James Bevan: A long-term view of credit -1985 to 2015

The (latest) Asian trade and financial market slump can be seen as part of a longer term process of rolling credit booms and busts that began in the mid-1980s.

Back in the 1980s, the macro fixation for markets was the US budget deficit which stood at unprecedented levels by peacetime standards, whilst the US dollar was expensive, US manufacturing was weak, and the Latin American debt crisis was in full swing.

Asia was in a quasi-recession, European problems were building with the Exchange Rate Mechanism, forerunner of the Single Currency, but the UK was doing rather well.

In response to these challenges, global policymakers contrived to create a series of credit booms, the first being in the US and the UK, then in Japan, and even to a more limited extent in Europe.

The resulting developed world credit boom in the late 1980s involved both the corporate and household sectors of the OECD economies, and Asia received a genuine trade stimulus.

However, when the Fed, BoE and BoJ began to tighten at the end of the decade, the global economy slowed and a number of legacy problems emerged in the US S&L sector and Japan’s financial system. Indeed, by 1990, many of the global economies were facing recessions, and this situation was exacerbated by the first Gulf War.

Response

The perhaps predictable response of authorities in OECD economies to these challenges was to cut interest rates and in some cases such as the US, initiate strategies that were in essence forms of Quantitative Easing.

At the same time, there was a drive for more predictable central banking with explicit inflation rate targets, leading to huge expansion in the volume of global capital flows in the early to mid-1990s, both in absolute terms and relative to the size of the underlying real economies.

Thus, central banks that provided seemingly predictable and easy monetary policies helped to create the boom in international capital flows that drove global financial markets from the 1990s.

Many of the capital flows driven by OECD central banks in the early to mid-1990s ended up in emerging markets (EMs) in Asia and Latin America, with such capital flows quickly recycled by recipient countries’ banking systems, creating domestic credit booms that financed rising levels of consumption, investment and speculation in local property markets, and some quantum of productive investment in recipient economies.

But by 1994, many EMs were beginning to overheat and were beginning to export inflation to the rest of the world via not only their own export pricing trends but also their surging demand for commodities and other goods.

Again perhaps unsurprisingly, the authorities in the OECD economies then reacted to the perceived increase in (global) inflationary pressures by tightening policy. Thus Japan was even threatening to raise rates in 1994 and the Fed raised rates quite aggressively, with the unsurprising result that there was a marked slowdown in global capital flows over the mid-1990s, leading eventually to the Asian and EM crises of 1997-98.

What had happened was that by the mid-1990s, many EM countries had become dependent upon ever expanding levels of capital inflows to sustain growth but, when the flows dried up, it was only a short and inevitable step to the crises that followed.

Easing monetary policy

Crucially, as EMs slipped into crisis in 1997 and hence began not to export inflation but instead to export deflation via collapsing currencies and demand for imports, DMs responded by easing policy, leading to the boom in US corporate credit that evolved into the TMT and Nasdaq bubble.

The Fed decided to burst these bubbles if only temporarily in 2000 but, when the results of the bust proved deflationary in the early 2000s, the Fed and other central banks relented and instead created another credit boom.

This new boom was centred on Western economies’ consumer and mortgage sectors and by 2005-6, the credit boom had also begun to spill over into EMs, with inflationary pressures rising by 2007, as the global economy accelerated. Then as inflationary pressures built, the Fed threatened to tighten policy, and the credit bubble burst, ushering in the global financial crisis.

The result was rising risk of deflation in 2008/9 but DM authorities once again responded by easing monetary policies and commencing modern QE. Not surprisingly given the scale and severity of the global financial crisis and countries’ elevated debt ratios, the new QE largely failed to re-start the credit booms in the West, but Western central banks did succeed in creating yet a surge of global liquidity that once again engulfed EMs and in so doing caused new credit booms in these economies.

As a result of the successive waves of capital flows and the credit booms that they encouraged, and indeed facilitated, EMs are now even more indebted than DMs were in the mid-2000s leading up to the global financial crisis, and this is of course part of the current EM problem.

It’s noteworthy that much of the credit that was advanced to EM companies during the 2005-2014 capital flows/credit boom was not in fact used to fund higher levels of household consumption.

Instead it was primarily used to finance the build of industrial capacity and the accumulation of inventories, and much of the new capacity and the build of inventories outstrip demand, with the result that many EMs are long of fixed assets, overly indebted, and increasingly short of cash flow.

In an effort to remedy this weak cash flow situation, many EMs have moved to heavy discounting and even dumping of goods with weaker currency regimes. Hence, EMs are again exporting deflation both amongst EMs and to DMs.

Close to zero

When faced with the deflation threats of 1998 and 2002-3, Western central banks, and particularly the Fed, were able to ease monetary policy to support credit growth and inflationary pressure. But in 2015, DM interest rates are already at close to zero and bond yields are arguably too low particularly for the pension and insurance sectors.

As a result, unless central banks are prepared to move to negative interest rates, there is little that they can to fight deflation exported from Asia, whilst DM commercial banks are now heavily regulated and private sector debt ratios are already stretched across much of the world.

Even the US, which is experiencing a level of capital inflows relative to its size that it has not seen since the mid-1920s, is clearly finding it hard to generate faster credit growth.

Indeed, the latest US credit data have been notably soft despite the Fed’s accommodative stance, and whilst the US is experiencing rapid ‘credit growth’ as companies borrow in the corporate bond markets to fund equity buy-backs, very little of these funds end up in the real economy, and hence exert only minimal impact on aggregate demand trends.

The worrying conclusion is that there’s a shortage of candidates that can borrow more and inflate their balance sheets further to offset the deflation emanating from Asia.

This implies that, as a group, the world’s central banks are becoming relatively powerless, and whilst countries and regions can go for competitive devaluations, these tend only to provide temporary respite and are by their very nature deflationary for the global system as a whole.

Our conclusions are that in the near term, financial risk asset markets will become increasingly uncomfortable with the reality that central banks are somewhat helpless.

We can hope however that for the medium term, governments will recognize that central banks cannot do the heavy lifting, and it would seem that this realization is already dawning in Japan.

We can suspect that the result will be that governments return to more public sector spending with higher budget deficits, and also seek to take more direct control of the private sector’s capital stock.

Indeed, we have already witnessed the beginnings of this process with the trend towards ‘living wage’ legislation, pricing threats for utilities and medicines, and other populist measures. It’s no coincidence that we have the rise of Syriza and Corbynomics. Alas, more state intervention is unlikely to be profit-friendly, although increased fiscal spending may revitalize economic activity for a while.

The preferred way forward for economies should be to invest in raising productivity through better education, encouragement of R&D and provision of physical infrastructure and if governments do not grasp the nettle, we worry that over the next few months, governments and markets alike may come to rue missed opportunities to produce real wealth gains rather than transitory asset price booms.

The practical implications for us are to stay safe, with a maintained focus on sustainable quality growth at the right price, and on assets that meet the secular growth requirements of economies.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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