10/1/20: Eight centuries of global real interest rates

There is a smashingly good paper out from the Bank of England, titled "Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311–2018", Staff Working Paper No. 845, by Paul Schmelzing.

Using "archival, printed primary, and secondary sources, this paper reconstructs global real interest rates on an annual basis going back to the 14th century, covering 78% of advanced economy GDP over time."

Key findings:

• "... across successive monetary and fiscal regimes, and a variety of asset classes, real interest rates have not been ‘stable’, and...
• "... since the major monetary upheavals of the late middle ages, a trend decline between 0.6–1.6 basis points per annum has prevailed."
• "A gradual increase in real negative‑yielding rates in advanced economies over the same horizon is identified, despite important temporary reversals such as the 17th Century Crisis."

The present 'abnormality' in declining interest rates is not, in fact 'abnormal'. Instead, as the author points out: "Against their long‑term context, currently depressed sovereign real rates are in fact converging ‘back to historical trend’ — a trend that makes narratives about a ‘secular stagnation’ environment entirely misleading, and suggests that — irrespective of particular monetary and fiscal responses — real rates could soon enter permanently negative territory."

Two things worth commenting on:

1. Secular stagnation: in my opinion, interest rates trend is not in itself a unique identifier of the secular stagnation. While interest rates did decline on a super-long trend, as the paper correctly shows, the broader drivers of this decline can be distinct from the 'secular stagnation'-linked declines in productivity and growth. In other words, at different periods of time, different factors could have been driving the interest rates declines, including higher (not lower) productivity of the financial system, e.g. development of modern markets and banking, broadening of capital funding sources (such as increase in merchant classes wealth, emergence of the middle class, etc), and decoupling of capital supply from the gold standard (which did not happen in 1973 abandonment of formal gold standard, but predates this development by a good part of 60-70 years).
2. "Permanently negative territory" for interest rates forward: this is a major hypothesis from the perspective of the future markets. And it is consistent with the secular stagnation, as availability of capital is now being linked to the monetary expansion, not to supply of 'organic' - economy-generated - capital.

More hypotheses from the author worth looking at: "I also posit that the return data here reflects a substantial share of ‘non‑human wealth’ over time: the resulting R-G series derived from this data show a downward trend over the same timeframe: suggestions about the ‘virtual stability’ of capital returns, and the policy implications advanced by Piketty (2014) are in consequence equally unsubstantiated by the historical record."

There is a lot in the paper that is worth pondering. One key question is whether, as measured by the 'safe' (aka Government) cost of capital, the real interest rates even matter in terms of the productive economy capital? Does R vs G debate reflect the productivity growth or economic growth and do the two types of growth actually align as closely as we theoretically postulate to the financial assets returns?

The macroeconomics folks will call my musings on the topic a heresy. But... when one watches endlessly massive skews in financial returns to the upside, amidst relatively slow economic growth and even slower real increases in the economic well-being experienced in the last few decades, one starts to wonder: do G (GDP growth) and R (real interest rates determined by the Government cost of funding) matter? Heresy has its way of signaling unacknowledged reality.

5/10/17: Leverage Risk, Credit Quality & Debt Tax Shield

In our Risk & Resilience class @ MIIS, we cover the impact of various aspects of the VUCA environment on, amongst other things, the Weighted Average Cost of Capital. One key element of this analysis - the one we usually start with - is the leverage risk. In practical terms, we know that the U.S. (bonds --> intermediated bank debt) and Europe (intermediated debt --> bonds) are both addicted to corporate leverage, with lower cost of capital attributable to debt. We also know that this is down not to the recoverability risks or credit risks, but to the asymmetric treatment of debt and equity in tax systems. Specifically, leverage risk is driven predominantly by tax shields (tax deductibility) of debt.

In simple terms, tax system encourages, actively, accumulation of leverage risks on companies capital accounts. Not only that, tax preferences for debt imply distorted U-shaped relationship between credit ratings (credit risk profile of the company) and the cost of capital, whereby top-rated A+, A and A- have higher cost of capital (due to greater exposure to equity) than more risky BBB and BBB- corporates (who have higher share of tax0deductible debt in total capital structure).

Which brings us to one benefit of reducing tax shield value of debt (either by lowering corporate tax rate, which automatically lowers the value of tax shield) or by dropping tax deduction on debt (or both). Here is a chart showing that when tax deductibility of debt is eliminated, companies with lowest risk profile (A+ rated) enjoy lowest cost of capital. As it should be, were risk playing more significant role in determining the cost of company funding, instead of a tax shield.

