CHANCELLOR: THE LEGACY OF ULTRALOW INTEREST RATES

A SIX-PART SERIES BY EDWARD CHANCELLOR

Part One: Trouble ahead

Back in November 2002, Ben Bernanke, then a governor of the Federal Reserve, attended Milton Friedman’s 90th birthday party. In his writings, the legendary monetarist had pinned the Great Depression on policy failures of the American central bank. Bernanke was a keen disciple and apologised to Friedman on behalf of his employer, vowing that the Fed wouldn’t make the same mistake again. Less than six years later, Bernanke found himself at the helm of the Fed on that fateful day, Sept. 15, 2008, when Lehman Brothers collapsed. Another Great Depression beckoned. But now the Fed chairman was ready to make good on his promise.

What followed has been the boldest monetary experiment in history, not just in the United States but around the world. Interest rates were held close to zero in the world’s largest economy for years, while negative rates prevailed elsewhere; trillions of dollars of debt securities, in some cases even including corporate bonds and shares, have been acquired by central banks with money conjured from thin air. The Fed’s balance sheet quadrupled to more than $4 trillion. Bernanke instituted other new practices, such as directing the markets as to the expected course of future rate changes known as forward guidance. During and after the crisis, the Fed made huge loans to foreign central banks so they could bail out domestic lenders with large dollar liabilities.

Ten years on, it’s possible to look back on some of what the Fed has accomplished. A severe market panic was quickly arrested. The Great Recession turned out to be mercifully brief. By acting as global lender of last resort, the Fed stopped the subprime mess from metastasizing around the world. True, a sovereign debt crisis in the euro zone cropped up a couple of years later. But the European Central Bank under Mario Draghi promising “to do whatever it takes” quickly put an end to that. When Bernanke’s successor, Janet Yellen, left her post earlier this year, the Fed had achieved its twin mandates of stable prices and low unemployment. The American economy is currently enjoying its longest recorded period of uninterrupted expansion.

Yet under the surface, something appeared to be going in the wrong direction. While the U.S. economy continued to hire new workers, productivity growth collapsed. Companies have been reluctant to invest. Savings have been abnormally low. Workers’ incomes have struggled to keep up with inflation. High asset prices are all very well, but the ownership of financial securities is heavily skewed towards the rich. There is a widespread political consensus on both the left and right that the post-crisis policies benefited the “haves” at the expense of the “have-nots”. Despite a swathe of new financial regulations, there are concerns that many of the unsound financial practices from before the crisis have resurfaced.

Productivity growth, inequality, financial risk-taking and asset price bubbles are mind-bogglingly complicated matters. Still, a single influence appears to have dominated in recent years. The low-interest rate policy of the Fed and other central banks has inflated a handful of speculative bubbles, thereby contributing to an increase in inequality. Easy money has created an indiscriminate search for yield that threatens financial stability at home and abroad. Low interest rates have dampened the forces of creative destruction, fostering “zombie companies”, which act as a drag on economic growth.

To understand what has happened in the post-Lehman era, it is crucial to grasp the multiple functions of interest. It governs the discount rate, which puts a value on future income streams (the so-called capitalization rate). In a capitalist economy, interest influences the allocation of resources. Interest determines the distribution of unearned income or rents between the “haves” and the “have-nots”. As the price of leverage, interest determines both the extent and quality of lending. Interest also regulates the flow of capital around the global financial system. Interest is not the price of money, as sometimes described, but the price of time. All financial and economic activities take place over time. This makes the rate of interest the single most important price in the economic system. Get that price wrong and unpleasant things are bound to happen.

This series of essays marking the 10 years since Lehman’s demise will show how the post-Lehman era of ultralow interest rates has: 1. Unleashed speculative manias, including the great crypto bubble; 2. Misallocated capital on a grand scale, creating the zombie company phenomenon; 3. Benefited Wall Street at the expense of Main Street, thereby contributing to the rise of populism; 4. Fuelled both domestic and foreign carry trades that threaten the stability of the global financial system; and 5. Produced an epic credit and real estate bubble in China, the country responsible for nearly half of global economic growth since Lehman’s demise.

