Falling Interest Rates Destroy Capital

Submitted by Keith Weiner of 'Gold and Silver and Money and Credit' blog

I have written other pieces on the topic of fractional reserve banking (http://keithweiner.posterous.com/61391483 and http://keithweiner.posterous.com/fractional-reserve-is-not-the-problem) duration mismatch, which is when someone borrows short-term money to lend long-term and how falling interest rates actually encourages duration mismatch (http://keithweiner.posterous.com/falling-interest-rates-and-duration-mis...).
Falling interest rates are a feature of our current monetary regime, so central that any look at a graph of 10-year Treasury yields shows that it is a ratchet (and a racket, but that is a topic for another day!).  There are corrections, but over 31 years the rate of interest has been falling too steadily and for too long to be the product of random chance.  It is a salient, if not the central fact, of life in the irredeemable US dollar system, as I have written (http://keithweiner.posterous.com/irredeemable-paper-money-feature-451).

Here is a graph of the interest rate on the 10-year US Treasury bond.  The graph begins in the second half of July 1981.  This was the peak of the parabolic rise interest rates, with the rate at around 16%.  Today, the rate is 1.6%.



Professor Antal Fekete introduced the proposition that a falling interest rate (as opposed to a low and stable rate) causes capital destruction.  But all other economists, commentators, and observers miss the point.  It is no less a phenomenon for being unseen.  In early 2008, a question was left begging: how could a company like Bear Stearns which had strong and growing net income collapse so suddenly?

Here is Bear’s five-year net income and total shareholder’s equity

Year	2003	2004	2005	2006	2007
Income	$1.156B	$1.345B	$1.462B	$2.054B	$0.233
Equity	$7.47B	$8.99B	$10.8B	$12.1B	$11.8B

Isn’t that odd?  Even in 2007, Bear shows a profit.  And they show robust growth in shareholder equity, with only a minor setback in 2007.

And yet, by early 2008 Bear experienced what I will call Sudden Capital Death Syndrome.  JP Morgan bought them on Mar 16, for just over $1B.  But the deal hinged on the Fed taking on $29B of Bear’s liabilities, so the real enterprise value was closer to $-19B.

Obviously, Bear’s reported “profit” was not real.  And neither was their “shareholder’s equity”.  I think it something much more serious than just a simple case of fraud.  Simple fraud could not explain why almost the entire banking industry ran out of capital at the same time, after years of reporting good earnings and paying dividends and bonuses to management.

Also, other prominent companies were going bankrupt in 2008 and 2009 as well.  These included Nortel Networks, General Growth Partners, AIG, two big automakers.

I place the blame for Sudden Capital Death Syndrome on falling interest rates.  The key to understanding this is to look at a bond as a security.  This security has a market price that can go up and down.  It is not controversial to say that when the rate of interest falls, the price of a bond rises.  This is a simple and rigid mathematical relationship, like a teeter-totter.

A bond issuer is short a bond.  Unlike a homeowner who takes out a mortgage on his house, a bond issuer cannot simply “refinance”.  If it wants to pay off the debt, it must buy the bonds back in the market, at the current market price.

Let’s repeat that.  Anyone who issues a bond is short a security and that security can go up in price as well as go down in price.

Everyone understands that if a bond goes up, the bondholder gets a capital gain.  This is not controversial at all.  Nor is it controversial to say that there are two sides to every trade.  And yet it is highly controversial—to the point of being rejected with scorn—that the other side of the trade from the bondholder incurs the capital loss.  It is the bond issuer’s capital that flows to the bondholder.  To reject this is to say that money grows on trees.

We won’t explore that any further; money does not grow on trees!  Instead, we will look at this phenomenon of the capital loss of the bond issuer from several angles: (1) Hold Until Maturity; (2) Mark to Market; (3) Two Borrowers, Same Amount; (4) Two Borrowers, Different Amounts; (5) Net Present Value; (6) Capitalizing an Income; (7) Amortization of Plant; and (8) Real Meaning of an Interest Rate.

Hold Until Maturity

There is an argument that the bond issuer can just keep paying until maturity.  While that may be true in some circumstances, it misses the point.  When one enters into a position in a financial market, one must mark one’s losses as they occur, no matter than one may intend to hold the position until maturity.  How would a broker respond in the case of a client who shorted a stock and the stock rose in price subsequently?  Would the broker demand that the client post more margin?  Or would the broker be sympathetic if the client explained how the company had poor prospects and that the client intended to hold the short position until the company’s share price reflected the truth?

Mark to Market

The guiding principle of accounting is that it must paint an accurate and conservative picture of the current state of one’s finances.  It is not the consideration of the accountant that things may improve.  If things improve, then in the future the financial statement will look better!  In the meantime, the standard in accounting (notwithstanding the outrageous FASB decision in 2009 to suspend “mark to market”) is to mark assets at the lower of: (A) the original acquisition price, or (B) the current market price.

There ought to be a corresponding rule for liabilities: mark liabilities at the higher of (A) original sale price, or (B) current market price.  Unfortunately, the field of accounting developed its principles in an era where a fall in the rate of interest from 16% to 1.6% would have been inconceivable.  And so today, liabilities are not marked up as the rate of interest falls down.

