Why it’s feeling like autumn of 2008

  • The stage is set for a major storm in financial markets and economies around the world. India will not be immune
  • The 2008 crisis was due to excessive debt carried by financial institutions. But the answer from central banks has been to reward even higher gearing of balance sheets

V. Anantha Nageswaran
First Published25 Jul 2019
With slowing consumption and an erratic monsoon, India may be sleepwalking into a major and prolonged economic slowdown.
With slowing consumption and an erratic monsoon, India may be sleepwalking into a major and prolonged economic slowdown.

It would have been unthinkable even a few years ago to have high-yield/speculative/junk bonds being sold for negative yields. But that’s exactly what’s happening now. The Wall Street Journal recently issued an oxymoron alert that high-yield bonds had gone negative. The report says 14 European companies with junk bonds worth more than €3 billion ($3.38 billion) are trading with negative yields. Then, a pension fund manager in a European country was told by his regulator not to hold too much cash because it is risky and was told to invest them in negative yielding bonds, instead!

Is this for real? These bonds were meant to be high-yielding because they carried a high probability of default. But now the logic of higher expected return for higher risk has been upended. This makes investing impossible. Globally, about $13 trillion of debt is trading at negative yields. Two US companies that issued leveraged loans have quickly seen their bonds lose value. Obviously, lenders chasing yields have ignored risks. This cannot and will not end well. It is time for investors to batten down the hatches and settle for safety rather than returns.

Amidst all this, what is funny or tragic (depending on your lens) is that investors, according to Schroders, have upped their return expectations for 2019 to 10.7% from 9.9%. This is based on a survey of 25,000 people across 32 countries. In other words, the survey respondents plan to make riskier investments (some of which now yield negative returns!) and they expect central banks to underwrite their risks with ultra-low interest rates or negative rates or nominal gross domestic product (GDP) targeting into eternity.

Who is responsible for this upside-down world of investing?

Ultra-low interest rates

Let us start with the US Federal Reserve. The Federal Open Market Committee, which sets monetary policy, is meeting on July 30-31. US President Donald Trump is putting tremendous pressure on the Federal Reserve to ease monetary policy aggressively. Although the Federal Reserve strenuously denies complying, it is behaving as though it is complying. The central bank is ready to cut interest rates by 25 basis points at the minimum in its meeting in July. One should not be surprised if the preemptive “vaccination” is 50 basis points. The US economy does not need it. William Dunkelberg of the National Federation of Independent Businesses marshalled data to show that no real business—including small ones—is being starved of credit.

All else being equal, a besieged Federal Reserve would have made the US dollar a sitting duck for speculators and for the world, in general, to fall out of love with the greenback. But, it won’t happen in a hurry because others are far worse off. So, the story of the world finally getting out of the dollar standard has to wait. That is because other central banks are again talking of cutting rates aggressively.

European Central Bank (ECB) is fully prepared to outdo the Federal Reserve. Eurozone countries have selected Christine Lagarde to replace Mario Draghi as the president of the ECB. She will be more populist and “bolder” than him with monetary policy experiments. That will be music to financial markets, hedge funds, private equity (PE) investors who place bets with a high degree of leverage.

The crisis of 2008 was supposedly due to excessive debt carried by different financial institutions—some visible and some hidden. But, the answer from central banks has been to incentivise even higher gearing of balance sheets. In the US, the number of companies with increased risk of becoming financially distressed—companies that either generated negative Ebitda (earnings before interest, tax, depreciation and amortization) or have net debt to Ebitda over 3x—has grown noticeably this cycle (53% as 30 June 2019) versus last cycle (32% as of 30 June 2007). It gets worse.

Central banks deliberately avoid thinking about why their decade-long policy of ultra-low interest rates has failed to mend economies. In less than a year after proclaiming the return to normalcy, central banks are priming themselves to become even more adventurous with their monetary policies. All that their policies have engendered is reckless risk-taking in financial markets, more leverage, greater inequality and tremendous stress on savers, bank deposit holders and pensioners.

No concern for profits

Another important consequence of such remarkable persistence with such ill-advised policies is the diversion of capital for unproductive ends and personal aggrandisement. Loss-making startups are carrying on without a concern for profits because cheap money means PE investors blanket them with funds. For instance, WeWork Companies Inc. is a technology unicorn in the office rental space. The company has filed for an initial public offering but it had the temerity to issue $4 billion debt before that and its co-founder has cashed out $700 million in the last year! It is valued at $47 billion. Softbank Corp. wanted to invest $16 billion in that company, but the investment was pared back after its investors protested.

We heard of price-eyeball ratio in the dotcom bubble era of the 1990s. Now, WeWork presents “community adjusted” Ebitda which strips out “not only interest, taxes, depreciation and amortization, but also basic expenses like marketing, general and administrative, and development and design costs”. No one has heard of this Ebitda before because it is effectively gross revenue and without accounting for costs, it turns into profits, of course.

Not only have promoters benefitted immensely from loose monetary policies and funds available on liberal terms from capital markets but they have also profited from the tendency of governments to compete away their tax dollars from firms.

