There are two big concerns for economists and market participants today. The first, rising debt levels and unbridled money printing, and the second, a sharp reversal in the interest rate trend. I share two interesting perspectives here that can help allay some of these concerns and suggest that both a debt implosion and a sharp rate reversal—which the Federal Reserve has ruled out, but watchers don’t fully buy—may not be on the cards in the near term.
Let’s address the public debt and finances bit first. For this, I draw extracts from a piece by Martin Sandbu in the Financial Times (Sandbu is FT’s economic commentator for Europe. He has taught at Columbia, Harvard and Wharton and advised on public policy. He was educated at Oxford and Harvard) titled “UK Spending Review: There is no fiscal emergency”. Key extracts are shared below, but the moot point is that with interest rates where they are, servicing higher debt is hardly a worry and Government’s need to focus on spending to boost their economies. Read on.
“There is red ink as far as the eye can see: public borrowing is set to hit £394bn. The UK is among the worst performers in Europe for both growth and public finances, but the challenges are similar in other countries. Everywhere, governments are having to spend a lot of money on immediate health and economic emergency. But beyond this, politicians and policymakers face three big questions. Here is what the UK spending review reveals how its government answers them. The first is whether to worry about the public finances. The instinct to do so is understandable: the deficit this year will be bigger than at any time since the Second World War, and the debt-to-GDP ratio is now forecast to be about 30 per cent of GDP higher than expected before the pandemic. But this is not a good measure of whether public finances are sound. Look instead at the most interesting chart from the independent Office for Budget Responsibility (reproduced below), of government expenditure on debt interest as a share of revenues. Even with the highest debt-to-GDP ratio in decades, the cost to the government of servicing that debt is the lowest since the war and falling. So what need is there to make “tough choices” to put public finances on a sound footing? None — provided, at least, that today’s low-interest rates are locked in and that debt does not keep rising forever. The first proviso is a matter of debt management (the UK government can borrow for 30 years at a 0.9 per cent rate), not budgeting.
The second requires that when the economy is back at its long-term path — but not until then — the deficit is not too large. Today any signal of austerity is likely to delay the recovery by undermining confidence in its strength…. While there is no fiscal emergency, there is clearly an economic emergency. The second big question is how to deal with it in the face of enormous uncertainty in the economy. As the independent forecasts of the UK economy showed, everything depends on the future path of the pandemic. The most important thing we do not know is how much permanent damage to economic activity it will cause, how much “scarring” it will leave behind. The OBR’s scenarios range from a zero to a 6 per cent long-term shortfall in GDP relative to what was expected before coronavirus. But the government’s actions can act to make this uncertainty better or worse because the amount of scarring depends in part on how deep and prolonged the temporary slump is.
That is something policy can influence. That is why, as I argued a few weeks ago, Sunak was wrong to drop a full-fledged, multiyear spending review because of the uncertain outlook. More detailed, longer-term spending commitments are a way to provide certainty to the private sector and encourage the spending and investment on which a speedy recovery — and hence better public finances — rely. From a government that is voluntarily inflicting the additional uncertainty of a potential no-deal Brexit (see chart below), that is the least one could ask for.”
An interesting example he shares in his piece that reflects the liquidity scenario is borrowing by the European Union. Stanbu writes: “In the third bond issuance for the EU’s SURE programme of common borrowing to finance short-term work schemes in member states, the European Commission borrowed €8.5bn for 15 years at an annual interest rate of minus 0.1 per cent, or just a quarter of a percentage point more than Germany”.
Now, let’s move to the next big one: a likely rate reversal. A discussion paper submitted by Moritz Schularick, Lucas Ter Steege and Felix Ward in May 2020 and later published by Centre for Economic Policy Research, UK, titled “Leaning against the wind and crisis risk”, shares some compelling findings that would support an easy-money policy for a longer period. Here are some key extracts.
“How should a central bank react when it observes that a potentially dangerous credit and asset price boom is underway? Can policymakers defuse rising financial stability risks by leaning against the wind and increasing interest rates?