Refusing to put ink on paper does not change the reality, however.  Closing one’s eyes does not prevent one from falling into a pit on the path in front of one’s feet.  The capital loss is very real, as we will explore further below.

Two Borrowers, Same Amount

Let’s look at two hypothetical companies in the same industry, pencil manufacturing.  Smithwick Pen sells a 20-year $10M bond at 8% interest.  It uses the proceeds to buy pencil-manufacturing equipment.  To fully amortize the $10M over 20 years, Smithwick must pay $83,644 per month.

The rate of interest now falls to half its previous rate.  Barnaby Crayon sells a 20-year $10M bond at 4%.  Barnaby buys the same equipment as Smithwick and becomes Smithwick’s competitor.  Barnaby pays $60,598 per month to amortize the same $10M debt.  Is it correct to say that both companies have identical balance sheets?  Obviously Barnaby will have a better income statement.  This is because it has a superior capital position, and this should be reflected on the balance sheets.  It certainly is not because of its superior product, management, or marketing.

Let’s look at this from the perspective of the capital position: the present value of a stream of payments.  Obviously, at 4% interest the monthly payment of $60,598 has a present value of $10M (otherwise we made a mistake in the math somewhere).  But what is the value of an $83,644 monthly payment at the new, lower rate of 4%?  It is $13.8M.  Smithwick’s has just experienced the erosion of $3.8M of capital!  This is reflected in reality, by the uncontroversial statement that it has a permanent competitive disadvantage compared to Barnaby.  Barnaby can undercut Smithwick and set prices wherever it wishes.  Smithwick is helpless.  Most likely, Barnaby will eke out a subsistence living, until the rate of interest falls further.  When Cromwell Writing Instruments borrows money at 2%, then Smithwick will be put out of its misery.  And Barnaby will be forced into the untenable position it had previously placed Smithwick.

It should be noted that the longer the bond maturity, the bigger this problem becomes.  For example, if this were a 30-year bond, then Smithwick would take a $5.4M hit to its capital if interest rates were 8% when it issued the bond and then fell to 4%.

Two Borrowers, Different Amounts

This is not the only way that a competitor can exploit the capital loss of a company who made the mistake of borrowing at a too-high interest rate.  Let’s look at the case of Poddy Hoddy Hotel and Casino.  Poddy sells a 20-year $100M bond at 8%, and has a monthly payment of $836K.  It builds a nice hotel and casino with bars, a restaurant, a pool, and a few jewelry stores.

A short while later, Xtreme Hotels sells a $138M bond at 4%, and has the same monthly payments.  The extra $38M goes into a second pool with a swim-up bar, another restaurant that is themed based on the Galapagos Islands, bigger and more opulent retail stores, and a spiral glass elevator to take guests up to their rooms while enjoying the breathtaking 270-degree views of the city.

Which hotel will consumers prefer?

The Poddy Hoddy Hotel may have been planned based on accurate market research that showed real demand for such a hotel in that location.  Unfortunately, the falling interest rate has undermined it.  Its investors will likely lose money.

The Xtreme Hotel, on the other hand, is probably a mal-investment.  It is likely a project for which there is no real demand.  But the falling interest rate gives a false signal to the entrepreneur to build it.  Of course, the Xtreme won’t be the one to experience Sudden Capital Death Syndrome first.  That fate will befall Poddy.  Xtreme’s turn will come later, at a lower interest rate.

With Smithwick, one might argue that it can pay off its bond in the 20 years it originally expected, so it has not experienced a loss.  But in fact, there is a loss even from this angle.  Smithwick is paying off its 8% bond at $83,644 per month.  But the rate of interest is now 4%, which should be a payment of $60,598.  The accurate way to look at this is that Smithwick is paying off a market-rate bond plus a penalty of $23,046 for every month remaining before the bond is fully amortized.

With Poddy Hoddy, one might similarly argue that it can pay off its bond as planned, so it has not taken a loss.  But the loss here is even clearer.  By borrowing $100M at a rate that was too high, it has effectively dissipated the extra $38M that its competitor, Xtreme, put to good use.  It will pay for this waste every month for 20 years (or until it goes bankrupt).

By not marking the losses at Smithwick and Poddy, the accountants are not doing these companies or their investors any favors.  In the short run, these companies may declare “profits” and based on that pay dividends to investors and bonuses to management.  But sooner or later, they will meet Barnaby and Xtreme who will deal the coup de grace of Sudden Capital Death Syndrome.

Net Present Value

As alluded above, one can calculate the Net Present Value (NPV) of a stream of payments.  First, let’s look at the formula to calculate the present value of a single payment is:

It should be obvious that the present value of a payment is lower the farther into the future it is to be made.  One does not value a payment due in 2042 the same as a payment to be made next year.  What is not so glaring is that the value is lower for higher rates of interest.  A $1000 payment due next year is worth $909 if the rate of interest is 10%, but $990 at 1%.  This difference is amplified due to compounding.  At 10 years, the payment is worth $385 at 10% versus $905 at 1%.

