On September 15, 2008, Lehman Brothers, the fourth largest investment bank in the United States, declared bankruptcy in the 158th year since its incorporation. The instantly escalated subprime mortgage storm drew urgent attention to the most serious financial crisis since the Great Depression. While severe liquidity crush put bankers’ confidence on the brink of collapse, the global central banks sought to rescue the financial markets by utilizing a variety of financial instruments and replenishing the liquidity with massive amount of money supply. 10 years slips away, the U.S. stock market set the record of longest continued bull market with the support of positive economic data and corporate profitability. The price level of the world’s major economies maintained stable, and the central banks dominated by the United States, which led the super quantitative easing monetary policy, have begun or were planning to tighten their monetary policy.
The problems a decade ago seems to have gone, but walking through those years ourselves, we are aware that the negative effects brought forth by quantitative easing monetary policy, including the widening wealth gap between the rich and the poor and the surge in government debts, are still haunting us and are hard to solve; some of the emerging markets, those rely on liquidity in particular, had experienced an exceptionally diverse stock market fluctuation under the influence of shift in monetary policy. 10 years, the price of financial asset has gone up under the super monetary easing policy, but the recovery in the real economy has not been matched. What kind of era are we in?
Low Interest Rate and Quantitative Easing: Widening the Wealth Gap
Under the financial crisis in 2008, central banks across main economies launched easing monetary policies one after another; among all, the Federal Reserve System on one hand lowered the benchmark interest rate from 5% to zero , ushering in a seven-year period of zero interest rate; and on the other hand introduced the three rounds of quantitative easing, which caused the balance sheet to expand rapidly. Meanwhile, the central banks in the European Union and Japan implemented negative interest rates policy, which toppled people’s perceptions of monetary policy and interest rate levels. The current interest rates are still at historic lows regardless the fact that the Federal Reserve has been gradually raising interest rates and shrinking its balance sheet since the end of 2015. ECB and BOJ however sat tight, and stick to their negative interest rate policy.
Chart 1：US Fed Fund rate at relatively low level
Source：Federal Reserve Economic Data, FinEX Asia Research Team
Although the global economy has recovered modestly thanks to low interest rates and quantitative easing policy, the central bank’s policies have been blamed for widening the wealth gap: extremely easing monetary environment may cause rise of asset prices, and wealthier population who are heavily involved in the stock market, fixed-asset investments and alternative investments may capture this opportunity to accelerate their wealth growth whereas the wage earners with little exposure in financial assets may suffer in their relatively slow growth of salary. The consumer finance survey data released by the Federal Reserve at the end of September 2017 corroborated this point of view. In 2016, the richest 10% of the Americans accounted for approximately 77% of the national wealth, while the wealth processed by the remaining 90% was declining. Certainly, the polarization of wealth is not a post-financial crisis phenomenon. At least the chart below proven the polarization in the U.S. started back at 1989. However, if we cover a longer period and look across several economic cycles, we can see that the decline in interest rates in the United States since the 1980s is still consistent with changes in the distribution of wealth.
Chart 2: Wealth distribution in the US
Source: Federal Reserve, Survey of Consumer Finances, FinEX Asia Research Team
Central banks balance sheets：Explosive Expansion
The balance sheets of central banks expanded rapidly after the financial crisis. The combined assets of the Federal Reserve, the European Central Bank and the Bank of Japan were approximately $4 trillion before 2008, and now it has soared up to over $14 trillion.
Chart 3: Changes in Assets of the Federal Reserve, the European Central Bank and the Bank of Japan
Source：Bloomberg, FinEX Asia Research Team
Central bank’s constantly injection of capital into the market over the past few years had fueled the asset prices to rocket high. In a low interest rate environment where a great deal of capital was eager for return, it is obvious that the cost of borrowing across various sectors fell sharply in the past few years, leading to a rise of total global debts. According to the data of Institute of International Finance (IIF), the total global debts has reached $247 trillion, accounting for 318% of global GDP, while it was less than $180 trillion in 2008, which accounting for 280% of global GDP. Clear trace of capital inflation can also be found in the stock market. After the financial crisis, especially after the European debt crisis, the U.S. stock market soared, while the VIX index representing the stock market fluctuation declined. This was partially driven by the recovery of corporate profitability, but the surge in cash available to financial institutions also accounted for the higher PE ratio of stock market as they had to find ways to utilize their capital.
Chart 4: US S&P Index P/E (Blue) and CBOE VIX Index (Green)
Source：Bloomberg, FinEX Asia Research Team
Government Debt: The ‘Elephant’ in the Room
Global debts comprise of government debt, financial corporate debt, non-financial corporate debt and household debt. The increase of government debt recorded is the most significant among all, which rocketed from $37 trillion in 2008 to $67 trillion in 2018, with the proportion in global GDP rising from less than 60% to 86%. The increase in government debt in mature markets was more pronounced than that in developing markets, representing higher government debt-to-GDP ratio. Over the past decade, the increase in government debt in emerging markets was relatively modest, rising from nearly 40% to approximately 50%, while that of mature markets climbed from approximately 70% to approximately 110%. Namely, the US government debt as a proportion of GDP soared sharply to 82.3% from 37.5% in 2008, and the debt ratio was expected to rise under the term of Donald Trump; and Japan’s government debt as an astonishing proportion of GDP which reached up to 236.4%! However, the US dollars and Japanese YEN are still regarded as the traditional safe-haven currencies. When there are any big swings in the market, capital would quickly exits from risky assets and flows into US and Japanese government bonds with high security and sufficient liquidity. Therefore, even if both countries significantly increase their borrowing their attractiveness as safe havens for financial institutions will not diminish.
