“The Fragile Foundations: Understanding Financial System Dissociations”
The most tracked metrics to assess an economy’s health would be inflation, GDP growth, and unemployment. A low inflation, high GDP growth, and low unemployment rate means the economy is robust – so goes the normal thinking. But a little peak into previous economic troubles, growth slowdowns or recessions informs that most were preceded by favourable inflation, GDP, and employment figures.
The ’real’ economy functions to provide the goods and services necessary to fulfil human needs and desires. The purpose of the financial system is to support the ‘real’ economy by facilitating transactions, majorly through credit and money supply. But on certain occasions, the financial system would dissociate from its principal purpose and start functioning for its own sake – its expansion and survival.
Unfortunately, the financial system gets seized by many ill effects if dissociated from its primary purpose of serving the real economy. Precariously high asset prices, credit booms, capital misallocation, and financial fraud are a few of the ill effects. They make the financial system fragile, and thus, easily vulnerable to external shocks. The likelihood of financial distress, panic, and crises is higher under such conditions.
However, a financial crisis and its aftereffects (loan losses, asset price declines, failure of financial firms) are never confined within its boundaries. Rather, it percolates into the broader ‘real’ economy in the form of economic slowdown, recession, income and job losses. Therefore, financial stability is a prerequisite for a robust economy.
However, assessing economic health and financial stability through the commonly followed evaluation metrics such as inflation, GDP growth, and unemployment figures isn’t very instructive. So are the financial systems metrics such as asset quality, capital adequacy ratios, and bank profitability. Instead, a more constructive approach would be identifying the malefactors for financial system dissociations, preferably, before the dissociation symptoms are apparent.
Financial system dissociations usually occur during periods of easy money, characterized by ultra-low interest rates, abundant credit, and rapidly increasing money supply. The dissociation will be severe if the easy money conditions have been forced upon by central banks. Also, the longer the easy money existed, the greater will be its ill effects on the financial system. Therefore, if the economy had to traverse an easy money policy in recent years, then a deterioration in financial stability is highly likely. In simple terms, an easy money policy could make the financial system fragile.
Credit growth is a useful metric to gauge financial stability. High credit growth is destabilizing to the financial system, particularly if the credit growth exceeds the economic growth for an extended period. During the easy money period, as credit is abundant and interest rates are so low, households, firms, and governments load up on debt. Although this makes the economic participants highly indebted, due to the ultra-low rates, the debt mountain never feels like a burden. Rather, it creates an illusion of prosperity.
Changes in money supply could also portend financial fragility. The money supply is the amount of money available to the public to conduct essential economic transactions. Ideally, the expansion in money supply should mirror the growth of economic output. Since much of the money supply used by the public for transactions is created through bank loans issued by commercial banks, credit growth and money supply growth may seem synonymous.
However, central banks too can increase the money supply by making loans and purchasing assets from commercial banks. If the central bank’s contribution to the expansion of the money supply is dominant, which is unnatural, it could be a likely cause for financial fragility. A large increase in money supply incommensurate with economic growth, particularly when central bank activities (loans and asset purchases) are the dominant contributor, makes the financial system more fragile. The balance sheet growth of central banks is a good indicator of the scale of their role in the expansion of the money supply.
Capital flow is another reliable metric that could inform us about the germination of vulnerabilities in the financial system. Capital flow measures the movement of money towards investment, trade, or consumption. Serious imbalances could arise if capital flows into an asset, sector, industry, or economy, that is more than that the destination could withstand. Credit booms, asset price inflation, consumer price inflation, and dangerously high trade deficits are prominent after-effects of excessive capital flows.
As the financial system becomes more fragile due to the various reasons discussed above, it becomes more prone to risks from exogenous shocks. There comes a point at which such risks begin to manifest in different forms depending upon the intensity of the exogenous shock and the degree of system fragility. Failure of systemically important (financial) firms, stock market crashes, large-scale loan defaults, and balance of payment crises are a few forms of manifestation.
But before going into the forms of risk manifestation, it is worth considering why the risks are manifesting now – why not earlier or later? It is hard-to-impossible to pinpoint the exact time at which risks would start manifesting. However, certain conditions or situations are conducive to risk manifestation, just like, some conditions are conducive to risk germination.
The exogenous shock is effective in disrupting financial stability only under conducive conditions. It was policy easing that made conditions conducive for risk germination. Likewise, what makes risk manifestation conducive is usually a tightening of policy, which could be at the monetary, fiscal, or regulatory level. A few such policy tightening measures include an increase in interest rates, withdrawal of stimulus measures, lenders tightening credit standards, regulators increasing margin requirements for margin loans, regulators restricting capital flow into financial markets from specific sources, and introduction of new taxes or increase in existing taxes.