The NPV of a stream of payments is the sum of the value of each payment.  The value of a $1000 payment made annually for 20 years is $9818 at 8% interest.  That same payment at 4% has an NPV of $13,590, a 38% increase.

It is important to emphasize that while the bond issuer’s monthly payment is fixed based on the amount of capital raised and the interest rate at the time, the NPV of its liability must be calculated at the current rate of interest.  The market (and the universe) does not know nor care what bond issuer’s entry point was.  Objectively, all streams of payments of $1000 per month have the same value at a given maturity and current interest rate, regardless of the original rate.

Capitalizing an Income

Let’s look at this from yet another angle.  An income can be capitalized, and the purpose of capital is to produce an income.  Professor Antal Fekete wrote[3]:

“Suppose you are a worker taking home $50,000 a year in wages. When your income-flow is capitalized at the current rate of interest of, say, 5 percent, you arrive at the figure of $1,000,000. The sum of one million dollars or its equivalent in physical capital must exist somewhere, in some form, the yield of which will continue paying your wages. Capital has been accumulated and turned into plant and equipment to support you at work. Part of your employer’s capital is the wage fund that backs your employment. Assuming, of course, that no one is allowed to tamper with the rate of interest.” [Emphasis in the original]

“Suppose for the sake of argument that the rate of interest is cut in half to 2½ percent. Nothing could be clearer than the fact that the $1,000,000 wage fund is no longer adequate to support your payroll, as its annual yield has been reduced to $25,000. This can be described by saying that every time the rate of interest is cut by half, capital is being destroyed, wiping out half of the wage fund. Unless compensation is made by adding more capital, your employment is no longer supported by a full slate of capital as before. Since productivity is nothing but the result of combining labor and capital, the productivity of your job has been impaired. You are in danger of being laid off ? or forced to take a wage cut of $25,000.”

Without capital, human productivity is barely enough to produce a subsistence living.  Without tools, one is obliged to work long hours at back-breaking tasks in order to have a meager meal, some sort of clothing, and something to keep the rain off one’s head.  Capital destruction is the process of moving backwards towards a time where one worked harder to obtain less.

As described earlier, when the rate of interest falls, it erodes the capital of every bond issuer.  If one looks at this capital as being the wage fund (or part of it is the wage fund), then the bond issuer can no longer afford to pay its employees the same wage.  If it does continue the same wage anyway, it will eventually suffer the consequences of running out of capital.

Amortization of Plant

Now let’s consider the concept of amortizing equipment and plant at Smithwick Pen.  Smithwick borrows $10M to buy equipment.  Out of its revenues, it must set aside something to amortize this over the useful life of the equipment, which is 20 years in our example.  This set-aside reduces net income; it is not profit but capital maintenance assuming the company intends to remain in business after the current generation of equipment and plant wears out.

How much should it set aside every month?  This is the inverse of the NPV calculation.  We are now interested in the current monthly payment to arrive at a fixed sum at a future point in time (as opposed to the present value of a stream of fixed payments).  The lower the rate of interest, the more Smithwick must set aside every month in order to reach the goal by the deadline.  To understand this, just look at what Smithwick must do.  Each month, it puts some money into an interest-bearing account or bond.  Even if it chooses the longest possible maturity for each payment (i.e. the first payment is put into a 20-year bond, the next into a 19-year 11-month bond, etc.) it is clear that if interest rates are falling then each payment must increase to compensate.  Smithwick’s profits are falling with the rate of interest!

If Smithwick persists in setting aside every month what it initially calculated when it purchased the pencil-making equipment, it will have a shortfall at the end, when it needs to replace the equipment.

Real Meaning of an Interest Rate

Let’s consider what it really means to have a high or a low rate of interest.  I propose to do reductio ad absurdum.  We will look at two cases (which would be pathological if they occurred) to make the point clearer.

The first case is if the rate of interest is 100%.  This means that a $1000 payment one year from today is worth ½ of the nominal value, or $500 today.  A payment due in two years is worth $250 today, etc.  At this rate of interest, for whatever reason, “future money” is worth very little present money.  In other words, the burden experienced by the debtor is a small fraction of the nominal value of the debt.

The second case is if the rate of interest is zero.  This means that a $1000 payment due one year from today or 100 years from today is worth $1000 today.  At this rate of interest, for whatever reason, future money is worth every penny of its nominal value today.  There is no discount at all, not for the loss of use of the money in the meantime, not for the risk, not for currency debasement.  In other words, the burden experienced by the debtor is the full nominal value of the debt.

Again, to emphasize, one must use the current market rate of interest not the rate of interest contracted by the borrower at the time of the bond issuance.

The lower the rate of interest, the more highly one values a future payment.  The higher the rate of interest, the more highly one discounts a future payment.  These statements are true whether one is the payer or the payee.  The payer and payee are just parties on opposite sides of the same trade.

Irving Fisher, writing about falling prices (I shall address the connection between falling prices and falling interest rates in a forthcoming paper) proposed a paradox[4]:

“The more the debtors pay, the more they owe.”