Chart 5: Government debt as a proportion of GDP in the US and Japan
Source：Bloomberg, FinEX Asia Research Team
The Financial Sector and the Banking Sector: the leverage ratio decreased in financial sector and the capital adequacy ratio increased in banking sector
Many deficiencies in the banking system were exposed in this financial crisis. Prior to the crisis, Lehman and other major banks did not reserve sufficient buffers against possible losses, and the tier one capital adequacy ratio was estimated to be only approximately 2%. Post crisis, regulations on banking industry became increasingly rigorous, the capital adequacy ratio in banking sector increased significantly and the tier one capital adequacy ratio of common stock of the world’s major banks basically raised to above 10%.
Chart 6: Tier one capital adequacy ratio of common stocks of the world’s major banks
Source：Bloomberg, FinEX Asia Research Team
Furthermore, the construction of capital of banking sector have been more solid. Pre-crisis, banks relied heavily on short-term financing channels, but now they rely more on deposits. A decade of monetary easing and stringent regulation had replenished the capital of the US financial industry, it had also restructured the business and decreased the investment leverage. The financial sector, after all, is vital to the real economy, and is one of the main reasons causing the difference of degree of recovery between the European and the U.S. economy.
Chart 7: Comparison of Bank Capital Sources
Source: Data is arrived by Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America and Citibank on aggregation basis; Bloomberg; FinEX Asia Research Team
Non-financial Sectors: By Increasing the Leverage with Low Interest Rates, Emerging Markets and Low-rated Companies Increased Their Debts Rapidly
The non-financial sectors accelerated their debts to boost profits under the low-interest environment. The liabilities of non-financial sectors increased from $46 trillion in 2008 to $74 trillion in 2018, its proportion in GDP rising from 77% to over 90%. It is particularly worrying because it appears to be industries or corporates with weaker fundamentals seem to be the main users of adding on leverage. The debt-to-GDP ratio of non-financial sectors in the developed markets maintained stable at around 90% over the past decade, with no significant increase; however, the non-financial sectors in the emerging markets increased their leverage significantly, and the debt-to-GDP ratio soared from 60% in 2008 to nearly 100% in 2018. We also observed rapid increase in the issuance of non-investment grade bonds at the same time. In the United States, for example, according to the Bank of America Merrill Lynch, the market value of non-investment-grade bonds was more than double of that before the financial crisis. According to the Bloomberg, the leveraged loans of the US corporates issued in 2009-2018 amounted to $8.7 trillion, which was nearly 2.5 times that of 1999-2008.
Chart 8: Market Value of the Non-Investment Grade Bond Market in the US
Source：Bank of America Merrill Lynch, FinEX Asia Research Team
Household Debts: Households in the Developed Markets Decreasing Leverage, and Households in the Emerging Markets Increasing Leverage
Overall, the increase in household debts is not significant. In 2008, the household debts accounted for $37 trillion, while it was $47 trillion in 2018, which is slightly higher as the proportion in the global GDP but still below 60%. Although the overall increase was modest, the trend in the developed markets and the emerging markets have been in opposing direction. Over the past decade, households in the developed markets decreased their leverage, with the debt-to-GDP ratio decreasing from over 80% to around 78%, but the debt ratios of households in emerging markets rose sharply, with the debt-to-GDP ratio rising from 20% to nearly 40%. We have selected the United States and china as the representative of each market to analyze the changes in household debt-to-GDP ratios: from which it can be observed that there have been a significant decline in leverage ratio after the housing market cooled down for the US households, while the Chinese households have increased their borrow to purchase properties to chase the rising housing prices.
Chart 9: Household Debt-to-GDP Ratios in the US and China
Source：Bloomberg, FinEX Asia Research Team
We can deliberate from the above discussion that the easing monetary policy in the past decade has brought profound effects: the easing monetary policy inevitably increased the wealth gap and printing more money made the asset prices rise, the government debts of developed countries repeatedly hit record highs and the non-financial sectors and households in emerging markets have been significant increasing leverage over the past decade. The central banks in various countries have gradually stepped into different stage of monetary policy 10 year after the crisis, and the Federal Reserve has taken the lead to raise interest rates and to shrink the balance sheet. However, in the period when the asset prices have already risen, how to reduce leverage while maintain the stability of financial markets is a topic that the central banks and the markets need to consider and explore together. The raising US dollar interest rate is bound to put pressure on emerging markets. Over the past decade, a huge amount of funds injected into the market were eager for returns and flooded into emerging markets The capital not only pushed up the stock price in emerging markets, but also incite leverage. After the financial crisis, the off-balance-sheet credit products and private lending products prevailed in China, which was the best evidence for the pursuit of rising asset prices through leverage. The pursuing in gain in financial assets have driven the capital away from the real economy investment. As a matter of fact, most of the investments were promoted by government funding and state-owned enterprises. With the US dollar strengthens, rising interest rate in the US will trigger different reactions in emerging markets, and the emerging markets will inevitably experience the process of deleveraging although passively. It had been 10 years, the U.S. has almost turnaround due to taking all the necessary steps c, and subsequently, it may be the turn for emerging markets to start their recovery process from the recovery of US economy.
