The process of quantitative tightening that the major central banks are currently engaged in makes many people worryingly remember one of Warren Buffett’s famous sayings: “Only when the tide goes out do you discover who’s been swimming naked”.
Such concern is understandable. The decade of ultra-low interest rates has fueled risky behavior on the part of both governments and companies. The fact that interest rates were kept so low, no longer reflecting the risk that the loans were financing, made debt risk management no longer a priority. No matter how much such entities borrowed on the bond market, there was always a central bank around, careful to keep interest rates extremely low and liquidity plentiful.
Tolerating this unhealthy behavior makes the fight against inflation difficult and risky today. These two problems stem from the fact that withdrawing liquidity from the market and making money more expensive, withdrawing the “tide” if you will, makes all government and corporate debt much more expensive to refinance.
And this pressure is multiplied when we are talking about vulnerable economies or companies. The IMF estimates that 60% of low-income countries are already at high risk of default or have already entered such a situation, with the vast majority having dollar-denominated debt. Even an area such as the eurozone is not free of tensions if we think of its weak links Italy or Greece, countries with a high degree of indebtedness and questionable credibility on the financial markets.
In these circumstances, many analysts and investors see central banks under increasing pressure to generate a new monetary “tide” to cover the “nakedness” of many debtors. On the occasion of a recent conference of private pension managers in Europe, I had the opportunity to participate in a panel with Mr. Michael Howell, Director of the asset management company CrossBorder Capital. Mr. Howell, a well-known financial market professional, believes that there are three important reasons why major central banks will be forced to resume quantitative easing, albeit perhaps in a different form.
Firstly, global financial fragility, caused mainly by the huge need to refinance debt. The global debt balance is estimated at 350 trillion dollars, or three times the value of world GDP. Assuming an average maturity of 5 years, it follows that 70 trillion must be “rolled over” each year worldwide. The question that arises is who will do it and with what money, given the withdrawals promoted by central banks.
The second reason is linked to the fiscal pressures induced, on the one hand, by the ageing of the population and, on the other hand, by the substantial share of interest costs in the budget structure of countries that have accumulated large debts.
The third risk is linked to the persistence of inflation, which could delay the initiation of interest rate cuts by central banks. Thus, the burden of the cost of high debt would remain for a longer period of time, making it difficult to bear.
Given these assessments, Mr. Howell suggests the need for a different, more moderate type of quantitative easing by targeting a certain yield curve by central banks. In other words, presetting and guaranteeing the interest rates at which governments borrow for different maturities. Such an approach would aim to prevent a liquidity crunch in the bond market, but also to put a price on money to discourage over-indebtedness.
In my view, such an approach is likely to substantially reduce the motivation of large debtors towards fiscal consolidation or financial prudence. The recent UK gilt crisis, cited by many as a precursor of what could happen in other markets, was resolved by a last resort intervention by the Bank of England, but it sent a particularly strong message to the UK government about its unsustainable fiscal policies. I’m not at all sure that yields targeting would have provided another opportunity for a lesson for populist politicians. The very fact that the Bank of England’s intervention was last-minute and not a routine, guaranteed intervention made the lesson not easily forgotten.
By targeting yields, central banks will in fact only prolong their unhealthy interaction with the political area, being subject to pressure and continually striving to maintain otherwise unsustainable fiscal policies. Not to mention that it would be hard to imagine an effective policy to keep inflation under control.
Whether they like it or not, slowly but surely, we need to see how “dressed” the big debtors are, and if they are “naked”, they had better be stingier in order to buy “clothes”. As for the central banks, they should only have interventions of last resort.
Have a nice weekend!