Debtors slowly pay down their debts and reduce the principle owed.  This would reduce the NPV of their debts in a normal environment.  But in a falling-interest-rate environment, the NPV of outstanding debt is rising due to the falling interest rate at a pace much faster than it is falling due to debtors’ payments.  The debtors are on a treadmill and they are going backwards at an accelerating rate.

How apropos is Fisher’s eloquent sentence summarizing the problem!

Will Operation Twist "Destroy Credit Creation"?

By John Mason Sep 8, 2011, 9:46 AM Author's Website  

Yesterday I discussed the concern Bill Gross, founder and co-chief investment officer of PIMCO, has about the current Federal Reserve policy of keeping short-term interest rates low for the next two years. The concern extends to the possibility that the Fed will attempt to “twist” the term structure of interest rates by buying more and more long-term government securities in an attempt to bring longer-term interest rates in line with the very low short-term interest rates. Gross sees the efforts extending to the seven- and eight-year maturity range.

The concern Gross has is that a flat yield curve will cause banks and other financial organizations to de-leverage even further and faster than they would under conditions the of un-sustainable debt levels created by the previous fifty years of credit inflation. Gross, in his Financial Times article, argued that the Federal Reserve consistently maintained a positive slope to the yield curve throughout this fifty year period (with the exception of periods of tight monetary policy) so that the banks and other financial institutions would continually provide “credit creation” so that the economy would continue to expand and create jobs.
The positive slope to the yield curve provided the mechanism for this credit creation through three channels that I have written about on a regular basis. First, the positive slope to the yield curve meant that banks and other financial institutions could borrow short at relatively low interest rates and lend long at higher interest rates. The mis-matching of maturities increases interest-rate risk but then if the yield curve, on average, remains positive, the positive yield spread can be maintained over time.

Second, credit inflation “bails out” riskier loans so the banks and other financial institutions could lend money on riskier deals and thereby earn an even larger interest rate margin. To paraphrase Warren Buffet…if credit inflation tide is rising, it is hard to tell bad assets from good assets. Only when the credit inflation tide recedes and the water level drops do we discover who is not wearing a bathing suit. Tell me about the sub-prime mortgage mess…

Third, narrow interest margins can be turned into substantial returns on equity by the use of financial leverage. And, if competition brings net interest margin levels down, banks and other financial institutions can maintain the levels of return on equity they had previously earned by adding more and more financial leverage to their balance sheets.

This third component of the growing risk exposure of a period of credit inflation can only succeed if the banks and other financial institutions are “liability managers”. In terms of the last fifty years, financial institutions became liability managers through the process of financial innovation. Most financial institutions were locked into their balance sheets before the 1960s because money and capital markets were not developed to the extent that banks and others could buy or sell all the funds they wanted a the going market interest rate.

Commercial banks, at this earlier time, could only obtain funds through “local” markets and these funds were not very interest sensitive. Hence, these organizations were “asset managers” limited to what Leo Tilman calls “Balance Sheet Arbitrage”. (See a review of Tilman’s book “Financial Darwinism”). Balance sheet arbitrage is the “old” way of commercial banking where banks are “local” in nature and obtain funds from demand deposit accounts and savings accounts which pay very low interest rates and lend the funds out to borrowers, many of whom have no other sources of funding so that the interest on these loans are relatively high. Thus, the banks worked with nice interest margins that were relatively stable and reliable.

Liability management came into pay through the financial innovation of the 1960s. Negotiable CDs and Eurodollar deposit along with holding company issue Bankers Acceptances became the innovation of choice in the larger banks and this freed up the balance sheets of banks so that they were no longer limited to “local” constraints on the choice of funding sources. Funding sources became world wide and the understanding was that, at most times, banks could now buy or sell as many funds as they wanted at the going market interest rate.

In essence, commercial banks could now “leverage up” as much as regulation…or accounting rules…would allow!

And, as regulation eased up, banks and other financial institutions got into other financial and organizational innovations. Tilman lists these as moves into “Principal Investments” (private equity and venture capital, investments in hedge funds, or, capital allocations to internal proprietary trading desks) and “Systematic Risks” (which included interest rate risks, credit risks, currencies, commodities, and equity indices). This created an environment I have called the “New Liquidity.”

The result? Bill Gross nails it in his article: “Thousands of billions of dollars were extended…” It seems as if capital requirements were non-existent. Credit could expand almost without limit.

And, why are we interested in credit inflation and not price inflation? Why do we focus on credit creation and not money? Focus, in the past, was placed on money because people were concerned about what was happening with consumer prices…”flow” prices. “Flow” prices relate to the prices paid for goods and services that are consumed in a relatively short period of time. “Flow” prices are to be differentiated from “asset” prices.

“Flow” prices are in many ways “constructed” prices. For example, in the construction of the Consumer Price Index, the price of a house is not included because that is the price of an asset. The “flow” of housing services is what people consume and the “price” of this flow of services is called “rent”. In the construction of the CPI, the “rental price” of housing services is, to a large extent, estimated. And, as it turns out, since the consumption of housing services is such a large component of consumer expenditures, the “rent” component turns out to be the largest part of the CPI.

