Sunday, April 20, 2014
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The Real Interest-Rate Risk

BEIJING – Since 2007, the financial crisis has pushed the world into an era of low, if not near-zero, interest rates and quantitative easing, as most developed countries seek to reduce debt pressure and perpetuate fragile payment cycles. But, despite talk of easy money as the “new normal,” there is a strong risk that real (inflation-adjusted) interest rates will rise in the next decade.

Total capital assets of central banks worldwide amount to $18 trillion, or 19% of global GDP – twice the level of ten years ago. This gives them plenty of ammunition to guide market interest rates lower as they combat the weakest recovery since the Great Depression. In the United States, the Federal Reserve has lowered its benchmark interest rate ten times since August 2007, from 5.25% to a zone between zero and 0.25%, and has reduced the discount rate 12 times (by a total of 550 basis points since June 2006), to 0.75%. The European Central Bank has lowered its main refinancing rate eight times, by a total of 325 basis points, to 0.75%. The Bank of Japan has twice lowered its interest rate, which now stands at 0.1%. And the Bank of England has cut its benchmark rate nine times, by 525 points, to an all-time low of 0.5%.

But this vigorous attempt to reduce interest rates is distorting capital allocation. The US, with the world’s largest deficits and debt, is the biggest beneficiary of cheap financing. With the persistence of Europe’s sovereign-debt crisis, safe-haven effects have driven the yield of ten-year US Treasury bonds to their lowest level in 60 years, while the ten-year swap spread – the gap between a fixed-rate and a floating-rate payment stream – is negative, implying a real loss for investors.

The US government is now trying to repay old debt by borrowing more; in 2010, average annual debt creation (including debt refinance) moved above $4 trillion, or almost one-quarter of GDP, compared to the pre-crisis average of 8.7% of GDP. As this figure continues to rise, investors will demand a higher risk premium, causing debt-service costs to rise. And, once the US economy shows signs of recovery and the Fed’s targets of 6.5% unemployment and 2.5% annual inflation are reached, the authorities will abandon quantitative easing and force real interest rates higher.

Japan, too, is now facing emerging interest-rate risks, as the proportion of public debt held by foreigners reaches a new high. While the yield on Japan’s ten-year bond has dropped to an all-time low in the last nine years, the biggest risk, as in the US, is a large increase in borrowing costs as investors demand higher risk premia.

Once Japan’s sovereign-debt market becomes unstable, refinancing difficulties will hit domestic financial institutions, which hold a massive volume of public debt on their balance sheets. The result will be chain reactions similar to those seen in Europe’s sovereign-debt crisis, with a vicious circle of sovereign and bank debt leading to credit-rating downgrades and a sharp increase in bond yields. Japan’s own debt crisis will then erupt with full force.

Viewed from creditors’ perspective, the age of cheap finance for the indebted countries is over. To some extent, the over-accumulation of US debt reflects the global perception of zero risk. As a result, the external-surplus countries (including China) essentially contribute to the suppression of long-term US interest rates, with the average US Treasury bond yield dropping 40% between 2000 and 2008. Thus, the more US debt that these countries buy, the more money they lose.

That is especially true of China, the world’s second-largest creditor country (and America’s largest creditor). But this arrangement is quickly becoming unsustainable. China’s far-reaching shift to a new growth model implies major structural and macroeconomic changes in the medium and long term. The renminbi’s unilateral revaluation will end, accompanied by the gradual easing of external liquidity pressure. With risk assets’ long-term valuation falling and pressure to prick price bubbles rising, China’s capital reserves will be insufficient to refinance the developed countries’ debts cheaply.

China is not alone. As a recent report by the international consultancy McKinsey & Company argues, the next decade will witness rising interest rates worldwide amid global economic rebalancing. For the time being, the developed economies remain weak, with central banks attempting to stimulate anemic demand. But the tendency in recent decades – and especially since 2007 – to suppress interest rates will be reversed within the next few years, owing mainly to rising investment from the developing countries.

Moreover, China’s aging population, and its strategy of boosting domestic consumption, will negatively affect global savings. The world may enter a new era in which investment demand exceeds desired savings – which means that real interest rates must rise.