Simples. com

23/8/2014: Real Cost of Capital: Euro 'Periphery' Dilemma

Staying on the topic of debt (see earlier post: http://trueeconomics.blogspot.ie/2014/08/2382014-that-pesky-problem-of-real-debt.html) here is IMF research on real cost of corporate capital (linked to the cost of debt) in the Euro area 'periphery' (this is from an IMF July 2014 publication that accompanied its Article 4 paper on Euro Area).

I highlighted with the red the range of recent capital costs range in each country to trace out historical comparatives.

Starting with the Euro area as a whole:

Two points:

• Current real cost of capital across the euro area is relatively benign, compared to both 1990s - early 2000s period and shows low volatility in recent (crisis) years post 2009 peak
• 2009 peak is pronounced but moderate compared to the one found in some 'peripheral' countries.

In basic terms, this means that euro area's capital costs are benign - above the 2004-2007 trough, but historically well below those observed in the 1990s.

Spain:

 Two points:

• Current capital cost levels are consistent with crisis peak 
• Capital today is as expensive in real terms as in the pre-euro era.

Which means that Spanish real cost of capital is now as bad as in the pre-euro period and is much worse than during the credit boom of the late 1990s-early 2000s.

Italy:

 Two points:

• Just as in Spain, real capital costs in Italy are comparable with peak of the crisis and 
• Capital costs today are more expensive than in the 2000s, but less expensive than in pre-euro era.

Italy's overall real cost of capital is currently comparable to the one observed in the late 1990s, and is higher than the one experienced in the credit expansion period of the early 2000s. That said, the cost uplift on 2000s is relatively moderate.

Portugal:

Two points:

• Capital costs today is below the peak levels of the crisis in real terms, but is severely elevated relative to 2000s and on-par with pre-euro era costs;
• Capital cost volatility is high and it was high during the entire euro era.

Thus, Portugal's real cost of capital is highly volatile, but on average is higher today than in the entire period from 1997 through 2010.

Ireland:

Ireland is clearly 'unique' compared to both the Euro area and the rest of the 'periphery' when it comes to the real cost of capital.

• The crisis peak in real cost of capital is massively out of line with historical trends.
• Ignoring the crisis peak, current real cost of capital is running well above the pre-crisis historical levels;
• Since the introduction of the euro, real cost of capital in Ireland trended above the pre-euro period levels

In summary, real cost of capital across the euro area 'periphery' shows one simple thing: investment is still a very costly proposition for businesses, especially compared to the pre-crisis period. Worse, it is now as expensive than (or comparable to) the cost averages for the pre-euro area period.

The above puts stark contrast between the cost of funding the banks (low) and Governments (historically low today) and real businesses (high).

25/6/2012: Thinking outloud: Euro Area Banks Levy

Latest reports suggest the EU leaders are pushing for a 'banking levy' to finance common deposit insurance scheme, a banks resolution fund and joint supervision authority.

It has been my view all along that the former two are required for the financial sector future health and to break the onerous link between the banks and the sovereigns. Alas, I must point out the reality of what such a proposals will mean.

To start with, let's us ask a question: What happens when economy enters a recovery stage from even a cyclical downturn?

Answer: surplus savings built during normal downturn alongside accommodative monetary policies result in an increased supply of capital to finance capex expansion in the private sector. This leads to rising cost of capital on demand side (as demand for capex quickly outstrips supply) and on supply side (as monetary authorities tighten rates into upswing cycle).

But here's a problem, Roger, and it's Europe: suppose the economy is about to take off onto capex growth path:

• Savings nowhere to be seen as deleveraging of households will be still ongoing
• Deleveraging of banks, including in anticipation of LTROs expiration means no supply of new credit
• Policy rates might stay low, but retail rates will remain higher than normal as banks balancesheets remain weak and state or EU-held (via 'resolution' vehicle) equity remains high
• In the mean time, five years of the crisis have created a massive penned up demand for capital, so market rates will be even higher
• Equity capital will be scarce, as global recovery will most likely be ongoing, sapping capital into more growth-generative regions, and
• There's that EU levy as an icing on the cake to add to costs and shrink the margins.

Now, posit the above against the following environment scenario:

• Households debts are still high, but incomes are now undermined by five years (plus) of a recession and stagnation
• SMEs and many corproates balancesheets are weak (due to stagnation in exports and internal demand, plus deleveraging costs)

What do you get? Oh, rapid increase in credit costs, leading to more households and business insolvencies. So, go ahead, as Clint The Market would have said, make my day, punk. Raise some more levies...