Tuesday, September 6, 2011

Nowhere to Run baby, nowhere to hide ....

Satyajit Das take on the current environment from his blog, Fear and Loathing in the Financial markets  ....

The crisis threatening to engulf world financial markets has been brewing since 2008. Until recently, markets were Dancing in the Streets. Increasingly, another Holland-Dozier-Holland standard also made famous by Martha and the Vandella’s is relevant: “Nowhere to run to, baby/ Nowhere to hide.”

The recovery from the first phase of the crisis was based on “botox economics”. Clostridium botulinum – “botox”- is commonly used to improve a person’s appearance, but its effects are temporary with toxic side effects. “Financial botox”, money from central banks and governments to prop up demand, temporarily covered up deep-seated problems, rather than resolving the real issues. As chastened individuals and companies reduced debt, governments increased their borrowing to limit the effects of the crisis on the broader economy.

The new phase of the crisis is different to 2008 and the “Lehman moment”. Then, governments had the financial capacity to backstop the private sector, especially affected financial institutions, and support the wider economy.  The crisis now involves entire nations and the ability of sovereigns to finance themselves is in question. Ultimately, there is no one to backstop the governments themselves. Contagion from sovereign debt crisis is especially pernicious and very different to that of 2008.


Europe’s debt problems provide an insight into the problem. While smaller nations can be bailed out by other stronger nations, the financial commitment required weaken the saviours and threatens their own survival. Saving Greece, Ireland, Portugal, Spain and Italy would probably require a facility of at least Euro 3.0 trillion with an effective lending capacity of around Euro 2 trillion dictated by the fact that maximum lending capacity is limited by the guarantee commitments of AAA rated countries.  As more countries need support, the burden of the guarantees becomes concentrated on stronger Euro-zone members - German, France and the Netherlands. In effect, the creditor nations rapidly become debtors themselves, ultimately affecting their credit ratings, cost of funds and causing financial problems if the contingent liabilities are triggered.

International Monetary Fund (“IMF”) support may spread the potential contagion to other countries. In effect, rather than containing risk, support for weaker nations spreads the crisis to the stronger countries. Government bonds are traditionally safe-havens as well as the preferred form of collateral used very widely to secure borrowing and other obligations. If the quality of stronger government issuers were to be contaminated, then this would lead to far reaching effects on financial activities.  Most banks have substantial holdings of government bonds, which have increased since 2008 as they have increased levels of liquidity. Any fall in the value of these holdings would affect the solvency of the affected banks.

For some European banks, lack of access to commercial funding has forced reliance on money from their central banks and the European Central Bank (“ECB”), generally against government bond collateral. Credit rating downgrades or fall in the value of government bonds would create liquidity problems, as banks are unable to finance themselves. If the banks need government support, then this further weakens the government. If individual national governments require external support, then this weakens the ultimate guarantors.  Falls in the value of government bonds or a loss of confidence in their value as surety would lead initially to a global “margin call”, as the value of the collateral is marked down setting off a “dash for cash”. In an extreme case, where governments bonds are not accepted as collateral, it would lead to a contraction of liquidity and financial activity generally.

Central banks, sovereign wealth funds, pension funds and insurers have significant investment in government bonds. A significant proportion of China’s substantial foreign exchange reserves (over $3 trillion) are invested in US and European government bonds. A loss in value in these holdings would reduce China’s wealth and financial flexibility, ultimately affecting its economic performance.  In reality, the crisis has returned to its starting point –debt levels and the reliance of the global economy on borrowing to fuel growth. The level of debt depends on the value of the assets or investment that supports it and the income or cash flows available to service the interest and principal. Many nations have debt that is above the level that can be sustained in a lower growth world – the “new normal”. The new crisis is part of the de-leveraging with governments now joining individuals and companies in being forced to reduce levels of debt. But if not managed properly, sovereign debt problems may escalate rapidly with the risk of a major disruption in financial markets.

In his pamphlet Gravity – Our Enemy Number One, investment analyst Roger Babson, who anticipated the 1929 stock market crash, argued that gravity was an evil force. In the credit boom, prices rose, defying gravity. At the commencement of the crisis, governments flooded the system with money to the keep the game going for a little longer. Now, financial gravity is reasserting its malevolent power.

An earlier version was published in the Financial Times

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (published in August/ September 2011)

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