In its annual report, the Bank for International Settlements (BIS) rightly insisted on the dangers arising from central banks’ rates being kept “low for long” (BIS Annual Report 2009/10). The study reminded us that such policies distorted the perception of risk while they encouraged a search for yield that laid the ground for the financial crisis.
The question asked by the BIS last June was “Do the risks of a repeat of such policies outweigh the rewards?” The report seemed to hint they do. Since it was written, the incoming information on the current state of the developed economies and their fiscal tightening plans have led markets to adjust their expectations of the (already distant) date at which monetary tightening will start even farther into the future.
Should this necessarily be as worrying as the BIS warnings seem to imply? To answer this, we need to understand the full role that low rates are playing in the working of today’s globalised financial system. More than ever, this role goes well beyond the mere stimulation of credit demand.
Low rates are not only influencing the flow of new lending but also helping the system carry the risks attendant to the stock of loans already made. Precisely because they encourage risk-taking, low rates are the cornerstone supporting the global financial system’s new and fragile equilibrium after its appetite for risk was dramatically diminished by the “subprime shock”.
Low rates have managed to induce private agents to finally accept taking on the outstanding risks that they had previously been trying to shed since the start of the subprime crisis in 2007 as the attitude to risk suddenly stopped being one of complacency. This is not a meagre achievement since the stock of risks to be taken on was – and still is – massive. Until mid-2007, the ever-increasing demand for risk of the years preceding the financial collapse had been met by a correspondingly increasing supply. But when the demand for risk vanished, the accumulated supply remained and finding somebody to carry it became a serious problem.
The fact that the demand for risk was, for many years, artificially inflated by perverse microeconomic behaviour did not prevent it from being answered by a supply that was real indeed – consisting mainly of mortgage loans granted to US households – and of macroeconomic origin (associated directly with the growing global imbalances of the last decade).
Recalling the current-account imbalances
To understand the key role low interest rates are now playing in the newly found equilibrium of the financial system, in recent research (Brender and Pisani 2010) we focus on the current-account imbalances and the risk-taking patterns underlying them.
The excess savings generated in the surplus countries were lent to deficit countries’ borrowers. But this transfer of savings was far from being direct – after all, Chinese households did not lend to American households! It was intermediated by the global financial system.
This implied that a lot of risk-taking had to take place within this system since the mismatch between the assets the savers wanted to hold and those the borrowers issued could hardly have been wider: OPEC governments’ or Chinese private agents’ savings were – and still are – invested in local currency, mostly in short-term and credit-risk free forms, while the debt those savings financed was mainly long-term, full of credit risk, and denominated in Western currencies.
Despite this mismatch, the globalised financial system made the transfer of savings possible by taking on the risks the savers did not take. The central banks of the surplus countries by accumulating reserves took on the currency risk: they borrowed short-term in their own currency to lend, mostly short-term also, in foreign currency. They acted exactly as any foreign exchange market player does when taking a carry-trade position; the only difference was that they were not seeking to make a profit but to prevent their currency from appreciating.
The developed countries’ risk-takers took on the other risks: most of the credit-risk and maturity-transformation risk associated with the close to $4,000 billion of savings transferred from 1998 to 2007 between the emerging and the developed economies was taken on by the then risk-demanding global banking and “shadow banking” systems (see Adrian and Shin 2008).
When things turned sour, many participants were forced – or decided to – de-leverage and cut their risk-taking positions. But the mass and the nature of the risks to be carried were left largely unchanged: the Chinese and OPEC savers did not use much of their deposits to buy riskier assets and most of the borrowers did not pre-pay their debt.
This is where the lower short-term rates helped: they induced the stronger hands to take on the risks – whether credit, interest-rate or liquidity risks – that the weaker ones could not hold anymore.
Figure 1. Surplus emerging regions’ cumulated current-account balance and foreign exchange reserves
Note: The surplus Emerging regions consist of Asia (including the Newly Industrialised Countries), the Middle East and CIS. Sources: IMF, Thomson Datastream.
Are things better now?
Have things improved so decisively during the last years for those low rates not to be necessary anymore? This is far from sure.
The risks attendant to some of the mortgages that were outstanding three years ago do not have to be carried anymore because the loans have been either paid back or written-off. New loans have however been made since 2007, so that the amount of mortgages outstanding in the US has diminished by only $300 billion. Moreover, the new mortgages may carry less credit risk but are still long-term, so that the maturity-transformation risk has not vanished.
On top of this, the Federal Reserve has relieved the system from a significant part of the maturity-transformation positions that somebody had to hold. The Fed now has $1,500 billion dollars of mortgages on its books (i.e. long-term debt) financed by banks’ excess reserves holdings (i.e. short-term funding). By taking on the positions that investment banks, hedge funds, or off-balance sheet vehicles could not take anymore, the Fed played a key role in bringing the global financial system back to stability.
But since 2007, the global imbalances have not disappeared (see for example Baldwin and Taglioni 2009 and Claessens et al. 2010). Close to $2,000 billion of additional savings have been transferred following roughly the same risk-taking patterns (Figure 1). For a while, however, there seemed to be one notable difference: the securities now issued in the deficit countries as a counterpart of the savings being accumulated in the surplus countries are now government debt instead of private mortgages. We might have hoped that this at least did not imply a build-up of credit-risk positions… until it appeared that not all government debt can be considered as being credit-risk free. In just a few weeks, the deepening of the Eurozone debt crisis made more than $1,500 billion of public debt1 look like “subprime” government securities, riskier to hold and more difficult to fund!
On balance, it looks likely that the Western financial system will still have to hold more maturity-transformation and possibly credit-risk positions than it can. A premature upward move in policy rates would put its stability at risk. From this perspective, the fact that this move may be further postponed is reassuring. It does not mean that low rates have no side effects, but, for a while at least, those side effects can and should be taken care of by other means than rate hikes.
Adrian T and HS Shin (2008), “Liquidity, Monetary Policy, and Financial Cycles”, Current issues in economics and finance, Federal Reserve Bank of New York.
Baldwin, Richard and Daria Tagloni (2009), “The illusion of improving global imbalances”, VoxEU.org, 14 November.
BIS Annual Report (2009/10), “Low interest rates: do the risks outweigh the rewards?”, Chapter 3.
Brender A and F Pisani (2010), Global imbalances and the collapse of globalised finance, CEPS, Brussels.
Claessens, Stijn, Simon J Evenett, Bernard Hoekman (2010), Rebalancing the global economy: A primer for policymaking, A VoxEU.org publication, 23 June.
1 This includes the government debt of Greece, Ireland, Portugal, and Spain.