First published Sept. 9, 2018

Part Two: Bubbles galore

In 1776, English man of letters Horace Walpole observed a “rage of building everywhere”. At the time, the yield on English government bonds, known as Consols, had fallen sharply and mortgages could be had at 3.5 percent. In the “Wealth of Nations”, published that year, Adam Smith observed that the recent decline in interest had pushed up land prices: “When interest was at ten percent, land was commonly sold for ten or twelve years’ purchase. As the interest rate sunk to six, five and four percent, the purchase of land rose to twenty, five-and-twenty, and thirty years’ purchase.” [i.e. the yield on land fell from 10 percent to 3.3 percent].

Smith explains why: “the ordinary price of land … depends everywhere upon the ordinary market rate of interest.” That’s because the interest rate discounts and places a capital value on future income. All the great speculative bubbles in the past – from the tulip mania of the 1630s through to the global credit bonanza of the last decade, have occurred at times when interest rates were abnormally low.

The trouble is that after the Lehman Brothers collapse, central bankers refused to accept this fact. The position of Ben Bernanke’s Federal Reserve was that the real-estate bubble was caused by lax regulation rather than his predecessor Alan Greenspan’s easy money. If this were true, then taking short-term rates down to their lowest level in history – to zero in the United States and negative in Europe and Japan – was sensible. But if Smith was correct, then monetary policy in the wake of Lehman’s bust was a case of the hair of the dog.

In the last decade the world has witnessed bubbles galore: in industrial commodities and rare earths; in U.S. farmland and Chinese garlic bulbs; in fine or not-so-fine art, depending on your taste; in vintage cars and fancy handbags; in “super-city” properties from London to Hong Kong, and across China’s tier-one cities; in long-dated government bonds; in listed and unlisted technology stocks; and in the broader American stock market.

Fed officials notoriously failed to spot the real-estate bubble until after it burst. That’s because the current generation of monetary policymakers were schooled in the belief that bubbles didn’t exist. The experience of the subprime crisis apparently left them not much wiser. In April 2016, Fed Chair Janet Yellen, flanked by former Fed chiefs Paul Volcker, Greenspan and Bernanke, denied that the United States was a “bubble economy”. A bubble market, said Yellen, was one that is “clearly overvalued” and marked by strong credit growth.

Yet at the time U.S. stocks were very expensive compared to historic levels. They are currently more overpriced on dependable valuation measures, such as total market value to GDP and on a replacement cost basis (Tobin’s Q), than at any time save for the 2000 dot-com bubble. By the end of the first quarter, U.S. non-financial stocks were 85 percent overvalued on a replacement cost basis, according to economist Andrew Smithers. American corporations have also been borrowing like there is no tomorrow.

A second technology bubble is evident in the nosebleed valuations of tech firms such as Tesla. In August, the market value of Elon Musk’s firm overtook BMW’s even though the profitable Bavarian luxury carmaker produced 30 times as many cars last year as the loss-making Tesla, whose shares have since declined. Seven of the world’s 10 most valuable companies are tech stocks, headed by the trillion-dollar Apple. Away from public markets, profitless unicorns, such as the taxi-hailing firm Uber, sport multibillion-dollar valuations. With so much dumb money about, one of Silicon Valley’s new mantras is “spray and pray”.

Consider what history will surely record as one of the most absurd speculative manias of all time: the cryptocurrency bubble. Bitcoin is pure digital fairy dust. Last year the price of the leading cryptocurrency soared nearly 20-fold, peaking at over $19,000. It’s worth around $6,250 today. The boom brought forth many imitators, including ethereum and dogecoin. Bitcoin even has its own offshoots or forks, as they are called, bitcoin gold and bitcoin cash.

