine. Many such countries have demonstrated strong economic performance over the last decade, and collectively have led growth of the world economy. They have been rewarded with credit rating upgrades accordingly. While they have historically traded at much higher yields than developed country sovereigns, that yield premium is evaporating rapidly.
Chart 1. Bond Yields, USD Denominated
Sources: Bloomberg L.P. and GR-NEAM
The recent collapse in yields implies that such sovereign borrowers have demonstrated not only an improvement in their credit worthiness, but a permanent one. Booms always appear sustainable at the time, but certain emerging countries show recognizable signs of unsustainability. The principal one, now familiar in emerging countries, is rapid rates of growth in credit extension. An acceleration of growth in domestic demand is accompanied by rapid growth in borrowing. In the case of Brazil at the moment, for example, a massive positive shock in terms of trade – the huge rise in commodity prices for Brazil’s exports – caused Brazilian incomes to rise. If Brazilians save, the country’s current account surplus will rise and the country’s fiscal positions improve. But if, instead, Brazilians’ rising incomes stimulate domestic demand, the opposite may occur. This is the choice they have made, and will be exaggerated if it is accompanied by rapid growth in credit.
Chart 2. Brazil Private Debt to GDP
Sources: Central Bank of Brazil, Haver and GR–NEAM
This is not self sustaining. The credit growth is merely a doubling up on an unsustainable burst of demand, and must in time meet expectations of repayment.
While Brazil is an important case because of its size, a similar pattern is appearing elsewhere. We select Indonesia, also because of its large population, and Turkey, because it appears to be a particularly overheated economy.
Chart 3. Indonesia and Turkey Private Debt to GDP
Sources: Bank Indonesia, Central Bank of Turkey, Haver and GR-NEAM
In each country strong domestic demand is behind the development and recent acceleration in current account deficits. Brazil is particularly worrisome. The very high commodity prices of the last decade were a gift, since the country is a massive exporter of natural resources. But Brazil’s current account surpluses have disappeared as import demand overwhelmed the rising value of its exports.
Chart 4. Brazil’s Current Account as Percent GDP
Sources: Central Bank of Brazil, Haver and GR-NEAM
Indonesia and Turkey have likewise had accelerating current account deficits. Inexpensive financing in the form of falling bond yields further stimulates demand.
The fearsome outcome is that growth slows as rising debt loads bite before deleveraging is complete in emerging countries. In that event there are few growth engines left.
Under such circumstances asset markets that are now inflating could decline enough to threaten the growth that central banks are trying so hard to produce. They could find themselves the buyer of last resort. Then they must face the threat to their independence if they acquire an asset carrying a risk of credit loss. There is precedent for support for risky assets, including the funding for lending program underway at the Bank of England, under which the central bank is indemnified against loss by the government. The Federal Reserve in the U.S. faces constraints in accepting risk, but did so in acquiring securities previously owned by Bear Stearns and AIG. In doing so the Fed invoked Section 13(3) of the Federal Reserve Act, which says that “in unusual and exigent circumstances” the Federal Reserve may purchase the obligations of private issuers—that is, risky assets.
The question is how to interpret “unusual and exigent.” History helps little, since Lehman was allowed to disappear beneath the waves. The provision is unlikely to be exercised unless circumstances deteriorate rapidly. But it would not be the first time that government behavior in time produced a result opposite that which was intended.
©2012 General Re-New England Asset Management, Inc.
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