The conducive conditions make risk manifestation more likely, however, knowing the exact time or form of manifestation is beyond human capabilities. But ‘more likely’ is a good enough discernment to make effective decisions. From an equity investor’s perspective, the twin goals of such effective decisions are to 1) forearm against wealth destruction during the mayhem, and 2) capitalise on opportunities that might emerge out of the mayhem.
Staying away from stocks trading at expensive valuations, with poor return on capital, or weak competitive positions could increase the portfolio’s resilience. Maintaining adequate liquidity would enable to capitalise on opportunities that might arise during or after the mayhem – brought about by risk manifestation from the financial system.
Over the past few months, authorities from the finance ministry, RBI, and SEBI, on different occasions, have expressed certain concerns that might destabilise our financial system if not attended to. The concerns include elevated stock prices in the midcap and smallcap segment, rapid increase in options trading activity, heightened retail participation in the options market, high growth in unsecured retail loans, and a misbalance between loan growth and deposit growth.
All the concerns expressed by authorities are regarding excesses in the system. Usually, such concerns are dealt with by authorities through warnings or corrective measures. Regarding the above concerns, only flagging and warnings have been done, so far. But historically warnings have always failed in rectifying excessive risk behaviours.
On 7 June 2024, the RBI Governor in his policy statement speech informed that, recently, there has been some moderation in the growth of unsecured retail loans, after they had flagged concerns about its excessive growth in November 2023. But the growth moderation in no way indicates that lenders and borrowers have abandoned their excessive risky behaviours.
Earlier this year, there was a moderation in stock prices when concerns regarding froth in midcap and smallcap space were expressed. Then, SEBI gave directives to AMFI to moderate inflows into small and midcap schemes. But, after a very short period of moderation, the stock prices resumed their rise at their earlier momentum. It is evident from these incidences that warnings and directives aren’t going to correct risky behaviour from market participants. Instead, it requires strong corrective actions from the authorities.
Risks might have germinated and accumulated in our financial system due to the prolonged easy money policy we enjoyed until 2022. The steep interest rate hikes and asset contraction by central banks from 2022 onwards show that we are now in a policy tightening phase. We saw earlier that a policy-tightening environment makes it conducive for risks accumulated during the policy-easing phase to manifest. Now we are in such a conducive environment, and what is required to trigger the risk manifestation is an exogenous shock.
In our previous outlook, I suggested the possibility of the outcome of Indian parliamentary elections to be an exogenous shock. The election result did come as a shock, as per suggestion, but never turned out to be the anticipated exogenous shock. After an initial sharp fall, prices recovered and soon made new all-time highs.
Despite the setback, I haven’t lost my appetite for prospecting for potential exogenous shocks, and I think I have identified a new one.
If the latest news reports are true, then authorities seem to be realising the essentiality of strong corrective actions, instead of relying on warnings and directives, to restrict excessive risky behaviour that could gradually destabilise the financial system. On 18 June 2024, The Economic Times reported that “Sebi is considering a series of tweaks to its derivative trading rules, according to two sources, as it seeks to address risks arising from the explosive growth in options trading. The new rules could include higher margins for options contracts and more detailed disclosures and are being considered after a series of meetings with exchanges, brokers, and fund houses over the past four months.”
Considering this news report alongside the discussion we had on risk manifestation earlier… there is a high probability that… the implementation of the tweaks to derivatives rules now under SEBI’s consideration… or any other similar action… whether from SEBI, RBI, or finance ministry… to restrict risky behaviour from market participants… to be an exogenous shock.
On 6 June 2024, the European Central Bank (ECB) reduced its key policy interest rates by 25 basis points. The main refinancing operations rate now stands at 4.25 per cent. ‘Eased inflation, weakened price pressures, and dampened inflation expectations’ were pointed out as the reasons behind the rate cut decision. The rate cut comes on the back of holding the rates steady for nine straight months. Previously, between July 2022 and October 2023, the ECB had raised rates steeply from zero per cent to 4.50 per cent. ECB was forced to make those steep rate hikes due to a rise in inflation from June 2021 onwards, which had peaked at 10.6 per cent by October 2022, but had moderated from there.
Since October 2023 onwards, the annual inflation rate in the Euro Area has remained below 3 per cent: it was at 2.6 per cent for May 2024. ECB’s inflation target rate is 2 per cent, which it hopes to achieve only by 2026, as per its latest inflation forecasts.