At a time when central banks with their negative rates and bloated balance sheets have undermined confidence in traditional money, it’s not surprising that people should look for alternatives. But these new “currencies” couldn’t be used to buy much in the way of goods or services, or to pay taxes. Bitcoin’s technology is far too slow and energy-consuming for such practical purposes. Like the California gold prospector’s storied tin of rancid sardines, bitcoin is good only for trading.

This collection of bubbles has pushed U.S. household net worth to a record $100 trillion, the Fed reported in June. As a share of GDP, Americans are now richer than they were at the peak of the dot-com bubble and the real-estate bubble, according to the Fed. But this is not real wealth derived from savings and investment, both of which have languished in recent years. It is merely the illusion of wealth.

Former Treasury Secretary Larry Summers once observed the American economy only expands when bubbles are inflating. Both U.S. corporate profits and GDP growth are responding to changes in household net worth. It should be the other way around. Yellen was wrong. The United States is a “bubble economy”, no sounder in its fundamentals than the one which collapsed in the subprime debacle.

Since the interest rate discounts future cash flows, ultralow rates have had an outsized impact on investments whose income lies far out in the future, whether through technology companies or 100-year Austrian bonds (sold in September 2017 for a yield of just 2.1 percent). The crypto carnival could only have occurred at a time when interest rates globally were hovering close to zero.

Adam Smith would have understood this well enough. No bubble lasts forever. The main justification for the elevated level of the S&P 500 Index is that long-term interest rates remain low. But the relationship between bond and equity yields isn’t stable over time. If the Fed keeps on tightening, or if inflation breaks out and bondholders take fright, this latest and perhaps greatest of bubbles will also come to burst.

First published Sept. 11, 2018

Part Three: The Zombies

The economy is like a rubber ball. The harder it hits the ground, the faster it bounces back. That’s what normally happens. After the Lehman Brothers bankruptcy, Western economies experienced their deepest contraction since the 1930s. Yet their subsequent recovery was decidedly lacklustre. Soon after, the markets witnessed a startling rise in the number of zombie firms – marginal businesses that appear to feed and multiply on an unchanging diet of cheap capital.

It’s no secret why economies normally rebound after sharp contractions. During a downturn, many companies restructure and loss-making businesses hit the wall. As a result, capital and workers are reallocated to more productive uses. Outdated machines and old-fashioned practices are replaced by the latest technologies and new forms of organisation. More efficient businesses can invest more and produce jobs. Business failures are essential to the recovery. As the saying goes, “capitalism without bankruptcy is like Christianity without hell”. This is how famed Austrian economist Joseph Schumpeter’s creative destruction, the driving force of capitalism, is supposed to operate.

The rate of interest plays a vital role in this process. The “true function of interest”, wrote Schumpeter, is as a “brake or governor” on economic activity. By setting a hurdle rate for businesses, interest rations the use of capital. Interest sets the tempo for economic activity, says James Grant of Grant’s Interest-Rate Observer. It is like the shot clock in basketball, he argues. When the clock is ticking, there’s no dawdling. During a credit crunch, interest rates spike and creative destruction goes into overdrive. “The riches of nations can be measured by the violence of the crises they experience”, observed Clément Juglar, a 19th century economist who studied business cycles.

During the global financial crisis, interest rates on corporate debt spiked. In November 2008, the yield on U.S. junk bonds topped 20 percent. Then the Federal Reserve went into action: expanding its balance sheet, cutting the Fed funds rate to zero, underwriting toxic loans and lending money to investors to buy up distressed debt. Those panic rates soon disappeared. Once the economy recovered, credit watchers noticed something surprising. Over the course of the recession, the cumulative default rate on junk bonds amounted to just 17 percent, around half the level of the two previous downturns. “The Fed’s extraordinary intervention”, opined high-yield analyst Martin Fridson, “enabled companies [to survive] that should have failed”.

