Global imbalances and the dichotomy between Real and Financial Sector Returns

Think Piece By Prof. Dr. Obiyathulla Ismath Bacha

Economists divide the macro-economy into two parts the real sector and the financial sector. While the real sector of the economy produces the goods and services, the financial sector, which is made up of the banking system and capital markets serves to provide the funding needed for the real sector to function. This funding occurs in two broad forms; debt and equity, while debt has lower cost, it is riskier than equity. One can invest directly in the real sector by establishing a business or indirectly via investments in bonds, stocks or even bank deposits. If as theory says, financial sector investments get channeled into the real sector, then risk-adjusted earnings from financial investments should be reflective of real sector returns. While equity returns should correlate with real sector returns, debt should have lower returns as it does not partake in the underlying business activity.

Neo classical economics argues that equilibrium interest rates should reflect factor productivity, ie-the productivity of capital. Yet, empirical evidence these days shows an obvious disconnect. For example, the average Return on Asset (ROA) for listed stock of 120 different industries across the globe shows average annual returns of 15% and 14% respectively for 3 and 5 years. Yet, the returns to debt, whether invested in bonds or bank deposits shows significantly lower returns. The yield, even out to 10 years on German and Swiss bonds is negative. Yields are meager on other sovereigns. Bank deposits give returns only marginally higher. Globally, interest rates are at historic lows. The irony is that, not only does debt today yield much lower than it did previously, it appears detached from real sector returns. It is obvious that there is massive distortion. If prices are meant to be signals and signals determine the allocation of resources, there has to be serious misallocation of resources. Furthermore, distortions give rise to perverse incentives. There is evidence aplenty of this. Even as GDP growth in the major economies is slow by historic standards, the financial sector especially bonds and stocks are at historic highs. Within economies, there are bubbles in isolated asset markets. Investor appetite for risk has increased several folds. Why is this so and what are the consequences? A recent report by Mckinsey shows global debt to have grown by US$57 trillion since 2007. Since the 1980s, the US has had three times the rise in debt to GDP. John Exter an American economist had put forth the idea of an “inverted pyramid”. As of 2007, at the bottom of the inverted pyramid lies world GDP of about $55 trillion. Every layer above it represents financial claims on these real sector output. The financial assets representing these claims easily add up to more than 10 times world GDP. Given these evidence, it is obvious that financial sector growth did not go into funding real assets but into a feeding frenzy of its own. All this distortion could be attributed to central banks; in particular the US Federal Reserve. Since 1981 when Paul Volcker, the then Fed Chairman was slaying the ‘dragon of inflation’, 10 year US treasuries yielded 15.32%, the next 30 years saw a steady decline in rates. The Greenspan years saw rate cuts in the name of growth while his successor Bernanke fought imaginary deflation with even further rate cuts. By July 2012 US ten year treasuries were yielding 1.5%, a 90% reduction in the coupon rate from 30 years prior. As the US Fed cut rates, the other central banks had little choice but follow. Hot money capital flows have an arbitrating effect on rates. The smaller open economies have had to take the cue of the bigger players and cut rates or be faced with massive inflows that can be destabilizing. The result, historically low interest rates with short term rates near zero and a world flushed with liquidity. Monetary policy has simply lost traction; it may now be pushing on a string.

That the US may have had a geopolitical agenda all along appears lost. With a reserve currency, a hold on global fund flows and being the world’s largest debtor nation, cutting interest rates was hugely self serving. Aside from reducing its debt servicing costs by effectively appropriating the wealth of its creditors, rate cuts can help ameliorate its huge trade deficit by weakening the dollar. In the absence of inflation, the downside risk of monetary looseness is small. Still when carried out over many years, imbalances build up and the US itself was brought to its knees with the subprime crisis. The tepid recovery that followed has meant that the loose monetary policy could not be reversed. Thus, the imbalances, the distortion and misallocation continue globally. Greece, Puerto Rico and very recently China have had blow ups. The rest of the world appears to be slowing percolating. Whether a normalization of rates can be engineered without a boiling over is to be seen. Meanwhile, central bankers, will have to worry about how to get off the tiger they have created.

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