It was good to speak again at the European Risk Council’s annual meeting in London, alongside Dr Pippa Malmgren and Alok Rustagi – chaired by the FT’s Marie Kemplay. Below were my opening comments, before we moved to a Q&A.
Today, I will focus on three areas: the end of cheap money, who is in a debt trap, and we are now moving to a G3 world; followed by come concluding comments.
The end of cheap money
First, the end of cheap money is the most important development that is impacting the outlook for risk and credit now. Since the 2008 global financial crisis, economies and markets across western countries have relied upon cheap money, in the form of low policy rates and asset purchases by central banks through quantitative easing.
As cheap money is being reversed it is vital to understand the distortions and damage that it has caused. It led to asset price inflation, to markets not pricing properly for risk, to a misallocation of capital that included allowing zombie firms to survive and in turn making it difficult for growth firms to access the capital they needed, it raised questions over what constitutes a safe asset and it fed the recent burst of inflation. It also led some economies and countries to not address underlying economic weakness, such as secular stagnation, instead relying on cheap money to see them through.
On top of this quantitative easing distorted the yield curve. Central banks were non-commercial buyers and in some countries they became the largest buyers of government debt. Regulation reinforced this distortion, incentivising banks to buy government bonds, as well as to lend to the property sector.
Last week I testified to the UK Parliament’s Treasury Select Committee on quantitative easing (QE) and quantitative tightening. I described QE as the good, the unnecessary and the bad. It was good in the immediate aftermath of the global financial crisis, unnecessary for much of the last fifteen years, and then bad following the pandemic, when central banks misread the situation and exacerbated the inflation outlook through their actions.
Given this, don’t be surprised if the end of cheap money leads to problems. It is like a minefield, so one needs to be careful where one steps. It exposes business models that are predicated on low and stable interest rates. It exposes crowded trades. It exposes asset and liability mismatches. It exposes over-leveraged sectors, although the full extent of this has yet to be seen. It will lead to a greater focus on credit risk. We have already seen examples, such as the LDI crisis in the UK last autumn, the recent banking crisis in the US and even on China’s Belt Road, with some countries renegotiating or writing off their loans.
Where will policy rates settle? One danger is group think at central banks.
At the annual gathering of central bankers at Jackson Hole in 2019, a few months ahead of the pandemic, there was widespread agreement that r-star, the neutral policy rate over and above inflation, had fallen to between zero and 0.5% in western economies. Thus, if inflation was two per cent, policy rates would be 2% to 2.5%; if inflation was three per cent, policy rates would be 3% to 3.5%. In my view that thinking will need to be reassessed as a guide to future policy rates.
Also, as we look immediately ahead, two wrongs do not make a right. One is that central banks were wrong to ease policy two to three years ago, as the pandemic hit, and the second is it be would be wrong to over-tighten policy now. Thus the speed, scale and sequencing of tightening must be sensitive to the performance of the economies in which the central banks are based.
Who is in a debt trap?
The second area is who is in a debt trap? This is about the relationship between growth, interest rates and debt.
In 2020, 77% of countries eased both monetary and fiscal policy. Last year, 74% tightened both monetary and fiscal policy. Globally, the ratio of gross debt to GDP reached 99.7% in 2020, according to the IMF’s recent Fiscal Monitor, and it fell to 92.1% last year. However, the IMF forecasts that because of weak growth, this ratio will rise to 99.6% over the next five years. High debt constrains future policy. Inflation may also limit the ability of rates to fall.
A debt trap occurs when debt is greater than one hundred per cent of GDP and also if growth is less than the rate of interest paid on the debt. Then the ratio of debt continues to rise. That is the trap. The relationship between growth and rates is key. Five of the seven G7 countries could be in a debt trap over the next decade.
What happens to inflation will have a critical bearing, both in terms of how it contributes to the growth in nominal GDP and also in terms of impacting interest rates.