Theoretically, the price of an ‘asset” (the price of a house) should be equal to the discounted present value of the future cash flows relating to the purchase of the housing services provided by the house (the rent or rental value of the housing services). In the world these two prices can differ from one another for a substantial amount of time as they did during the 2000s where housing prices were severely inflated and estimates of rental values lagged far behind.

This is true of other asset categories like equity shares that are traded on the stock markets (take for example the Internet bubble of the 1990s).

Thus credit and credit inflation are of crucial interest to the behavior of prices…all prices…in the economy. And this is why we must be interested in cumulative credit inflations that become unsustainable and turn into cumulative debt deflations that create a “formidable headwind” (thank you Mr. Bernanke) that must be overcome by any fiscal or monetary policy hoping to stimulate growth in the economy.

The problem seen by Mr. Gross, however, is that the monetary policy now being followed by the Mr. Bernanke and the Federal Reserve that promotes a flat yield curve will just exacerbate the situation because it will accelerate the debt deflation taking place. One could also argue (ala Mr. Gross) that the situation created by recent financial innovation, the “new liquidity”, will further add to the volatility of the whole situation.

Pick Your Debt Poison

Submitted by Tyler Durden on 07/17/2012 21:28 -0400

When it comes to estimating the biggest threat to the global financial system, by far the biggest threat and biggest unknown is the total Financial debt in the system, for the simple reason that as we have been showing for over two years, it is simply impossible to quantify just what the real level of such debt in the developed world truly is, especially when one accounts for shadow liabilities, rehypothecated collateral, derivatives, and all those other footnotes in financial statements that only become relevant when daisy-chained collateral links start collapsing following the default of one or more financial entities, and when gross becomes net. What we can, however, do is show the other three major categories of debt currently existing in the system: Government, Corporate and Household debt, as they are distributed among the "developed" countries. We also know what the tresholds are beyond which the debt becomes unsustainable. In the words of the BIS: "For government debt,  the threshold is around 85% of GDP... When corporate debt goes beyond 90% of GDP, it becomes a drag on growth. And for household debt, we report a threshold around 85% of GDP, although the impact is very imprecisely estimated."

So in light of all these various thresholds, where do the "developed countries" of the world stack up? It's not pretty.

Total Government Debt distribution:

Total Corporate Debt distribution:

Total Household Debt distribution:

And one final chart showing all three non-financial debt categories combined. We leave conclusions to the reader.

Source: Metis Risk Consulting, Feasta

IHH Healthcare IPO Oversubscribed by 5.45 times

13/07/2012

IHH Healthcare Berhad Initial Public Offering (IPO) received an overwhelming response with its public portion of 161.14 million shares. It was oversubscribed by 5.45  times. The IPO attract 65,834 applications or 1.04 billion shares.

The Institutional Price was fixed at RM2.80 per Offer Share. Accordingly, the Final IPO Price for the Retail Offering is fixed at RM2.80 per Offer Share. The difference of RM0.05 per IPO Share will be despatched to successful retail applicants within 10 market days from 16 July 2012.

The IPO allocate 208.51 million shares for public. Of these, 80.57 million shares were allocated for Bumiputera category while 80.57 million shares were allocated for Malaysian Public category.
Below are the allotment summary for public portion.

Allotment summary for Bumiputera portion

Denomination		No of Application	No of Successful Application	% Chance	Share / Successful Applications
From	to
100	200	105	21	20.00	100
300	900	162	46	28.40	300
1,000	1,900	2,590	1,301	50.23	1,000
2,000	2,900	1,476	760	51.49	2,000
3,000	3,900	1,278	670	52.43	3,000
4,000	5,900	2,096	1,130	53.91	4,000
6,000	10,900	3,556	1,950	54.84	6,000
11,000	19,900	2,481	1,380	55.62	9,000
20,000	49,900	3,490	1,960	56.16	14,000
50,000	99,900	896	515	57.48	20,000
100,000	199,900	462	285	61.69	22,000
200,000	499,900	138	98	71.01	24,000
500,000	999,900	23	17	73.91	26,000
1,000,000	ABOVE	10	10	100	28,000
		18,763	10,143

Allotment summary for Public portion

Denomination		No of Application	No of Successful Application	% Chance	Share / Successful Applications
From	to
100	200	181	21	11.60	100
300	900	390	46	11.79	300
1,000	1,900	7,497	1,124	14.99	1,000
2,000	2,900	4,903	750	15.30	2,000
3,000	3,900	4,111	660	16.05	3,000
4,000	5,900	5,373	916	17.05	4,000
6,000	10,900	9,623	1,735	18.03	6,000
11,000	19,900	9,547	1,815	19.01	9,000
20,000	49,900	9,481	1,896	20.00	14,000
50,000	99,900	2,546	535	21.01	20,000
100,000	199,900	1,172	258	22.01	22,000
200,000	499,900	242	58	23.97	24,000
500,000	999,900	44	15	34.09	26,000
1,000,000	ABOVE	60	30	50.00	28,000
		55,170	9,859

Notices of Allotment will be dispatched by post to all successful applicants on or before 24th July 2012. IHH Healthcare is expected to be listed on the Main Market of Bursa Malaysia on 25th July 2012 under stock name “IHH”.