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  1. CommentedLuis de Agustin

    The article is correct in its expectation that interest rates in China, Japan, and the United States and the world generally must rise in contended coming years. Additional to negatives noted brought on by the nearly early zero central banks interest rate policies; these have pernicious effects on the majority of potential borrowers, contrary to policy intentions.

    Research conducted by Wainwright Economics, the investment research firm led by David Ranson, finds that when the Fed has printed money faster than usual, the economy’s growth was actually slower. Ranson’s interpretation works in terms of Hayek’s price signaling mechanism as the economy’s main way of allocating capital to its best uses. That mechanism is bound to be upset by an unstable medium of exchange.

    Dr. Ranson confirms that low interest rates do not expand credit, but instead induce credit rationing and or queuing. Those at the head of the line will include politically advantaged groups and safer credits, and they are able to borrow easily. But lesser credits find it more difficult to qualify. Baa and lower grade companies will be farther back in the line, and some excluded. For them the credit fundamentals are unlikely improved.

    It’s true that today borrowers in general are paying lower rates thanks to the Fed. But that’s just the successful borrowers. Unsuccessful borrowers, who might have been successful in a freer market, have to find capital some other way.

    Ultimately, printing money reduces the average cost of borrowing less than it seems, because claims Ranson, we should include in that average, companies that are closed out of the market by credit rationing. It’s like the problem of estimating the effect of minimum wage laws on average wages. The average includes those who remain employed (some at a higher wage) but those who are pushed out of the labor market and whose wages go to zero are uncounted.

    Luis de Agustin

  2. Portrait of Gregor Schubert

    CommentedGregor Schubert

    This columnist seems very confused about the determination of real interest rates.
    On the one hand, she speaks of "low, if not near-zero, interest rates...easy money as the 'new normal'", on the other hand, she speaks of "anemic demand" - so which one is it? Is money abundant, reflected in high aggregate demand, or is it tight? Given that interest rates are notoriously bad indicators of the stance of monetary policy, maybe we should listen to Milton Friedman's wise words:

    "After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."

    But not only does she incorrectly characterize the current tight-money environment, she also seems torn about what causes the low interest rates: central banks are allegedly "guid[ing] market interest rates lower", and a "vigorous attempt to reduce interest rates".
    But in her last sentence she asserts that "The world may enter a new era in which investment demand exceeds desired savings – which means that real interest rates must rise." - Again, which one is it? Do central banks control interest rates or are they the result of the market for credit. The answer should obviously be the latter. Central banks set monetary policy by giving guidance on the future path of money supply relative to the natural interest rate, which is determined by the credit market. Thus, central banks are not guiding anything lower, rather they are following - and slowly at that.
    Policy makers will find it hard to get this right, if such muddled thinking may persist

    1. CommentedHongbin Lin

      I guess the confussion was caused by translation. The text in Chinese is quite smooth, so I guess it was originally prepared in Chinese and later had someone translated. The phrase "real interest rate" appears more times in the Chinese version than in its English version.

  3. CommentedJonathan Lam

    Gamesmith94134: The Real Interest-Rate Risk

    In pushing the low or negative interest to the ‘new normal”, the developed nations would have exposed certain risks on the valuation that the dumping of its currency, like Euro or even dollar. It is why the FED would have change it tone on mortgage rate marketwise; after they realize the higher price housing may increase default and bankers would have pay a higher price and cut profit on maintaining the mortgage, especially the new housing is not running either.

    “With the persistence of Europe’s sovereign-debt crisis, safe-haven effects have driven the yield of ten-year US Treasury bonds to their lowest level in 60 years, while the ten-year swap spread – the gap between a fixed-rate and a floating-rate payment stream – is negative, implying a real loss for investors.” The FED may insist on the risk free dollar; and it continues on its twist on the long-term bonds and low rate sovereign-debt. The reality show there are more risky in dealing in US dollar since Mr. Bernanke is building Brussels on the Potomac. Consequently, the economy may not collapse from inside, but the current economic policy is making a flight risk for foreign investors and its shrinking on the global finance would explode to a flight risk on dollar that is being devalued.