A few years ago, I asked which ‘p’ would the rise in inflation be? Would it pass through, persist or be permanent? At that time I felt central banks were wrong to say it would pass through. At Netwealth we felt inflation would persist, and it has. I did not think the surge would become permanent.
This bout of inflation has been triggered by both supply side factors and by inappropriate monetary policy. Now, the supply side factors have eased and central banks have now tightened monetary policy. Thus, inflation is now falling. Over the next year, inflation looks set to decelerate, and it could undershoot before then settling at a slightly higher level than before the pandemic.
Over the last quarter of a century, four factors globally have kept inflation low. Two of these four, technology and financialisaton, remain in place. But two are now changing; the low share of wages and globalisation. In particular, the relationship between workers and managers is changing, with the wage share starting to rise, having previously been supressed by global competition. Also, globalisation is now being replaced by fragmentation, as decisions over supply chains are not being driven solely by cost. Thus, just in time is being replaced by just in case, and as firms seek in some instances to re-shore or to friend-shore their production. This latter is linked to my third point.
The G3 world
Third, we are now seeing a G3 world. This was evident in the UN vote immediately following the outbreak of the war in Ukraine, with countries dividing into three distinct groups. These were: the US and her allies; China and its allies; and the non-aligned countries, who probably neither wanted to be seen to be in America’s pocket nor wished to alienate China. This G3 world is likely to lead to geopolitical challenges. It could feed a breakdown in trust in regional or global institutions. Also, it is already feeding wider issues, such as a challenge to the dollar.
What then will be role that China plays? Here, the immediate focus for many is on China’s growth path. Between 2013-21 China accounted for 38.6% of global growth. Last year it grew around 3%.
A significant shift in policy is underway in China. As a result of the trade dispute with the US under President Trump, China has focused on self-sufficiency in food, fuel and technology. This is part of its dual circulation policy, aimed at moving China up the value-curve. China’s population is ageing and this points to a slower future trend rate of growth.
Last October, President Xi’s message at the 20th National Congress focused on common purpose, higher quality development, a global agenda and peace. Many of these messages aligned with that non-aligned group. Since then, the country has reopened after the pandemic and the annual central economic work conference in December resulted in former premier Li outlining the economic message at this spring’s annual Two Sessions in Beijing. That pointed to a 5.5% growth target for this year, which I think should be achieved, inflation of 3% and a stable monetary policy. Consistent with the existing 14th Five Year Plan, the focus was on avoiding financial and fiscal risks, and keeping these under control. Addressing environmental issues also figured prominently in that plan.
The policy for China can best be thought of as the three G’s of growth, global and green.
A few weeks ago the question was being asked as to whether there will be another global financial crisis now? The answer should be no. But that very question could have a bearing on the regulatory environment. Ahead of the 2008 global financial crisis, the regulatory pendulum was at one extreme, too light. Then it swung towards the other extreme, very heavy. But to get the balance right between regulation, the need for financial stability and growth the pendulum needs to settle in the middle. Now, however, the current climate may result in another push of that regulatory pendulum towards even more intrusive regulation.
Already we know from open letters and policy statements from regulators that they are highlighting an array of areas that all are understandable. These include operational risk, and the need to be focused on third parties, financial risk and the need for liquidity risk management and conduct risk, among others.
As the regulatory burden intensifies, it will lead to further change. One example of this was reflected at the end of last year in the Financial Stability Board’s (FSB) annual assessment of what used to be called the shadow banking industry. This is now referred to as non-bank financial institutions (NBFIs), although in my view this is a slightly wider definition. It showed that at the end of 2021, global financial assets reached $486.6 trillion, and of this the share accounted for by NBFIs had risen to a huge $293.3 trillion. The changing regulatory environment incentivises and impacts where business is conducted and points to a further shift towards NBFIs.
So, in conclusion, I have highlighted three areas. These are the end of cheap money, who is in a debt trap and the G3 world.
Such an uncertain environment may led to more regulatory intrusion, not less, and that may impact how and where business is conducted.