Stock Learning

Once again, cheap money is driving up asset prices

THE opening of the Burj Khalifa, the world’s tallest building, in Dubai on January 4th had symbolic as well as architectural significance. Skyscrapers have long been associated with the ends of financial booms. The Empire State Building opened in 1931, two years after the Wall Street crash. The Petronas towers in Kuala Lumpur were unveiled in 1998, in the depths of the Asian crisis. Such towers are commissioned when money is cheap and optimism about economic growth is at its height; they are often finished when the champagne has gone flat.

The past three decades have been good for skyscraper-building. The cost of borrowing money, in nominal terms, has fallen sharply (see chart 1). Small wonder that one bubble after another has appeared in financial markets, with the subjects of investors’ dreams ranging from emerging markets and technology stocks in the 1990s to residential housing in the decade just ended. Nor is it surprising, with money so cheap, that consumers and companies have indulged in regular borrowing sprees.

When investors borrow money in order to buy assets, they push prices even higher. But this also makes markets vulnerable to sudden busts, as investors sell assets to pay their debts. The credit crunch of 2007-08 was the result of this process, with the debts greater and the price swings more violent than at any time in the past 30 years.

Critics argue that central banks, by focusing on consumer- rather than asset-price inflation, have encouraged bubbles to grow by keeping interest rates too low. By intervening when markets fall, but doing little to curb them when they rise, they have offered investors a one-way bet.

Such critics are worried that, in their eagerness to bring the credit crunch to an end, the authorities may be making the same mistake again. Official short-term interest rates are below 1% in much of the developed world. Emerging markets, through their currency pegs, tend to import these easy-money policies, even though most of them are growing faster than the rich economies are.

Low rates have certainly persuaded investors to move money out of cash. Investors withdrew $468.5 billion from money-market funds in the course of 2009. The “carry trade”—borrowing in low-yielding currencies to invest in high-yielding ones—is back in full swing. The Australian dollar has been a popular beneficiary.

Equity markets have rebounded strongly: the MSCI world index is more than 70% higher than its March low. Even bigger gains were seen in emerging markets, with the Brazilian, Chinese and Indonesian bourses all more than doubling, in dollar terms, last year. Those rallies have by themselves helped boost economic sentiment and have brought to a halt the vicious spiral of 2008, in which falling markets forced investors to offload assets at fire-sale prices.

At the same time, in the English-speaking markets of America, Australia and Britain, the stabilisation of house prices has bolstered consumers’ balance-sheets. Again, low interest rates have been a crucial supporting factor.

Optimists argue that the markets are now in a sweet spot. The global economy is recovering, with most developed countries coming out of recession in the third quarter of 2009. The authorities, concerned about the fragility of the recovery, will be reluctant to raise interest rates in the near term. Thus investors have been given a licence to buy risky assets.

The global consequences of Dubai's debt problems

FOR years, Dubai strove to capture the imagination of the financial world, projecting its young financial centre as a “global gateway” for capital. Last week it succeeded in grabbing attention. Its announcement that it would delay repayment of the debts of Dubai World, a vast government-owned conglomerate, swept through global markets like one of the blinding sandstorms that occasionally afflict the emirate, obscuring the gleam of its skyscrapers.

Like those storms, Dubai’s announcement was so damaging because it reduced visibility. Investors had assumed that the Dubai government was willing to rescue the indebted conglomerates it sponsors, and that Abu Dhabi, its well-heeled neighbouring emirate, was willing, in turn, to rescue Dubai. In particular, they had looked forward to the full and timely repayment of a $3.5 billion Islamic bond issued by Nakheel, a Dubai World subsidiary, on December 14th.

Dubai’s failure re-awakened a number of dormant fears in investors. Some worried about banks that had lent heavily to the region. Others wondered if Dubai was carrying far more than the $80 billion or so in debt that it has owned up to. The announcement reminded investors that tacit sovereign guarantees may be worthless. Earlier in November, for example, Ukraine’s state railway firm, Ukrzaliznytsya, failed to repay part of a syndicated loan, and its energy firm, Naftogaz, restructured its debt.

More fundamentally, Dubai’s wobble raised the spectre of a sovereign default. Dubai’s government is not technically on the hook for Nakheel’s debts. But the government’s hesitation in saving its national champions nonetheless demonstrates its fiscal limits.

AS AMERICA’S financial crisis recedes, the rumblings of its next crisis can be heard. The federal government has wrapped its guarantees around banks and the housing market. It has borrowed hundreds of billions of dollars to stimulate the enfeebled economy, while tax revenues crumble. And in the years to come the cost of retirees’ benefits will explode. “There is every reason to worry that the banking crisis has simply morphed into a long-term government-debt crisis,” says Kenneth Rogoff of Harvard University.

But what kind would it be: acute or chronic? If it were an emerging market, America would probably have hit trouble already: foreigners would have recoiled from financing its gaping budget deficits; default or a bail-out would have followed. The past two years have shown that rich countries are not immune to acute crises. Iceland’s case has been the most severe: the IMF had to save the country from collapse. Others have displayed milder symptoms: credit markets have discounted meaningful odds that Greece, Ireland or Italy would default. But although an acute crisis cannot be ruled out, America’s is far more likely to be chronic. Its expansion is likely to be sluggish and deflationary, which make it economically and politically hard to reduce debt.

Of course, America could still give investors a scare. Within two months the Treasury will probably have reached the statutory limit on the amount of debt it can issue. In a peculiarly American ritual, Congress often grandstands before agreeing to raise it. In 1996 its Republican leaders unsettled markets by pooh-poohing the consequences of default before eventually granting Bill Clinton’s request.

The Treasury’s ravenous borrowing needs also leave lots of opportunities for something to go wrong. In the past two years the portion of its debt maturing in less than a year has jumped from 30% to over 40%, the most since the early 1980s (see chart 1). In the fiscal year that ended on September 30th the Treasury held an auction on average more than once a day to finance nearly $7 trillion of new and maturing debt. A failure to raise as much money at an auction as planned—as occurred in Britain earlier this year—could send a shudder through global financial markets. “Other countries can afford a failed auction; we can’t,” says Lou Crandall, chief economist at Wrightson ICAP, a financial-research firm. “What do you do when there is a confidence shock to your flight-to-safety asset?”

But it is difficult to identify any such concerns today. If anything, the underlying demand for Treasury bonds is rising. Mr Crandall notes that in the past year the share of Treasury debt bought at auctions by big investors and foreign central banks (as opposed to dealers) has roughly doubled to around 60%. Yields on ten-year Treasuries, at 3.3%, are lower than they were in August 2008, before bail-outs and recession sent projected deficits into the stratosphere.

It may be that other, temporary forces, such as the lack of private borrowing or the Fed’s easy monetary policy, are offsetting any worries about deficits. Yet Tom Gallagher, an analyst at ISI Group, a broker-dealer, estimates that investors’ expectations of yields in five years’ time, when such temporary factors will have faded, are no higher than they were last summer. The reason, he says, is not that bond investors do not care about deficits, but that they assume—perhaps wrongly—that politicians simply will not allow those deficits to materialise.

America may be the world’s strongest borrower, thanks to its size, wealth, legal and political stability, and two centuries of timely debt repayment (the one exception being its abrogation in 1933 of a promise to repay some bondholders in gold). Such demonstrated willingness to pay means a lot to lenders, because they cannot push countries into bankruptcy court.