In 2002, the legendary former Fed chair said: ``It was very difficult to definitively identify a bubble until after the fact – that is, when its bursting confirmed its existence.’’
Come 2021, this is what the Reserve Bank of India (RBI) Governor Shaktikanta Das had to say: ``The disconnect between certain segments of financial markets and the real economy has been accentuating in recent times. Stretched valuations of financial assets pose risks to financial stability.’’
The phrase 'stretched valuations of financial assets’ is euphemism for 'asset price bubbles’ because no central banker can afford to utter the `B’ word and be crucified for eroding the wealth of the masses, although the majority of the population is untouched by the paper wealth.
After a record rally in financial assets in the past 10 months, some are beginning to wonder as to what’s happening. The latest Financial Stability Report of the RBI brings to fore the inherent conflicts in the economy and what the RBI itself is doing. Simply, policy makers are caught between the devil and the deep sea.
Governor Das’ worry about financial asset valuation, expressed for the third time in the past few months, is in a way caused by the incessant running of printing presses across the world. The only panacea central banks have for every crisis since the Long Term Capital Management blow up in the '90s when Greenspan was the Fed Chairman is to slash rates and flood the market with cash. When the pandemic struck, the playbook was the same.
Greenspan’s bubbles is the new norm. As he was blamed for sowing seeds of asset price bubbles, central bankers now are sowing seeds of financial instability.
“Congenial liquidity and financing conditions have shored up the financial parameters of banks, but it is recognised that the available accounting numbers obscure a true recognition of stress,’’ warns Das. It is also a fact that RBI decides rates and liquidity.
While bond traders and borrowers celebrate the ever falling interest rates, bankers like Jamie Dimon of JPMorgan, and the Bank For International Settlements have warned of the risks of running banks at ultra-low interest rates where depositors are punished and banks’ profitability is squeezed.
The FSR’s admission that banks numbers do not reflect the true picture should worry. But the contrast as well as the unpredictability comes up when it simultaneously states that the `worst is behind us’ and `the recovery path remains uncertain.’
There are enough caveats in the report to show that neither the economy nor the financial system is out of the woods. Although the importance of financial stability has been put forth, the likely increase in bad loans due to extreme stress raises questions on whether the market is factoring in adverse outcomes.
To be sure, the methodology has been changed from applying 3 Standard Deviation in the July test to assess extreme stress to 2 Standard Deviation in the current one, which has been the practice.
Latest stress tests using 2 Standard Deviation indicate bad loans could surge to 14.8 percent by September 2021, which was forecast to be 14.7 percent for March 2021 under 3 Standard Deviation. This exhibits the difficulties in assessing the impact of the pandemic triggered wall of liquidity and the moratorium.
The adverse scenarios used in the macro stress tests were stringent conservative assessments under hypothetical adverse economic conditions so the model outcomes do not amount to forecasts, the report said.
One of the adverse fallouts of excess liquidity and low rates is investors beginning to `chase the yields.’ When credit markets froze after the implosion of Infrastructure Leasing & Financial Services Ltd., non-banking finance companies blamed the mutual funds, which in turn blamed enormous inflows post demonetisatiion. The FSR shows how investors are running to money market mutual funds when deposit rates began to slide, taking their share to 39 percent of total assets of debt funds.
Something unusual happened during the pandemic when the debt market was in a tug-of-war with the RBI, forcing the Governor to call for a `competitive’ market and not a `combative’ one.
The record low rates for government borrowing may have helped government and traders, but the risk is building up in banks’ bond portfolios. When rates turn there could be a demand for another round of forbearance on mark-to-market provisions.
Though Greenspan is remembered for his assessment on how central banks can’t identify asset price bubbles, the fact remains that he did so with his `irrational exuberance’ comment in 1996, but his folly was not pricking the bubble.
Das last week took a baby step in normalization of liquidity operations to pull up overnight interest rates to his desired levels. The Monetary Policy Committee has affirmed easy monetary policies through 2021 to sustain growth revival. But given the FSR warning, would Das taper his easy policies?
The jury is out on that.