The low level of corporate failures might appear a boon. But in the past decade, U.S. productivity growth collapsed to below half its postwar average. New business formation, although recovering, has created fewer new jobs than in past upswings, according to the Bureau of Labor Statistics. The U.S. economy operated for years with excess capacity, yet fewer firms than in similar periods in the past went bust. Even though corporate interest costs had never been lower, a rising number of American companies had trouble servicing their debts. These are the corporate zombies.

Among rich nations, the OECD in 2016 estimated that 10 percent of firms qualified as zombies. For many reasons, these creatures are bad for economic growth: they invest less and create fewer jobs; they crowd out more efficient businesses and act as a barrier to entry for new firms; when industries are dominated by zombies, profitability declines and new investment is discouraged; weighed down with these firms’ bad debts, banks are hindered from making fresh loans. “When too many resources are stuck in low productivity areas and in zombie businesses”, writes economist Phil Mullan, “then the potential for the wider positive impact of particular innovative business investments will be frustrated”. And without productivity growth, there can be no sustained growth in worker incomes.

In the post-Lehman period, a close relationship exists between the rise in the number and survival rate of zombies and the decline in interest rates, according to the Bank for International Settlements. This phenomenon was first observed in 1990s Japan after the collapse of its “bubble economy” at around the time when the Bank of Japan inaugurated its zero-interest rate policy. Zombies survive for longer nowadays, says the BIS, because they face less pressure to reduce debt.

This problem has not been confined to the United States. Europe has suffered an even worse infestation. Italy has had some of the worst cases. Clothing retailer Stefanel is a prime example. Beaten up by strong competitors, such as Spanish fashion house Zara, Stefanel has produced a string of losses and faced several debt restructurings over the last decade. Still the Veneto-based firm clings onto life – its shares down 70 percent since 2014 – thanks to loan forbearance from its banks and to the ECB’s negative interest rates. Zombies are largely responsible for the mountain of nonperforming loans on the balance sheets of Italian banks, among them Stefanel creditor Monte dei Paschi di Siena.

It is conventional wisdom in policymaking circles that a repeat of the Great Depression must be avoided at all costs. That was the rationale for the great monetary experiments of the past decade. Yet contrary to popular lore, the Great Depression was not an unmitigated disaster. Nearly a quarter of a million businesses failed but the survivors, in industries such as auto-manufacturing and aerospace, were given a clear field to invest in new more productive technologies. Economist Alexander Field describes the 1930s as the “most technologically progressive decade of the century”. In the following decade, U.S. economic output returned to its pre-1929 trend. For the postwar generation of Americans, it was as if the depression had never happened.

We may not be so lucky this time. A recent paper by former Treasury Secretary Larry Summers and former IMF Chief Economist Olivier Blanchard points out that U.S. economic output (per working-age adult) was on course to recover by less than in the years after the 1929 crash. This year, economic growth has picked up and wages are also rising. But should this “Trump Bump” collapse, then the verdict of history may well be that central bankers after Lehman saved the world from another Great Depression – only to deliver the Great Stagnation.

First published Sept. 11, 2018

Part Four: Haves more

The Greek philosopher Aristotle attacked the charging of interest on grounds that lenders demanded more money in return than they supplied. This ancient prejudice against interest lingers in the French economist Thomas Piketty’s claim that inequality increases when the return on capital, a quantum which includes the rate of interest, is higher than that of economic growth. Yet the overwhelming evidence from the easy money that followed Lehman Brothers’ demise shows that inequality really takes off when interest rates are maintained at artificially low levels.

In the decade after 2008, the U.S. central bank has maintained its fed funds rate at a level below the rate of inflation. The Federal Reserve also used quantitative easing and other newfangled monetary tools to bring down long-term interest rates. This unconventional monetary policy was intended to boost household wealth and spending. It ended up inflating a handful of asset price bubbles. Since wealth is unevenly distributed, the bulk of the gains in the United States and abroad have been enjoyed by the rich.

