Another happy view of the ongoing upheaval in global markets comes from Avinash Persaud, author, chairman of Intelligence Capital and emeritus professor at Gresham College, London.
“Central bank intervention last Friday to inject liquidity into the global financial system did not mark the beginning of the end of financial market turmoil. It was merely the end of the beginning,” he writes in Thursday’s FT.
Central banks’ liquidity injections will not deliver lengthy respite, he warns. “The next phase of market volatility will be more vicious than before, led by downgraded ratings on credit instruments and followed by further dislocation in the credit markets that will spill over to equity markets.”
Credit markets are what Persaud calls “the big brother of equity markets”.
In the US and Europe, capitalisation of private debt securities is a combined $28,000bn, compared with $23,000bn in equity markets. Although rating downgrades will be a consequence of existing anxieties about credit quality, they will have knock-on effects. Substantial parts of the credit markets are priced off these ratings. This presents rating agencies with serious conflicts of interest that will move centre stage when investors start looking for a scapegoat.
Rating downgrades will convert risks into losses. Lossmaking credit funds will suffer redemptions, forcing fund managers to dump well-performing parts of their portfolios as well. Loan covenants will require rated entities to inject liquidity on a downgrade. Where central banks are pushed to ease liquidity more aggressively than their inflation objectives may suggest, currencies will weaken. The yen will rebound.
Those who are older than the trading floor average will have seen this before, says Persaud. But what makes this particular credit cycle more complicated and perhaps more hazardous is the very thing that former Fed chairman Alan Greenspan and others argued had made financial systems safer, he says: the securitisation of credit.
Securitisation brings benefits. But in these circumstances it will make the down cycle more severe and will transmit systemic risks along untraditional paths that may prove less sensitive to interest rate cuts than in the past.
Over the past 20 years, says Persaud, governments built regulatory systems to avoid credit problems at one bank becoming “systemic. These systems succeeded, but only by shifting risks elsewhere. A measure of this failure is that the instances of emergency rate cuts have become no less frequent. Think of 1987, 1989-92, 1995, 1998 and 2001-03.”
Today, he says, “the principal avenues of systemic risk are via investment losses, not bank runs. The example from Japan in the 1980s and emerging Asia in the 1990s is that large and widespread investment losses will lead to big reductions in consumption and investment.”
Can lower interest rates temper investor losses? Yes, if the problem is caused by a temporary lack of liquidity; no, if it is caused by a “de-rating” of asset quality, as is occurring today, says Persaud. “Cutting interest rates for everyone does not encourage investors to take more care in the future. Each of the emergency rate cuts referred to above spawned an asset bubble.”
The crash of 2007-08 need not have occurred, he concludes.
It was the result of poor investment decisions that were supported by the monetary and regulatory background. There is not a great deal that can be done about that today. But in responding to the anguish of this crash, policymakers must not lay the foundations for the next one.
