[Mb-civic] The Long View: Caught in a credit bubble

[Michael Butler]

FT.com     
 
 
 
The Long View: Caught in a credit bubble
>By Philip Coggan, Investment Editor
>Published: May 20 2005 16:47 | Last updated: May 20 2005 16:47
>>

Confusion reigns. The global economic climate is marked by a staggering boom
in China, apparent stagnation in Europe, a massive US trade deficit, booming
corporate profits, soaring (until recently at least) commodity prices and
government bond yields at their lowest level for a generation.

It is hard to knit all these themes together but those who have assembled
the most convincing stories tend to focus on the role of credit.

George Cooper is a strategist at Deutsche Bank in London. In his latest
note*, he argues that the US Federal Reserve may have learnt the wrong
lesson from the Japanese experience of the 1990s.

Cooper looks at the relationship between risk premia (the excess return that
investors demand for risking their capital) and asset prices. If confidence
improves, risk premia will fall. In other words, investors will apply a
lower discount rate to future cashflows. This will encourage them to invest
in more marginal projects, ones that would not be profitable if they applied
a higher discount rate.

Indeed investors will be willing to borrow money to invest in these risky
projects, provided the expected returns are higher than the cost of
borrowing. Their leverage will increase.

But a lower risk premium means the value of their existing assets will rise.
That will bring down the investors¹ leverage, making them even more
confident and encouraging them to borrow even more. A virtuous circle sets
in.

Consider the housing market. Traditionally, consumers are confident when
house prices are rising. That confidence persuades them to take on more debt
in order to buy houses. The extra capital they borrow pushes up house prices
even further, increasing confidence and so on.

At any given point, those who look at consumers¹ balance sheets are not
worried. Yes, consumers have a lot of debt but those debts are more than
covered by their assets (the houses).

But a rise in credit does more than this. Improved confidence increases
investment (backed by credit) and thus incomes in the form of higher wages
or profits. As incomes rise, confidence improves further and so on.

These cycles have existed for centuries. What normally brings them to an end
is some outside event (a shock such as a war). At that point, confidence
falls, investors opt to save rather than borrow, asset prices turn down,
reducing confidence further and so on.

Here is where the US Federal Reserve comes in. Alan Greenspan, the Fed
chairman, has made it clear it is very hard to identify a bubble and
therefore it is not a central bank¹s job to pop it.

However, Greenspan has been more than willing to intervene in cases of
crisis (such as the LTCM hedge fund crisis or September 11) by slashing
interest rates. Cooper dubs this an ³asymmetric intervention policy².
Investors have noticed this behaviour. Rationally, therefore, if the risk
premium they demand should fall since the Fed will always ride to the
rescue.

But here is the dilemma. Prices are being kept artificially high because of
Fed policy. But if they start to fall from those levels, the Fed is forced
to intervene again to avoid a crisis. This drives prices even higher, making
them even more vulnerable to a shock. The market becomes a junkie, needing
an ever greater fix to get high.

The problem in Japan, Cooper argues, was not that the central bank did too
little, too late; it did too much, too soon. It did not prevent the late
1980s bubble but when the crash came it did slash rates. The corporate
sector had over-invested during the bubble and, by avoiding an outright
slump, this excess investment was never scrapped. The economy became locked
into a period of abnormally low interest rates.

The Fed is trapped in a similar cycle, says Cooper. Like Sisyphus, it is
³attempting the futile task of eternally pushing asset prices up an ever
steepening valuation slope².

Richard Duncan is an American who works for a Dutch bank in Hong Kong. His
analysis, in a revised version of his book**, also focuses on Japan and the
US.

He sees the key to recent events as the period of dollar decline in 2003. At
that stage, investors suddenly became alarmed at the size of the US current
account deficit. They sold dollars and switched the proceeds into euros and
yen. But the Japanese did not want the yen to rise against the dollar. They
intervened heavily in the foreign exchange markets to prevent this from
happening, acquiring the equivalent of $320bn.

This intervention could have been ³sterilised² by the process of selling
government securities to Japanese investors. But the Bank of Japan did not
do this. Instead, it effectively created the money. This was a monetary
stimulus equal to around 1 per cent of global gross domestic product. It is
small wonder global growth was so strong in 2004, as this liquidity sloshed
around the system.

Indeed, if you add all the Asian countries¹ foreign exchange reserves
together, Duncan argues, there has been a massive increase in global
liquidity. This helps explain why bond yields are so low; a mass of Asian
savings has been chasing relatively little in the way of new bond issuance.

Low bond yields in turn stimulate the US economy, which sucks in more
imports from Asia. That builds up more Asian foreign exchange reserves. We
have another virtuous circle.

Either thesis helps explain quite a lot of what is going on in the world.
They can even explain low inflation. Normally, surges in credit push up
inflation, but this time around most of the credit has gone to support asset
prices while goods prices have been kept low by the emergence of Chinese
competition.

What the authors cannot tell us, of course, is when these processes will
stop. That they will is inevitable. But it will probably need some external
shock for the credit bubble to pop.

*The Burden of Sisyphus, george.cooper at db.com
>**The Dollar Crisis: Causes, Consequences, Cures, published by John Wiley,
£12.99

philip.coggan at ft.com
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