This is what happened in the UK, where the Bank of England followed the Fed’s playbook. A 2012 study by the bank found that quantitative easing had boosted household wealth by more than £600 billion but that nearly two-thirds of these gains had gone to the richest 10 percent of households. Another study by S&P Capital IQ found that in the aftermath of the crisis the wealthiest decile of UK households had increased their share of financial assets at the expense of the poorest. As former UK financial regulator Adair Turner writes: “quantitative easing has been good for the rich, and ultra-easy monetary policy thus exacerbates inequality”. Few would disagree with this conclusion.

American income inequality has been especially aggravated by the Fed’s interest-rate policy. Most executive pay is linked to share-price performance. When easy money gooses the stock market, as it did in the years after the Lehman bust, corporate chieftains and their extended retinue receive an unearned windfall. Management has also used cheap debt to repurchase shares rather than invest in new plant and equipment, as the Fed intended. Since 2013, companies in the S&P 500 Index bought back approximately $2.4 trillion of stock, helping boost share prices, according to Standard & Poor’s. The executive pay bonanza got even bigger.

Easy money has particularly aided Wall Street as it recovered from the Lehman shock. The financial sector, including insurance and real estate, soon regained its position as a U.S. economic powerhouse, accounting for nearly a third of GDP growth between 2010 to 2015, up from 14 per cent between 1998 and 2008, according to the Bureau of Economic Analysis. Bankers’ bonuses returned with a vengeance – with the average payout rising to the highest level since 2006, New York state’s comptroller estimates. These bonuses derive largely from fees levied on securities issuance, corporate-finance activity and on assets under management.

U.S. corporate-debt levels doubled since 2008, says Goldman Sachs. M&A activity soared to a record $2.5 trillion in the first half of 2018, according to Thomson Reuters. AT&T’s recent $85 billion takeover of Time Warner could generate up to $390 million in bank fees, Freeman & Co has said. Investment-management fees also picked up as the stock market rebounded after 2009. Activists have pushed venerable companies from Procter & Gamble to Campbell Soup to engage in financial engineering to increase shareholder returns, and thereby justify their management fees.

Life has been particularly sweet for the private-equity world. The current leveraged-buyout boom has been spurred on by some of the cheapest financing in history. Private-equity firms even used low-cost debt to snap up repossessed properties after the housing bust. Blackstone’s listed residential business, Invitation Homes, has become one of the country’s largest landlords. The buyout barons have never had it so good. Over the past five years, Blackstone founder Stephen Schwarzman is estimated by the Wall Street Journal to have earned more than $3.2 billion in dividends and fund payouts.

But consider how easy money has treated the not-so-privileged. The financial crisis hit them hard. As many as 10 million homes were repossessed, according to the St. Louis Fed. Since the middle classes have most of their wealth tied up in their houses, they experienced the greatest proportionate losses in the downturn. New York University economist Edward Wolff estimates that median wealth fell by a staggering 47 percent between 2007 and 2010. The surge in unemployment after the financial crisis and a weak jobs market in the subsequent years further contributed to income inequality.

Central bankers claim that ultralow interest rates have helped fix the jobs market. This year, the official unemployment rate has fallen below 4 percent, its lowest level since 1969. That’s good news, but the share of the workforce employed or actively seeking work declined after 2008 and remains depressed at below 63 percent, the Bureau of Labor Statistics reports. Unconventional monetary policies contributed to the productivity slowdown which has hurt incomes. Until their recent pickup, U.S. wages stagnated in the years after 2008.

Nor did the poor benefit directly from the Fed’s zero interest rates. In fact, interest charges for “subprime” households actually rose as banks tightened lending standards. Because the less well-off maintain a higher proportion of their liquid assets in cash, they have also suffered most from deposit rates being held for years below the level of inflation.

Most workers own financial assets indirectly through their pensions or retirement plans. The decline in long-term rates has pushed up the value of pension liabilities, more than offsetting gains from investments. A pensions crisis affecting both private and public pension plans looms on both sides of the Atlantic. Ultralow rates have sounded the death knell for the defined-benefit pensions which enabled the postwar generations to enjoy a secure retirement.

