The Debasement of the Riskless Rate

Structural causes and effects on world macroeconomics

Gian Luca AmbrosioA Chat with

Fonderia OxfordExeter College, Oxford

16 February 2012

1

Finance and the Riskless Rate

• What is Finance?– The business of borrowing and lending money in the free capital

markets

• What is the Riskless Rate?– Or risk-free rate of return, is the interest an investor would expect

from a theoretically risk-free investment over a specific period of time

• Why Does the Riskless Rate Matter to Global Macroeconomics?– By representing the certainty or near-certainty of principal

repayment, both short-term (CB Repos/Deposits; Treasury Bills; AAA CPs) and longer-term (AAA Treasury and Corporate Bonds) risk-free rates work to anchor the credit risk (insolvency) hierarchy; crucial prerequisite to an optimal allocation of capital

2

When the Riskless Is at Risk• During Normal Times Financing and Investment Anchored by Risk-Free Rate

– Traditional foundation is high-grade sovereign (e.g. US, Germany, UK)– Extends across the maturity spectrum – from o/n deposits at CBs’ to long-term bonds

• Underlying Source or Cause of Risk– Debt that Cannot be Repaid– Insolvency or the prospect of insolvency

• Responses – A Typology of Sovereign Risk• The Good – Growth, Taxes, and Re-payment• The Bad and the ugly

– Nominal Default • Simplest and most obvious – as in Russia 1998 , Argentina 2001, Ecuador 2008, Greece 2012? Actually

pretty common over history

– Inflation• Moderate to High Unexpected Inflation – as in most Latin American countries over past 70 years, but

also Europe and the US in the 1970s. Devalues the debt

– Financial Repression• Restrictions on nominal rates or other financial activities• Current example – US – low rates, negative real rates devalues the debt**

– Currency Revaluation• For foreign-denominated debt – equivalent to nominal default

3

** Expected Positive Real Interest Rate – The Anchor to Economic Growth and Investing- Key price for decisions on consumption today vs. tomorrow, investing, growth

Credit Risk Distorted

• Problems Start when Credit Risk (Insolvency Hierarchy) is Distorted

• It is Bad Policies, not Financial Markets, that Produce Long-Term Credit Risk Distortions– Fed’s monetary policy 1994-2007*

• The Productivity Miracle

• The Y2K

• The “Great Moderation”

– US Congress housing policies: ’00s mortgage democratisation*• “One mortgage for every American”

• Fanny Mae and Freddy Mac’s balance sheet leverage

• Government implied guaranty on GSEs’ MBS

4* See Appendix

Current State of Affairs - Riskless Rate Debasement

• Current Disarray – “Financial Repression” and Negative Real Rates– Past four years has seen explosion of sovereign debt and increasing sovereign risk– Shows up in places as explicit default risk – pretty obvious (e.g. Greece)– More important – although harder to see and far more damaging – is the effect of

financial repression and negative real rates – default by a thousand cuts

• Global Quantitative Easing Distorts Real Rates and Credit Risk Hierarchy – US, Eurozone, and UK CB short-term funding to banking system provides

emergency liquidity– But banking system hoarding reserves in anticipation of further funding difficulties

and investors losing confidence in extending credit to indebted governments– The creeping sovereign risk of financial repression distorts traditional risk-free

benchmarks

• This Leaves Global Markets Looking for “True” AAA Assets– Borrowers and investors looking for transparency, liquidity, and stable credit

hierarchy

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Current State of Affairs (cont.)

• Only few Surviving “True” AAA Lenders and Borrowers Globally– Low sovereign risk requires good growth prospects, low debt, good fiscal

management– China, Germany, Canada, Norway, Australia,….?

• China, Currently Pursuing the “Bilateral” Way i.e. Investment + Currency Bilateral Agreement vs Strategic Collateral – Bilateral convertibility

• Opens to bilateral finance and trading• By-passes traditional capital markets

– Crucially, China has no Borrowing Needs so no AAA Bond Issuance

• Germany, Trapped in Captive Political Environment, Trading Funds vs Political/Fiscal Conditionality; Too Small to Fill “True” AAA Assets-Global Savings Gap

• IMF and EMU’s (EFSF, ESM) Rescue Funds Creating Unprecedented Credit Seniority Debasement – Crucially, No IMF Issuance; EMU’s not a AAA

• US, Backed by China’s Captive AAA Investor Status, Precariously Extending Role of Global AAA Liquid Asset Provider

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Current State of Affairs (cont.)

• Financial Markets Pressing for Credit Standing Differentiation While Policy Makers and Rating Agencies Catching up with Reality

• New Ranking of “True” AAA Lenders/Issuers Emerging

• “True” AAA Lenders/Borrowers Unwilling to Offer Funds Without Strict Conditionality

• China and Germany’s “Bilateral” Approach Inadequate to Solve Global Credit Anchoring Vacuum

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AAA Debasement: Macroeconomic Impact

• Global Business Confidence Likely to Remain Low as Businesses and Individuals Perceive Their Savings as Unsecured

• CBs Short-Term Lending Provision and QE Likely to Increase Confusion Between Liquidity and Solvency Risk Leading to Misallocation of Capital, Next Financial/Asset Bubble

• Lack of Credit Hierarchy Anchoring and Credit Differentiation Hampering Private and Public Sector Financing/Re-financing Activity

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Desirable Outcomes

• “True” AAA Lender/Borrowers (China, Germany, Canada, etc.) and C/A Surplus Countries (Russia, Brazil, India, etc.) to Establish Voluntary Global AAA Fund Which Lends to Countries and Banks Against Streamlined, Market-Based Conditionality

• Global AAA Fund Resources to be Provided Through Up-front Cash + Issuance of a Global AAA Bond

• “True” Global Longer-Term AAA Lending, Coupled with AAA Issuance to Provide Credible Anchor to Global Credit Hierarchy

• Struggling European Countries to Re-acquire Credit Standing Differentiation

• “Implied” Chinese Capital Market as a By-product of AAA-Global-Bond Issuance Sets off Additional Global Reserve Currency

• US to Compete for Global Savings; Budget Deficit to Be Tackled by Congress Sooner Rather than Later

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Greenspan’s Expansionary Mon. Policy + US Congress Housing Policies

Excess Liquidity AAA Pool ExpansionGSEs’ AAA Implied

RatingRating Agencies’ Modelling Error

Excessive Leverage

AAA MBS and AAA CDOs Proliferation

Sub Prime Lending Expansion - Real Estate Bubble

Generalised Capital Misallocation - Real Estate, Financial Assets, Commodities

Real Estate Bubble Burst - Sub Prime Derivatives Default

Banking Insolvency Risk Re-pricing

Government Insolvency Risk Re-pricing

AAA Poll Contraction 10