by Mish Shedlock, The Maven:
No Clear Skies Yet
Inquiring minds are slogging though the 78-page BIS annual report looking for an all clear signal.
It’s nowhere to be found. The BIS explicitly warns “No clear skies yet”.
Monetary Policy Cannot Be Engine of Growth
Hitting the nail squarely on target, the BIS chastises central banks “What is good for today need not necessarily be good for tomorrow. More fundamentally, monetary policy cannot be the engine of growth.”
Central banks, beg to differ. Markets are going gaga over expected rate cuts while Trump plays a year-long tune of on-again off-again tariff threats.
The corporate sector in some countries has shown clear signs of overheating. Perhaps the most visible symptom of potential overheating is the remarkable growth of the leveraged loan market, which has reached some $3 trillion.
For quite some time, credit standards have been deteriorating, supported by buoyant demand as investors have searched for yield. Structured products such as collateralised loan obligations (CLOs) have surged – reminiscent of the steep rise in collateralised debt obligations that amplified the subprime crisis.
Fire Sale Collapse in Investment Grades
Given widespread investment grade mandates, a further drop in ratings during an economic slowdown could lead investors to shed large amounts of bonds quickly.
As mutual funds and other institutional investors have increased their holdings of lower-rated debt, mark-to-market losses could result in fire sales and reduce credit availability.
The share of bonds with the lowest investment grade rating in investment grade corporate bond mutual fund portfolios has risen, from 22% in Europe and 25% in the United States in 2010 to around 45% in each region
Firms that are unable to cover debt servicing costs from operating profits over an extended period and that have muted growth prospects – so-called zombie firms – have been on average 40% more leveraged than their profitable counterparts.
They sap economy-wide productivity growth not only by being less productive themselves, but also because they crowd out resources available to more productive firms. Evidence suggests that their increase over time has had an economically significant macroeconomic impact.
Unfortunately, bank profitability has been lacklustre. In fact, as measured, for instance, by return-on-assets, average profitability across banks in a number of advanced economies is substantially lower than in the early 2000s.
Both macroeconomic and banking-specific factors have sapped bank profitability. On the macro side, persistently low interest rates and low growth reduce profits*.* Compressed term premia depress banks’ interest rate margins from maturity transformation. Low growth curtails new loans and increases the share of non-performing ones. Therefore, should growth decline and interest rates continue to remain low following the pause in monetary policy normalisation, banks’ profitability could come under further pressure.
Moreover, low profitability may also lead to credit misallocation. Less profitable banks are more likely to evergreen loans or lend to zombie firms, thereby crowding out funding for new, more productive ones. In turn, over time, credit misallocation may depress bank profits further, thus setting in motion a vicious cycle.
Monetary Policy Balancing Act
There are diminishing returns and costs in relying too much on monetary policy. Such an overburdening can contribute to the re-emergence of financial vulnerabilities and reduce the room for policy manoeuvre. It becomes natural to ask where the limits to this approach are. Ostensibly, monetary policy cannot be the engine of higher sustainable economic growth. More realistically, it may be better regarded as a backstop.
Structural Reforms and Productivity
The only way to raise long-term growth on a sustainable basis is to implement structural reforms. Indeed, productivity growth has been on a long-term downward trend in advanced economies.
Unfortunately, over the past decade, the momentum in structural reforms has been lost, as the sense of urgency associated with the GFC has faded.
Europe and China
Europe and China are the two arenas most in need of structural reform.
Italy, Greece, and France are basket cases. ECB and EU policies do not help. A Eurozone breakup is but one accident in Italy away from happening.
China is overly dependent on State-Owned-Enterprises (SOEs) and property bubbles as a means of growth.
Trade wars with Trump, capital controls, and lack of property rights contribute to the problems.
Trump’s trade wars with the world are a huge negative.