Commentators from Aristotle to Piketty have argued that high interest rates aggravate inequality. Yet the ultralow rates of recent years have made it harder for the “have-nots” to accumulate the resources to buy a home or build a nest egg. The “haves” have enjoyed soaring wealth gains. The chief beneficiaries of easy money have been those on Wall Street with access to cheap loans. Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch puts it this way: “Never in the field of monetary policy was so much gained by so few at the expense of so many.” And he’s right.

First published Sept. 13, 2018

Part Five: Carrying on

The official position of the Federal Reserve is that the subprime crisis of 2008 was largely a consequence of poor financial regulation. There’s an alternative view: That the Fed’s easy-money policy after 2002 created a desperate search for higher-yielding securities. It also encouraged banks to partake in what are known as carry trades, borrowing cheaply in dollars and lending at higher rates both at home and abroad. From this perspective, the catastrophe following Lehman Brothers’ collapse was simply a giant trade gone wrong. Even lower interest rates in the past decade have revived this lending frenzy.

There’s no doubt that financial regulation was too lax prior to the 2008 fiasco. That’s why liar loans and mortgages to uncreditworthy borrowers proliferated and Wall Street firms including Lehman and Bear Stearns were allowed to take on too much debt. The watchword since the crisis has been macroprudential regulation. This has involved thousands of pages of new financial rules incorporated in the Dodd-Frank Act and other banking regulations, policed by armies of examiners and in-house compliance officers.

Yet in the era of zero and negative interest rates, financial regulators were set an impossible task. Interest puts a price on leverage. That means high rates discourage excessive risk-taking, while low rates have the opposite effect. As a result, interest serves as a kind of omnipresent regulator of the financial system. Given the U.S. dollar’s role as the global reserve currency, the Fed’s interest-rate stance also regulates international capital flows.

New research suggests that when interest rates sink, investors compensate for a loss of income by taking on more risk. Harvard University’s Yueran Ma and Wilte Zijlstra of the Dutch Authority for the Financial Markets observe  that when the risk-free yield falls below its historic average investors’ allocation to risky assets increases in a non-linear fashion. It stands to reason, then, that when interest rates decline and investors start chasing yield, systemic financial risk also picks up.

That’s what happened in the years before the financial crisis. Subprime and other structured-finance products were Wall Street’s inventive response to investors’ craving for yield during the Greenspan easy-money era. The carry-trade mania had an international dimension. European banks borrowed dollars to buy subprime securities. They also lent heavily to countries like Spain and Ireland and across central Europe where yields were higher. This cross-border lending began to unravel in the summer of 2007 and imploded in September 2008.

Once the Fed reduced short-term rates to zero and brought down long-term rates with quantitative easing and other tricks, investors became more desperate than ever for income. American companies found a ready appetite for the bonds they issued to buy back shares and acquire other firms. Total U.S. non-financial corporate debt is up by more than $2.5 trillion, or 40 percent, since 2008, according to the St. Louis Fed.

Credit quality has deteriorated. Leveraged loans stripped of their protective covenants have become the norm, including securities being issued in a Blackstone deal to fund the buyout of a business owned by Breakingviews’ parent Thomson Reuters.

The market reopened for payment-in-kind “toggle” notes, which allow borrowers to make interest payments with more debt. Leverage multiples on some buyouts returned to their credit-bubble peak. Subprime mortgages were out, but subprime auto loans were in. Even the collateralized loan obligation, a complex structured-finance product of the type blamed for causing the financial crisis, has made a comeback.

Demand for U.S. junk bonds has been unquenchable, even as credit quality has declined. Last year the share of junkiest credits, rated Caa to C by Moody’s, reached 44 percent of total high-yield issuance, up 11 percentage points since 2012. And yields in absolute terms, as opposed to spreads, fell to record lows. The yield on European junk bonds touched 2 percent in 2017, below the rate on 10-year U.S. Treasuries.