Two prominent historical episodes delineate the issue that our paper speaks to. Consider the U.S. economy in 1928. Concerned about booming stock prices, a frenzy in commercial real estate markets, and substantial lending against both, the Federal Reserve increased policy rates from 3.5% to 6% between January 1928 and August 1929, surprising market participants. Most economic historians today think that these policy decisions, instead of bringing financial markets and credit growth back to more sustainable levels, played an important role in triggering the Great Depression (Eichengreen, 1992; Bernanke, 2002). Could the economy have avoided the financial crash had policymakers not raised interest rates to discourage what they perceived as rampant speculation in the stock market?
Fast-forward 75 years. In the 2000s, U.S. policymakers decided to not lean against booming credit and housing markets. Instead, they stuck to a policy that was, by and large, consistent with flexible inflation targeting without taking financial stability considerations on board (Bernanke, 2010). Financial imbalances continued to grow and erupted in the 2008 global financial crisis. What would have happened had the Federal
Did reserve raise interest rates to lean against the credit boom? Could the crash and the Great Recession have been avoided?
The two biggest financial crises in the past 100 years come with conflicting messages regarding the effectiveness of leaning against the wind (LAW) policies in safeguarding financial stability. Notwithstanding, current debates on the financial stability mandate of central banks often invoke one or the other episode to argue for or against leaning against the wind. Yet, which historical lesson is actually representative? The issue looms large for current thinking about monetary policy (Stein, 2013; Svensson, 2017; Adrian and Liang, 2018). It has become exceedingly clear how large the economic costs of financial crises are (Cerra and Saxena, 2008; Jorda, Schularick and Taylor, 2013). Moreover, recent research suggests that such financial boom states are detectable in real-time using quantity and price indicators (Richter, Schularick and Wachtel, forthcoming) so that policymakers have the chance to intervene. Yet, what do we know about the effects of monetary policy changes on financial stability during financial booms? The answer so far is not much, other than inconclusive anecdotal evidence.
This paper aims to close this gap. Our results are unambiguous in the sense that the estimates suggest that the effect of LAW policy on crisis risk has the opposite sign from what is often assumed. We show that a 1 percentage point (ppt) policy rate change during a financial boom increases the risk of a financial crisis by about 10 ppts over a one-year horizon. Crisis risk remains elevated for about two years after the monetary shock before subsiding to its long-run average level. However, at no point in the five years following the policy rate increase do we find evidence for a reduction in crisis risk… contractionary monetary policy at best appears ineffective at addressing financial instability risks and at worst appears outright harmful. The dataset contains 1,525 country-year observations of countries whose currency is pegged to a base country's currency. Among those, we observe more than 170 credit boom episodes, of which 98 coincide with exogenous increases in base country policy rates.”
If this is in line with the Federal Reserve’s own assessment, any prospects of it leaning against the wind by upping the rates in the near term look dim.
GREAT TIME TO CASH UP
What’s good for Governments should be good for businesses too: record low-interest rates. For capital-starved Indian businesses, this is a God-send opportunity to raise capital—both debt and equity—for their future needs. Given that money is gushing into equities and global credit is available at abysmally low, if not negative, interest rates, there is an opportunity for businesses with a clear demand outlook beyond the pandemic to tank up on both debt and equity, without upsetting the leverage picture.
A quick study of BSE-500 non-financial companies to gauge the effects of the debt-equity ratio equation over time and its implications on growth and profitability seems to suggest that increases in debt-equity and EPS growth is mostly inverse, though earnings tend to spike with a lag after a jump in debt-equity followed by normalization.
Besides, gross block additions, sales and earnings held up fine as long as debt-equity stayed stable in the average 0.7-0.85x range till 2013. A sharp jump in 2014 to well beyond 1x was followed by an acceleration in equity expansion and a shift down in capex, before it picked up again. What’s important to note is that leverage hit a low of 0.15x on average for our data set in 2019, though at the close of fiscal 2020 this had perked up to 0.59x. However, given where we are, there seems some room to spill expand leverage a bit without impacting growth. But a mix of more equity and some low-cost debt could prove to be earnings accretive given where stock valuations and interest rates are today.
THE EQUITY PARTY MAY GO ON
The big one for the markets and the economy is demand sustainability and policy steps to revive the economy. If these fall into place, armed with cheap capital to deploy, India Inc—read the bigger listed universe—could well be on its way to delivering a few years of above-trend earnings growth, with more re-ratings down the road, as return on capital and equity improve.For those invested in equities, therefore, while some caution is always good at the lofty valuations today. This might not be the right time to exit. The final hurrah, maybe still some time away.