Japan’s Demographic Trap

Posted by Scott Boyd at 8:39 am EDT, 06/25/2012
 
Japan recently surpassed a dubious milestone when the country’s total debt officially topped the one quadrillion yen ($14 trillion) mark. Expressed as a percentage of the country’s Gross Domestic Product, Japan’s total debt exceeds 225 percent of the country’s GDP, and with the exception of only Italy, Japan’s debt-to-GDP ratio is now more than twice that of any other G7 country.
Despite having one of the world’s highest debt ratios, Japan’s debt remains in demand even though yields on Japanese bonds are at their lowest in nearly two years. The yen too continues to appreciate in spite of efforts by the Bank of Japan to weaken the currency.
Considering how yields have ballooned for the more indebted of the Eurozone countries, it may appear that Japan is not being held to the same standard by the investing community. Greece was forced to work out a deal with its creditors to avoid a default and bond yields for several countries, including Spain, have risen sharply and are nearing levels many consider to be unsustainable. Meanwhile, Japan has no trouble finding buyers for 2-year bonds offering a measly 0.11 percent; given all that we have witnessed in Europe, it seems counter-intuitive that Japan’s bond sales and currency should remain so robust.
However, there is a fundamental difference between Japan and Europe; in Japan, the vast majority of the debt is actually held by, and continues to be snapped up by, Japanese institutions and the people of Japan themselves. Very little – relatively speaking – of Japan’s debt is held by foreign interests.
Unfortunately, while keeping most of the country’s debt within its own borders may avoid issues similar to those facing the Eurozone, this arrangement is not without concern. Japan is coping with negative population growth and this means that as Japan’s soon-to-be retiring workers leave the workplace, the number of younger workers to replace the retirees are too few in number to support current growth levels. This alarming situation puts the long-term sustainability of the economy at peril. As we shall discuss later on, the demographics that have for so long worked to Japan’s advantage, will soon align against the country’s best interests.
Japan: A Nation of Savers
A 2009 breakdown of Japan’s debt placed foreign ownership at just slightly over 5 percent. Clearly, Japan’s reputation as a nation of savers is well-earned. However, in this case, the diligence exercised by the people of Japan to build their savings has had unintended consequences on the yen.
Because the lion’s share of Japan’s debt is held by the people of Japan, and because they continue to eagerly purchase new bond issues, the yen is considered well-supported. This, together with Japan’s historically strong export sales has contributed to the yen’s track record of consistent exchange rate gains. It is this track record that has led to the yen being considered a “safe haven” destination.
Adding to the yen’s appeal as a safe haven currency is the expectation that Japan’s inflation rate will remain stable for the near-term at least. This reduces the likelihood of future buying power being eroded by an unexpected rise in inflation and these are the factors investors look for when seeking to shelter assets during times of market turmoil. While there may be better choices for speculative exchange rate gains, there are few other currencies offering the degree of stability the yen represents, and with the growing uncertainty in Europe, the amount of money “parked” in the yen is likely to rise.
While the yen bulls and those seeking shelter from market volatility may welcome the yen’s persistent appreciation, the Bank of Japan does not share the same enthusiasm. The modern form of Japan’s economy was built largely on exports taking advantage of a cheap labor force and low manufacturing costs as the country entered a rebuilding phase following the end of the war in 1945.
Nearly seventy years later, Japan’s export industry remains a key part of its economy but with global consumer demand still well below pre-recession levels, Japan has suffered a decline in sales as importing economies struggle to find their feet. Even internal factors including last year’s earthquake and a general slowdown in productivity have conspired to send Japan’s balance of trade into a rare deficit situation.
Of course, it is not only a stronger yen that has hurt Japan’s export sales. Japan is also forced to import its oil and rising energy costs have further eroded Japan’s ability to compete. Japan’s well-documented problems with its nuclear energy program will force Japan to continue its reliance on costly forcing energy to power its industries. For a country that counts so heavily on exports, this is a dangerous turn of events and authorities have come under increasing pressure to ease the yen’s rate of appreciation to make Japan’s exports more competitive.
Bank of Japan Intervenes
When Central Banks determine that weakening the currency would be advantageous for the economy, the first course of action tends to be a reduction in interest rates. The resulting lower yield on deposits simultaneously reduces demand for the currency which can – potentially – lead to a decrease in the exchange rate for the currency. For exporting nations, a weaker currency can boost export sales as the reduced exchange rate helps make exports more affordable for foreign buyers.
Previous attempts by the Central Bank to slow the yen’s ascent has already resulted in slashing interest rates to just 0.05 percent. With rates practically at zero already, there is no further benefit available from an interest rate adjustment and the Bank can dispense with any hope that other Central Banks will act to strengthen their respective currencies. The European Central Bank is facing the prospect of a possible recession in several Eurozone countries and this essentially nullifies the likelihood of an interest rate hike at this time.
Likewise, the U.S. economy is recovering at a painfully slow rate and the Federal Reserve has taken every opportunity of late to reconfirm its pledge to hold interest rates at 0.25 percent at least until the middle of 2014. This leaves the authorities in Japan no alternative but to resort to direct market intervention to ease monetary policy.
Resigned to the fact that market intervention is the only viable option still available for weakening the yen, Japan initiated a series of actions last year to release trillions of yen into the economy. The Bank has continued these efforts into the new year and since the beginning of 2012, authorities have made an additional 20 trillion yen available to the banking system. This includes a 10 trillion yen infusion in February, followed by an additional 10 trillion yen in April.
While the actions slowed the yen’s appreciation – even reversing it following the February event – the impact was hardly long-lasting. Looking at a chart tracking the exchange rate history, from February until early March, the yen did indeed weaken with the dollar rising from a low of just over 76 yen to the dollar to nearly 84 yen to the dollar:
US Dollar / Yen Comparison
 