The global carry trade rapidly rebounded after the Lehman bust, thanks to interest rates being held at zero at the heart of the international financial system and the dollar weakening under the impact of quantitative easing. Hyun Song Shin, head of research at the Bank for International Settlements, refers to this development as the “second phase of global liquidity”. This time around, however, hot money found its way into emerging markets rather than the periphery of Europe.

Corporations in these developing countries have borrowed heavily, issuing both local- and hard-currency bonds. Firms in China and other emerging markets have been directly involved in the cross-border carry trade, issuing dollar bonds through foreign subsidiaries and investing the proceeds back home at higher yields. Over the past decade, emerging-market corporate debt has roughly doubled from around 50 percent to 100 percent of GDP, according to the BIS.

Borrowing binges in emerging markets often come to a sudden stop when U.S. monetary policy tightens. The first sign of vulnerability appeared in mid-2013, when the Fed announced a lower level of future asset purchases. That so-called taper tantrum exposed several emerging markets, among them Brazil and Turkey. The Fed’s successive interest-rate hikes since 2015 have tightened the screws.

So far this year the Turkish lira has fallen by nearly 40 percent against the dollar. Turkey’s President Tayyip Erdogan rails against interest rates which he calls “the mother and father of all evil”. But Turkey is suffering because interest rates globally were too low for too long. Turkish banks, construction companies and energy firms have gorged on cheap foreign-currency loans.

Foreign lenders have financed Turkey’s real-estate bubble, leaving the country in a similar position today as Spain and Ireland found themselves 10 years ago. Claudio Borio, head of the monetary and economic department of the BIS, fears that the contraction of global capital flows could trigger an “epoch-defining seismic rupture”. Under this scenario, capital controls could become widespread.

The 2008 maelstrom showed that when the Fed keeps interest rates too low, investors respond by taking on more risk. Unfortunately, central bankers failed to heed this lesson. They argued that financial regulation should operate independently of monetary policy. Yet financial players will always find ways to evade the rules when the price of leverage is mouthwateringly cheap. An appropriate level of interest rates is required to ensure financial stability. That’s because, as former Fed Governor Jeremy Stein nicely puts it, only interest rates “get into all the cracks”.

First published Sept. 14, 2018

Part Six: Chinese import

Interest rates in China may never have turned negative, as they did in neighbouring Japan. Yet China’s economy has also become distorted by the decade of easy money since the 2008 financial crisis. As in the West, low interest rates in China are responsible for inflating asset prices, misallocating capital, aggravating inequality and undermining financial stability.

With the yuan pegged to the U.S. dollar, Beijing could not avoid the impact of the Federal Reserve’s monetary easing after the Lehman Brothers collapse a decade ago. In December 2008, by which date the Fed funds rate was already at zero, the People’s Bank of China slashed its lending rate. Over the following five years, the policy rate averaged just 0.7 percent after adjusting for inflation, and remained far below annual GDP growth. For a developing economy, like China, monetary policy was extremely loose.

The result has been a bewildering number of bubbles inside of China. A stock market boom burst in 2008; not long after another bubble inflated and then popped in mid-2015. There have been bubbles in Chinese art and even in the local bubbly, known as Moutai.

By far the most important bubble, however, has been in real estate. China’s property market rebounded strongly in 2009, spurred by massive lending growth and cheap mortgage rates. By 2014, rental yields in Beijing and Shanghai fell below 2 percent, making property in these cities more expensive than in San Francisco, according to the National Bureau of Economic Research.

When monetary policy was further loosened in the wake of the 2015 stock market bust, the bubble really took off. Beijing house prices rose 33 percent in 2016. In parts of Shanghai, land prices started selling for more than neighbouring buildings – giving rise to the saying, “flour is more expensive than bread.” China’s total real estate was worth $43 trillion by the end of 2016, according to Savills, equivalent to 375 percent of GDP – on par with the aggregate value of Japanese property at the peak of its speculative fever in 1990.