    In the recent analysis:
    • November exports were $1.7 billion more than October exports of $180.8 billion.
    • November imports were $8.4 billion more than October imports of $222.9 billion.

    The U.S. Census Bureau and the U.S. Bureau of Economic Analysis, through the Department of Commerce, announced today that total November exports of $182.6 billion and imports of $231.3 billion resulted in a goods and services deficit of $48.7 billion, up from $42.1 billion in October, revised.

    As of the end of December, the China’s US dollar reserves portfolio went up by $128 billion to $3.31 trillion, from $3.29 trillion three months earlier, US deficit hit $172B in November, with US on path for fifth straight year topping $1 trillion.

    The RMB rose 0.03 percent to close at 6.2244 per dollar in Shanghai on Thursday, according to the China Foreign Exchange Trade System. It touched 6.2216 on Wednesday, the highest level in 19 years. Why shouldn’t someone suggest bringing back discussion on the CNH and CNY if China had another over 20 billion surplus over US? Or anyone think of another currency than dollar? Yes, $170 more invested in China. In fact, International payments in RMB increased by 24 percent in November from the previous month and reached a record 0.56 percent of the global total, the global transaction services organization SWIFT said in a report on Tuesday
    Perhaps, liquidity may ease the tensions on the fundamentals; it does put valuation on a shaky ground. Consequently, Deflation may not happen internally in the consumer or capital goods but devaluation will pressure on to its exchange rate as the global transaction shrinks. Eventually, it will face at a point that foreign investors will cut their loss if the fiscal cliff or Edward – the “European Debt Wall and Repayment Deadline” could give it the resonance of a coming storm in creating more uncertainty for the global financial world. Perhaps, fundamental and valuation do interact and even in an adverse effect when there a line is drawn, or how the global market is sustaining its equilibrium.

    Finally, I would suggest a quick change on the real interest rate risk which United States is no longer immune to the risk if a policy is valid for long-term Sovereign-debts that is guaranteed by World Bank which is designated to purpose as the Secondary Central Bank for the other Currencies. In addition, the WTO and IMF should be involved to monitor the plausibility of the resonance of a coming storm, including the collapsible Euro-Dollar. If only if we can distinguish the risk factors in our currencies exchanges by marginalizing the sovereign-debt, I do not think the FED would have another alternative to steer off it 17 trillion but to continue.

    I hope my earlier discussion of the seven percent solution to the sovereign-debt with its three percent on debt, three percent on collateral and a one percent insurance of the transaction will work if we ever develop the visible margin on its equilibrium.

    Often, I hope I may overstate its risk on the status quo, but we must be prepared.

    May the Buddha bless you?

  4. CommentedProcyon Mukherjee

    There are some very interesting facts about the two interest rate regimes, one prior to 2008 and the one later in U.S. where we have seen deleveraging of the private sector reducing debt loads, and a sharp increase in the public sector debt, taking the total debt to $29 Trillion.
    One of the very important observations taken from the report by Ron Rimkus CFA, (, is that in the five year period prior to 2008, the delta change in Debt was $12 Trillion, while this in the post 2008 period is $2.7 Trillion. But what is significant is that the debt efficiency in the latter period has come down drastically to 50%, which is a vindication of the fact that Federal government debt to GDP has been found to have no positive correlation, which is more prominent when one plots absolute Federal debt to absolute change in GDP.
    One very striking observation in the St Louis FED, FCA report is that in the high interest rate period the debt growth still created a debt efficiency of 200% while the sharp decline in debt growth in the ultra low interest rate regime is not even sufficient to increase the debt efficiency to grow beyond 50%.

    Given this picture, the global re-balancing and change in China's external account would more than significantly impact real interest rates.

    Procyon Mukherjee

  5. CommentedPaul Mathew Mathew

    With nearly 17 trillion dollars of debt... how can the US possibly accept higher interest rates?

    The country will be insolvent if rates rise to anywhere near long term averages.

    Ben will not stop printing - until forced to stop printing