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Ambrose Evans-Pritchard: IMF fears the world's financial system is even more destructive than in 2008
By Ambrose Evans-Pritchard
The Telegraph, London
Wednesday, October 16, 2019
The International Monetary Fund has presented us with a Gothic horror show. The world's financial system is more stretched, unstable, and dangerous than it was on the eve of the Lehman crisis.
Quantitative easing, zero interest rates, and financial repression across the board have pushed investors -- and in the case of pension funds or life insurers, actually forced them -- into taking on ever more risk. We have created a monster.
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There are "amplification" feedback loops and chain reactions all over the place. Banks may be safer -- though not in Europe or China -- but excesses have migrated to a new nexus of shadow lenders. Woe betide us if this tangle of hidden leverage is soon put to the test.
That broadly is the message of the International Monetary Fund's Global Financial Stability Report, always a thriller but this time almost biblical. "Policymakers urgently need to take action to tackle financial vulnerabilities," said the fund's directors piously. It is a bit late for that, my friends.
Even a moderate shock would cause company "debt-at-risk" -- that is, where the debtors do not earn enough to cover interest payments -- to spiral up to $19 trillion. This is a staggering 40 percent of corporate liabilities.
The tally includes a future cascade of "fallen angels" now perched at BBB ratings just above junk. Such firms will be squeezed mercilessly by tumbling earnings and soaring risk spreads in a downturn.
"In France and Spain, debt-at-risk is approaching the levels seen during previous crises, while in China, the United Kingdom, and the United States, it exceeds these levels. This is worrisome given that the shock is calibrated to be only about half what it was during the global financial crisis," the report said.
Late-cycle reflexes are again on display. The debt is "increasingly used for financial risk-taking -- to fund corporate payouts to investors, as well as mergers and acquisitions. Global credit is flowing to riskier borrowers."
Donald Trump's tax reform has pushed M&A volumes in the United States to record levels. We knew that. It is the detail that is revealing. The "markups on intangibles" for debt-funded takeovers have jumped, "signaling increased bets on future gains despite a weakening outlook" -- which means they are pocketing fictitious returns, and the bankers are winking obligingly to secure their fee.
This year “highly leveraged deals" made up almost 60 percent of U.S. buyouts, comfortably surpassing the pre-Lehman peak. Firms are using “add-backs" based on purported M&A synergies (usually exaggerated or non-existent) to boost how much they can borrow.
On The Street the use of debt for share buybacks or dividends is called "using your balance sheet efficiently." I remember the term well from the mass delusion phase of 2008. Just wait until the funding markets jam shut.
Elizabeth Warren, Bernie Sanders, and the Marxisant Piketty activists of the Democratic primaries wish to shut the U.S. capitalist casino once and for all. They will have their excuse when these chickens come home to roost.
In Europe almost all leveraged loans are now being issued without covenant protection. The debt to earnings (EBITDA) ratio has vaulted to a record 5:8. Is the European Central Bank asleep or actively promoting this?
The IMF's directors call for “urgent" action to stop these excesses but in the same breath suggest or admit that the cause of leverage fever is the easy money regime of the authorities themselves -- that is to say the central banks and their political masters who refuse, understandably, to permit debt liquidation and to allow Schumpeter's creative destruction to run its course in downturns.
We are all to blame (with notable exceptions). Few of us have the stomach for the cleansing trauma of epic defaults and mass layoffs. I have supported central bank largesse since the Lehman crisis, with a clothes peg on my nose, though with hindsight I would rather it had been used for targeted public investment rather than stoking asset bubbles.
But the longer this goes on, the greater the debt trap, and the harder it is to break free. The idea that tougher "macro-pru" regulations can suppress the effects of a massively distorted incentive structure is surely wishful thinking. It is an empty IMF piety.
As the report states, monetary perma-stimulus is wreaking havoc on the $10.5 trillion bond fund industry and forcing insurers, fixed income funds, and pension funds to join the hunt for yield. “It is driving investors into riskier and less liquid assets."
Funds are having to go out further on the maturity curve to eke out a few miserable pennies. But this is still not enough. The defined benefits funds in the U.S., U.K., and Holland are going into real estate or private equity ventures by necessity. These have “embedded leverage" and long lockup times. They are being forced into “greater illiquidity risk."
So what can detonate these ticking time-bombs? The Bank of England's Mark Carney says funds -- like the now-defunct Woodford entities -- that promise investors the right of instant withdrawal while parking the money in illiquid assets are “built on a lie." They have become a systemic risk.
Pension funds and insurers that used to act as a stabilizing buffer in financial crises are now part of the problem and might next time join the panic rush for narrow exits. The IMF says this could amplify any shock very quickly and this in turn would lead to a full-blown credit crunch.
What is different about the current cycle is that every region is flashing warnings in one way or another. That was not the case in 2008. Asia and the commodity "BRICS" states were then in the middle of a credit-driven boom. They were able to bulldoze their way through the storm and act as a global shock-absorber.
This time emerging markets are in the swamp too. Their median ratio of external debt to exports has risen from 100 to 160 percent over the last decade, rising to 300 percent in some cases. The fund says this leaves them exposed to a rollover crisis if the global liquidity tap is ever turned off -- and in my view the Fed came close to doing this over recent months by over-tightening. A number of state-owned behemoths will need a sovereign bailout.
China is in a class of its own. The authorities had to rescue Baoshang Bank in May. Depositors faced "haircuts" for the first time, which came as a nasty surprise. This led to an investor panic over nine other regional banks that had failed to publish their accounts. The interbank funding markets seized up. Hengfeng and Jinzhou banks then required bailouts as well.
The banks had been relying on wholesale capital markets for short-term funding (like Northern Rock and Lehman) to buy illiquid assets. What has come to light is the Chinese doom-loop of banks and investment vehicles buying each other's debt.
The Baoshang failure is a big reason why China's monetary stimulus has gained so little traction this year. A state-run banking system can (probably) avert a Chinese Minsky Moment but it cannot wish away the slow rot of bad debt in the real economy.
A lot of the rising debt in Asia, Latin America, Africa, and the Middle East is in dollars and that makes borrowers acutely sensitive to a complex interplay of derivatives, Fed policy, and the U.S. exchange rate (now too strong). Global offshore dollar debt has jumped from $9.7 trillion to $12.4 trillion since 2012.
The metric to watch is the "cross-currency funding gap" -- or liability gap -- now a record $1.4 trillion. It has risen to 13 percent of U.S. dollar assets from 10 percent in mid-2008. Asian, European, and other non-U.S. banks are prohibited from drawing on U.S. subsidiaries -- if they have them -- to cope with a dollar liquidity squeeze overseas.
They have to tap the offshore funding markets. These famously blew up in 2008. The international banking system was saved then by the Fed's currency swap lines to fellow central banks. The IMF is not sure if these are still forthcoming from Donald Trump's Washington. (The swaps need Treasury approval.)
The world is on a sticky wicket. Past crisis policy has left us acutely vulnerable to an even bigger crisis. The central banks of Europe and Japan have reached exhaustion. The Fed's remaining powder is a fraction (2/5) of what is normally needed to fight downturns. It is uncomfortably close to a credibility crisis of its own.
Fiscal policy can still pack a punch but for how long and which countries? The IMF's Fiscal Monitor out today says the U.S. "cyclically adjusted" budget deficit is already a shocking 6.3 percent of GDP. Public debt is on track to rise from 104.3 percent last year to 115.8 percent by 2024 even on the most benign growth assumptions. You might say the U.S. is turning Japanese.
We will have to be very creative if any of the IMF's dark fears come true.
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