To fend off recessions, depressions, deflation and downturns, central bankers around the world have been providing “monetary morphine” in all shapes and forms. This will have unintended consequences
Recessions, depressions, deflation and downturns are reckoned to be bad things by economists and central bankers. So bad, in fact, that they are willing to do just about anything to avoid them. To fend off these demons central bankers around the world have been providing “monetary morphine” in all shapes and forms. From the low interest rates and QEs (quantitative easing) by the United States’ Federal Reserve, to the LTROs (Long Term Refinancing Operations) of the European Central Bank, to the unlimited loans provided by Chinese state-owned banks. The question is whether this monetary largess comes at a price? Certainly, massive interventions in the markets by governments always have unintended consequences. Many think that the eventual result will either be inflation, asset bubbles or both, but there is something else. The life support maintains the living dead. It creates the dreaded zombie bank!
Right now the markets do not seem afraid. Like the attractive heroine in a horror movie, they go along blissfully unaware of the dread threatening them. Stock prices of Chinese state-owned banks have outperformed the Hang Seng index by 10% and their profits have grown by 25% to 30%. Not to be outdone, share prices of European banks have also increased by 30% since the introduction of the LTROs.
The happiness in the market may ultimately be short-lived. The stimulus creates a paradox. Stimulus meant to delay financial contraction until an economy recovers actually prevents the growth necessary to solve the problem.
The recent history of bad banks started with the Japanese banks in the 1990s. Western and Chinese policymakers learned from Japan and acted swiftly to provide large stimulus. But they did not learn the next lesson, that more stimulus did not force the Japanese to solve their real problem—the recognition of bad loans.
The reason that all the governments have avoided the pain is simple. Forcing weak banks to write off large portions of their dud loans would make weak banks weaker and lead to bank failures. It certainly has an effect on their share prices. Last November the Italian bank, UniCredit, decided to bite the bullet and recognize its bad losses. It also raised additional capital, but its stock dropped 39%.
Such dramatic drops in the value of banks are not pretty. So to avoid such messy creative destruction of capitalism, central bankers provided them with cheap loans. The cheap loans do provide time, but they do not necessarily provide the thing that the financial systems need most— growth.
Non-performing loans, until recognized, represent a bleeding ulcer. The real purpose of banks is to efficiently allocate capital. If they have no incentive to do so, the economy cannot grow. If the banks seem healthy, the governments assume that that the crisis is over and have no incentive to reform other parts of their economies.
For example, one of the major problems of the Spanish, Italian, Portuguese and Greek economies is that they have laws that create very inflexible labour markets that favour older workers in the organized and state sector as opposed to younger workers, small businesses and entrepreneurs. The result is a lack of growth that has brought all of their sovereign debt to the brink of default and pushed Greece over.
The liquidity crises last fall might have been sufficient incentive for reform, but the new money from the LTRO has delayed the need. Instead banks in Spain and Italy have used the cheap money in a carry trade to buy their own government’s bonds. Spanish banks increased their holdings of Spanish bonds by 29% while their Italian counterparts increased their holdings of Italian paper by 13%. Now weak banks are tied ever more closely to weak government finance.
The Chinese have a different but similar issue. Their state-owned banks are theoretically safe. Although they are still awash in bad debts, some left over from ten years ago, they are protected in two ways. First, the government simply allows the banks to roll over the bad debt. Second, the banks have a monopoly on their financial system, so depositors are forced to subsidize profits by accepting low rates. The system allowed state-owned banks to lend to inefficient state-controlled enterprises and insolvent local governments while the most efficient sector or the economy, small to be medium sized businesses, were forced into the risky underground financial system.
Last week the Chinese government finally gave grudging approval to the informal lenders in the city of Wenzhou, but instead of solving the problem it will probably make it worse. Legalising private lenders will only increase the flood of money away from state-owned banks forcing them to hoard ever more funds.
The recent market rally implies that the financial system is alive and well. The reality is that it is part of the undead.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at [email protected] or [email protected]).
Inside story of the National Stock Exchange’s amazing success, leading to hubris, regulatory capture and algo scam