The corporate tax rates in developed world have come down steadily from 38% in 1990 to 22% in 2018. This has forced low-income countries to lower their tax rates as well as, otherwise, companies will shift their tax bases to havens that still remain in high-income countries. Corporate tax rates in low-income countries have come down from 46% to around 28% in the same period. This data comes from the International Monetary Fund which, officially, has been the cheerleader for unconventional monetary policies that have played a leading role in precipitating the next biggest crisis after 2008. That will not be just an economic crisis but a sociopolitical one too.

A global firestorm

There has been much schadenfreude in Asia at the self-destruction of capitalist western societies. Asia, if anything, is more vulnerable. The crisis of 2008 has damaged their growth models irreparably. Let us start with China. Beijing is presiding over a shaky economy as official growth rate is again overstating true economic growth and global manufacturing supply chains are moving out of China, exactly as intended by the US administration, even if they are not returning to the US.

In the meantime, China Minsheng Investment Group is defaulting on its dollar debt. Its parent, China Minsheng Banking Corp. Ltd is China’s largest private sector bank by assets. In 2015, it did warn of “systemic, concentrated financial risk happening in China” but it has become a victim of it, itself. In Hong Kong, protests against the pro-Beijing government are intensifying.

Smaller Asian nations are faring no better. Japan’s exports have had seven straight months of decline up to June 2019. So has the performance of Korea’s exports. Singapore’s non-oil domestic export is a bellwether for international trade and global economy. It is declining precipitously and Singapore economy itself appears headed for harder times. Singapore’s overall GDP contracted 3.4% in the second quarter (q-o-q, annualized). Of course, this is an advance estimate based on two months’ of data. Then, Indonesian exports have declined for eight straight months up to June, and Malaysia’s exports have fared slightly better than Singapore’s and Indonesia’s.

A survey of the global political landscape confirms our worst fears. Leaders are ill-equipped to face the oncoming economic storm. Worse, they are seeding and nourishing it. Japan and South Korea are back to feuding in which the trade disputes playing a small but significant role in it. The wounds are historical and they were reopened by a Seoul court ruling last October. Malaysian Prime Minister looks all set to walk back on his word to hand over power to Anwar Ibrahim, again! Such political conspiracies and power-grab have rendered Association of Southeast Asian Nations (Asean) irrelevant both politically and economically. It was laid low by the crisis of 1998 and it has not recovered since then.

Moving to Europe, German investor and economic sentiment indicator, ZEW, is going deeper into negative territory. The same ZEW survey also pointed out that “the indicator for the current economic situation in the euro zone fell 6.9 points to a level of minus 10.6 points in July.”

In the UK, Boris Johnson has become Prime Minister and Brexit—deal or no deal—looks likely. Its consequences will be unpredictable because the country has now fraught relations with the IS, with European Union, with China and with Iran. In continental Europe, Angela Merkel’s physical health is deteriorating.

Elsewhere, Iran has seized a British oil tanker and the US has shot down an Iranian drone. Of course, the current expectations are that things won’t spiral out of control. But, a president seeking re-election is increasingly focusing on cementing and consolidating his base. Belligerence towards his domestic and global opponents will be consistent with those political goals.

The India factor

Finally, let us examine if India is anywhere close to being a safe haven from the turbulent world. After all, in the elections held in May, its government won a strong mandate with a better majority. Alas, its economy is getting deeper into trouble. The slump in the Indian auto sector mirrors that of South Korea and its overall economy has not stopped slowing. The Reserve Bank of India (RBI) governor has taken to chiding public sector banks on their non-transmission of his rate cuts.

Just as it is the case in the West, monetary policy has no answers to structural ills. One way of resolving such issues starts with admitting to them and then being patient without too much anxiety about short-term growth pains. Window dressing only complicates the problem and delays eventual resolution, recovery and strong growth. The budget was incoherent and privileged financial liberalization and trade illiberalization. It socked the rich again and that was needless, both politically and economically.

The government announced that it would go for sovereign foreign currency borrowing at a time when India’s export performance is poor and the global growth environment is becoming worse. Dr. Y.V. Reddy, former governor of the RBI, wrote that a decision on India’s capital account convertibility must precede the decision to issue sovereign dollar bond. But, this is not the best time to liberalize capital account when India’s fiscal health is not at its best and when export performance is sluggish at best.

What appeared to be a cleverly disguised (positive) move to divest government stake in public sector enterprises below 51% has been denied, as well. Monsoon is erratic once again and anecdotal evidence points to India being more vulnerable to global climate change than most other nations. India may be sleepwalking into a major and prolonged economic slowdown.

In conclusion

As we head into 2020—the year of US Presidential polls—present trends in financial markets around the world would coalesce into a major storm, convulsing most of them in the process. The US presidential election campaign could yet be the most fractious in its history, at a time when the economy may be pushed into a recession by a crash in the stock market or the other way around. That may set off a dollar crisis. The rest of the world with its own political and economic problems will be unable to fill the leadership vacuum left by a politically fractious and economically floundering US.

Once the storm subsides, a new world economic and political order might emerge. To end on a positive note, the destruction wreaked by the storm might mark a true and a lasting bottom for the world economy on which its durable recovery could be built with more sensible policies than the snake oil that central banks have applied.

The writer is the dean of IFMR Graduate School of Business (KREA University).

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