Over the past decade China has experienced an extraordinary investment boom. Spurred by Beijing’s stimulus package, launched in November 2008 to mitigate the impact of the Lehman fallout, investment as measured by gross domestic fixed capital formation averaged around 45 percent for five years after 2008, according to the World Bank.

The Middle Kingdom was quickly fitted out with the world’s most extensive high-speed railway and longest bridge. Between 2011 and 2013, China poured more cement than the United States did during the entire the 20th century, the United States Geological Survey estimates.

Property investment has been the main driver of economic growth. Measured in terms of residential space, by 2013 China was building every fortnight the equivalent of modern Rome. Dozens of “ghost cities,” of which Ordos Kangbashi in Inner Mongolia is the most notorious example, have sprouted. This building boom has continued. At the start of this year, some 25 skyscrapers taller than New York’s Empire State Building were under construction.

Cheap loans from state-controlled banks to state enterprises have produced a capital glut in industries ranging from glass manufacturing to shipbuilding. The country is infested with zombie companies. Surplus capacity in the steel industry has given rise to another saying: “steel is cheaper than cabbage.” Julien Garran of MacroStrategy estimates that 40 percent of recent Chinese investment will have to be written off.

At the time of Mao’s death, the People’s Republic was one the most equal societies on earth. Today, it is one of the most unequal. Bank deposit rates below the rate of inflation have depressed household incomes. Millions of farmers have been forced off their land to clear space for development. The infrastructure spending spree has fuelled public corruption, despite Beijing’s endless purges.

The real estate bubble has minted vast fortunes for developers, including China Evergrande founder Xu Jiayin, estimated to be worth nearly $40 billion. Meanwhile, buyers of overpriced properties have been transformed into “mortgage slaves,” a Chinese expression referring to homeowners who spend two thirds of their income repaying loans.

Over the past decade, China has witnessed one of history’s great credit booms. Data collected by the Bank for International Settlements are staggering. Nonfinancial debt has grown by more than 100 percent of GDP – a far greater increase in debt than Japan experienced in the 1980s or the United States prior to 2008 – but on par with Spain and Ireland’s debt binges in the years leading up to the financial crisis. Corporate debt has climbed to 170 percent of GDP. Household debt as a share of GDP has more than doubled.

Despite low interest rates, the cost of servicing China’s debt mountain now exceeds the level of the United States 10 years ago. Autonomous Research banking analyst Charlene Chu estimates that up to a quarter of bank debts are nonperforming. Much new credit is being used to roll over bad debts, a practice known as “evergreening”.

Low rates on bank deposits have encouraged savers to seek higher returns elsewhere. As a result, China has developed its own shadow banking system, comprised of wealth-management products, trust funds, entrusted loans, online peer-to-peer lending, and debt receivables. By the end of 2016, these opaque and potentially illiquid nonbank liabilities amounted to 71 percent of GDP, according to the BIS.

China’s shadow banking “eerily resembles” Wall Street practices in the run-up to the Lehman crisis, says hedge-fund boss George Soros. The late economist Hyman Minsky noted that when the financial system comes to depend on rising asset prices and new debt issuance, there is a heightened risk of collapse. Last year, departing PBOC chief, Zhou Xiaochuan, warned that China faces a “Minsky moment.”

After the collapse of Lehman, confidence in Western-style capitalism took a hit. Many commentators have hailed Beijing’s alternative growth model. It has even been said that China is exempt from normal economic laws.

Yet China’s so-called economic miracle, coming over the last decade from a combination of low interest rates, massive debt issuance and a giant property bubble, closely resembles any number of former Asian success stories which ended in disaster. On most measures China’s bubble economy looks far more extended than Japan’s did in 1990. Some insist that this time is different. Then again, some always do.

First published Sept. 17, 2018