On 12 June 2024, the Federal Reserve announced its decision to keep rates unchanged, ‘until it has gained greater confidence that inflation is moving sustainably toward 2 per cent.’ On 20 June 2024, the Bank of England too kept its policy bank rate unchanged at 5.25 per cent. The inflation rate in the UK for May 2024 was at 2 per cent, but BoE expects a slight rise in the second half of the year. Meanwhile, in India, RBI kept the policy repo rate unchanged at 6.50 per cent in its latest MPC meeting held on 7 June 2024.
The ECB and the Swiss National Bank (SNB) – the central bank of Switzerland – are the two major central banks to cut interest rates post the steep rate hikes of 2022-2023. SNB had cut rates two times this year – 25 basis points each. Apart from these, globally, policy interest rates mostly remained unchanged for the past nine months. But they remained unchanged at a high level, post the rate hikes of 2022-2023. Meanwhile, although gradually, central bank balance sheets of large advanced Western countries have been shrinking since the second half of 2022.
So, the current monetary policy environment is a vague mix of restrictive and tightening: an environment prone to risk manifestation. It should be a period of heightened uncertainty, characterised by volatile asset prices, subdued investor sentiments, and increased risk perception by market participants. But the global equity market now reflects none of these characteristics; rather, it remains buoyant.
Stock indices in India and the US are at their all-time highs now; both their indices are up more than 20 per cent in a year. In the UK, Germany, and France, their respective stock indices hit all-time highs in May 2024, and have corrected by 2 – 7 per cent since then; their respective indices are up 10.88 per cent, 15.42 per cent, and 6.81 per cent in a year. In Japan, stock indices are up 18.67 per cent in a year but peaked much earlier – in March 2024 – and have corrected by 5 per cent from the peak.
This buoyancy of global equity markets under a largely restrictive monetary policy order could be construed as evidence for the financial dissociation we discussed earlier. Speculative frenzy and asset price inflation are symptoms of financial dissociation. The current dissociation is not of a recent origin, its genesis lies in the loose monetary policy adopted consequent to the 2008 global financial crisis. The loose monetary policy existed for a very long time – almost 13 years; so, the scale of dissociation and excesses accumulated over the long years should be colossal.
However, it is mysterious that the financial dissociations haven’t been rectified yet, despite nine months into restrictive monetary policy. In many previous crises, an average time lag of 3 – 15 months between adopting restrictive policy and risk manifestation could be observed – one probable reason for the mystery. Moreover, compared to the 13 years of loose monetary policy, the 9 months of restrictive monetary policy looks inconsequential.
The current market has many similarities found at the end of a major bull market. These include an all-time high market, a flurry of IPOs (most of poor quality), high retail participation, and increased economic optimism consequent to upward revision to GDP growth by various agencies.
In 2022, 41 IPOs cumulatively raised around ₹60,000 crores (this includes the ₹21,000 crores LIC IPO – the largest in Indian IPO history). In 2023, around ₹53,000 crores were collectively raised through 59 IPOs. So far in 2024, there were 37 IPOs, which raised around ₹34,000 crores. Over the past three months, around 20 companies have filed their draft IPO prospectus with the SEBI: the most prominent being that of Hyundai Motors India Limited, which expects to raise around ₹25,000 crores through the issue, as per media reports. At this pace, the IPO count in 2024 could easily outpace that of previous years.
Another worrisome not-so-recent development is the breakdown in the correlation between 10-year bond yields in India and the US. Over the past 25 years, India’s, and US’s 10-year bond yields were positively correlated: as US bond yields rose, so did India’s; as US bond yields fell, so did India’s. However, the positive correlation seems to have broken from July 2022 onwards. During the period, the US 10-year bond yields rose from 2.64 per cent to 4.50 per cent, whereas India’s 10-year bond yields declined from 7.30 per cent to 6.96 per cent. That is, for the past two years, they have been inversely correlated. Consequently, the yield differential of 2.50 per cent between them is the lowest in a decade.
The US now have a negative yield curve – considered a reliable indicator of a recession. But it has been so for close to two years: only the recession hasn’t arrived yet. In India, although we don’t have a normal yield curve, it is not negative either; it is more of a flat yield curve – considered a sign of high uncertainty. However, our equity market performance sharply contradicts what the yield curve indicates.
Dissociations, imbalances, distortions… their sightings in our financial system are broadening with increasing frequency… They are being sighted in more and more places than ever…
However, the market remains in denial amidst this… why is it so? Maybe the truth is so painful… But is it possible to circumvent the truth and stay delusional or in denial for too long… I don’t think so… the more the market stays in denial… the more severe would be the reckoning…
“Markets can remain irrational longer than you can remain solvent.”
– John Maynard Keynes.
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