However, since then, the dollar has continued to fall and as of the first week of May, has retraced to about 80 yen to the dollar. This has increased pressure on Japanese currency officials to take more decisive action to protect exports as the yen once again closes in on 82 yen to the dollar. Last year, Chief Cabinet Secretary Yoshito Sengoku referred to this level as the “line of defense to prevent currency strength from harming the economy”.
Given that statement, and seeing that, presently, one U.S. dollar has fallen back to about 80 yen, most expect further intervention is inevitable.
Nevertheless, on May 1st, Takehiko Nakao, vice finance minister for international affairs, opted to suspend the release of more money to the system but did signal that further easing efforts remain under consideration.
“We are concerned about the somewhat rapid appreciation of the yen since the end of last week,” noted Nakao. “We will continue to closely monitor the market with caution so that we can act in a timely, appropriate manner when needed.”
Japan’s Demographic Trap
While officials grapple with what seems to be a currency that simply does not react to the laws of economics, there is one law that even the yen will be powerless to resist – the law of nature. Japan’s population as a whole is growing older and the demographics point to a future where retirees outnumber workers, and to a time when the country’s famous savings will be whittled down to next to nothing.
Japan’s aging populace is the result of declining birth rates and exceptionally low immigration. According to a 2009 United Nations report, Japan was the oldest society on the planet with a median age of 44 years.
The outlook is expected to worsen as the country’s death rate now exceeds the birth rate indicating the average age will only continue to rise. Naturally, as more of Japan’s citizens reach their retirement years, they will start to withdraw money from their savings thereby reducing the pool of savings, eventually resulting in a near-total drawdown on these funds.
The county’s growing legion of retirees will also have little need to add to their savings and this could prove the event that forces Japan to turn to outside investors to bridge the growing deficit. Unlike most of those now buying Japan’s debt, these new investors will not be purchasing Japan’s bonds for patriotic reasons – they will be looking for speculative gains, and in order to attract new investors, yields will unquestionably be forced higher. Considerably higher, in fact, and given the current debt-to-GDP ratio, and a structural annual budget deficit expected to top 15 trillion yen by 2015, investors may feel the new Japan represents too great a risk.
With Japan’s population aging at an accelerated pace, and with the coming generations insufficient in number to fill the thinning ranks, the long-term sustainability of the economy is at risk. This is the demographic trap that is poised to spring shut.

Is Keynesianism Running Dry?

Submitted by Tyler Durden on 07/15/2012 17:56 -0400
 
Why policymakers must be brave and innovate with economic policy
Even though the policy mix is extraordinarily stimulating, developed-world economies just cannot embark on a virtuous circle of recovery. Worse still, governments, whose finances have been bled dry, are powerless to boost demand. This all suggests Keynesian policies have failed. A fresh approach to economic policy is needed. But policymakers will need to be both bold and brave.

The current state of economies is serious and worrying: although deliberate expansionary policies have been pragmatically implemented since March 2009, governments and central banks throughout the developed world have been unable to push recalcitrant economies back into the virtuous loop of self-sustaining recovery. The implications are plain for all to see: once governments apply a brake to public spending, growth slows considerably. Economies of the developed world have become addicts, ‘hooked’ on government spending.
The annualised rate of US economic growth has slackened to no more than 2%, down from 6% in Q2 2009, in spite of the mix of reflationary fiscal policies and the US Federal Reserve’s unprecedented quantitative easing. Europe’s economies are heading for recession, crippled by draconian budget austerity in many countries intended to redress astronomical public-sector deficits and national debt. Worst-case scenarios are pointing to Europe’s GDP shrinking by 2% over the coming 12 to 18 months. This calamitous failure of economic policies will have serious social, political and, self-evidently, economic repercussions.
Keynesianism running dry
Both US and European economies see jobs being destroyed once growth slows below 2%. If recession bites, obviously jobs are wiped out on a more massive scale and household income shrinks. Unemployment and contracting income penalise social well-being in developed nations: the number of people living below the poverty line is rising non-stop. Although this stratum of society was considered just a marginal fringe twenty years ago, it now accounts for between 10% and 20% of the total population in most developed economies (15% in the US, 12% in France, 21% in the UK).
Draconian austerity measures in a setting of lacklustre growth make a recipe for despair in the population, creating a breeding-ground for ever more popular extremist political parties. Recent general elections in Greece, France, the Netherlands, Austria and Sweden have seen farright populist and parties disturbingly making electoral breakthroughs or scoring big gains. Modern societies can no longer promise future generations a better, brighter future. Political instability precludes the vital nationwide consensus being formed to push through measures required to rebuild the foundations of a solid economy.
This economic-policy stalemate, in particular, is becoming increasingly blatant. Traditional Keynesian remedies are proving both unworkable and ineffectual. Record public deficits of 10% of GDP in 2009, inflated by the host of budget reflationary programmes, have resulted in governments being either de facto or potentially insolvent. Since then, with no financial ammunition left, governments have been unable to push through any further reflationary measures and compensate for the drop in wages by distributing increased social-welfare benefits. Worse still, by slashing public spending, a strategy regarded by economists as essential to restore countries’ sustainable financial viability, policymakers are making matters worse: as growth slows, deficit-cutting targets are being missed and the trajectory on public debt is moving ever further away from its optimal pathway. With no credit to dispense, State-administered Keynesianism is, in effect, bankrupt as government spending levers can no longer be activated.
A new role for government needs to be envisaged
How serious have things become?
After all, Keynesianism’s limitations have been apparent for some time. By seeking to kick-start growth by boosting consumer spending, it has become clear that modern economies no longer rely on consumption. To be more precise, the dynamics of virtuous, self-sustaining economic growth are not triggered by consumer spending. In contrast, the dynamics feed through eventually into consumption – they are instigated by investment and, by extension, jobs. This key focus on the investment/employment duo has been noticeably lacking in the US and European economic policy mix over the last four years. The time has come to review the role government and the State, shown now to be effectively toothless, play in influencing economic growth.
As governments alone are no longer able to spend and stimulate growth, they need to turn towards encouraging spending by other economic players, especially those who can intervene effectively to boost jobs and incomes, i.e. businesses. To do that though, politicians will need to be both bold and brave. At a time when capitalism is being accused of the most reprehensible wrongdoings, policymakers will need to display great courage to promote the virtues of entrepreneurship and business. However, while Keynesianism may be looking bankrupt, demand-side economic policies are looking dead in the water as well. As a result, moving to economics geared to boosting supply is absolutely indispensible. The rub is that the policies for this still have to be invented.
There has, however, been one illustrious precedent: the supply-side economies implemented with success by the Reagan Administration in the early 1980s, followed by twenty-five years of sustained growth in a period referred to as the era of the ‘Great Moderation’. The fresh approach to economic policy now will need to be generous in seeking to promote innovation. Investment and job creation tend not to happen without a major wave of innovation. Of course, innovation cannot be decreed into existence. But it can be nurtured through fiscal incentives that favour risk-taking. Huge tax breaks for R&D and capital spending would be likely to form the major building-blocks of any future budget policy to stimulate supply. Making such moves would call for great political courage as, nowadays, it is regarded as socially equitable and electorally advantageous to tax – even so heavily as to veer close to financial repression – those generators of wealth most liable to be most useful in boosting supply.
A fresh approach to economic policy
There is a second challenge though.
Unchecked, supply-driven economic policies tend to lead to excess. Modern economic history covering the Great Moderation period has demonstrated that overgenerous use of credit always ends in tears. First of all, in the 1990s, the belief that boom-and-bust cycles were things of the past thanks to the advent of revolutionary new information and communications technologies lured companies into running up huge borrowings beyond what their returns on equities could withstand. This sparked the bursting of the dot.com bubble and TMT (technology, media, telecom) crash. Then, from the early 2000s, it was households’ turn to overstretch themselves with debt, culminating in the sub-prime crisis. Moreover, innovation per se should not be regarded as universally wonderful. Just take the example of financial innovation which, unregulated, lay behind the ballooning debt.
Excess lending will inevitably lead to artificially-driven economic growth as it breaks the link between the cycles of innovation and economic growth. The virtuous qualities of real economic growth evaporate and become unreal. Growth fuelled by excess credit leads inevitably, as night follows day, to ballooning bubbles, burst by devastating crashes on financial markets. Fresh and well formulated supply-focused economic policies would need to take due account of such undesirable and destabilising implications. This concern points to a new role for central bankers, implying, by osmosis, a fresh style of monetary policy being needed as well. Inflation targeting (keeping core inflation around 2%), the sacred cow for central banks since the early 1980s, is no longer appropriate for either today’s growth conditions or for an innovative, supply-geared economic policy mix.
Imagination will be required to forge this new role for central banks. Not to mention the bravery in calling into question the orthodoxy that has held sway for so long. In the past though, periods when there have been serious ruptures in cyclical economic patterns have often seen major shifts and key policy breakthroughs. However, all the courage and boldness will be futile if the will to bounce back is lacking. The challenge is most daunting. The direction of economic policies over the next few years will dictate the structural trends for developed economies for decades to come. We just have to hope that policymakers will dig deep amid all the grave economic, political and social crises today to find that courage to be bold and innovative.