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Credit Today: The challenge of macro imbalances
Published on 01/12/2010

Financial services has been in the news incessantly over the past 30 months. Most of the press coverage has focused on the excesses that tweak public attention: banker bonuses, bailouts and scandals.

Ironically, (always a dangerous word for an American in the UK), the history books will probably focus on macro-economic excesses during the past five years as the noteworthy story when this chapter of financial history is written and not the sordid details of personal greed and graft.

 For example, newspaper audiences prefer bonus bashing to counting the beans on who owns the most UK government bonds. However, history will challenge the experiment of the Bank of England at one point purchasing circa 20 per cent of all gilts in the market. This action did drive interest rates down but it created a very rare convexity in the gilt market. The Bank of England buys the gilts to make interest rates fall but when interest rates rise, those same gilts will fall precipitously in value. This will create a lose-lose risk that is extreme and will make it hard to find buyers for the gilts. 

Look at the fiscal position of Japan. Japan faces substantial budgetary burden servicing its debt of more than 200 per cent of GDP while interest rates are near zero. If interest rates in Japan rose, servicing the national debt would become very challenging without a massive inflationary action (which Japan has failed to deliver for the past 20 years).  One of the most epic imbalances came during the 2005-2007 period when the UK government and the UK public were both net borrowers at the same time. That is historic because you need very significant foreign account flows to even mathematically make that happen despite the fact that it was problematic for future national financial health.

All of these macroeconomic points are very difficult to absorb because they are so abstract. The place where UK financial services needs to focus hard is on the intersection of UK monetary policy and UK fiscal policy.  For example, the government has made globally leading austerity commitments that will reduce the size of the UK welfare state. This will inevitably damage UK economic growth at least in the short-term. The government says it is doing this to establish fiscal responsibility and evidence credibility in the bond markets. This is a funny concept when UK interest rates are at 350-year lows. The bond market is saying 'I will lend the government money at the lowest price in modern history' and the government is saying 'I would rather take less of your money so that I can cut welfare and make even more people unemployed'. It seems likely that this imbalance is the unintended political safety net to the government's fiscal austerity. 

Opportunity knocks?

All governments need to borrow to spread out spending on large infrastructure projects. Why not borrow and build now when interest rates are at historic lows? I suspect Ed Miliband will figure this out and shout like crazy on this "wasted opportunity". This will limit the real effect of fiscal austerity as the next UK general election approaches. 

For debt buyers, I think 2011 will be a year of trying to figure out what these macro-imbalances mean for our businesses.  Interest rates are low but funding is not very available. Welfare is being cut and debtors will have less money, but to politicians those people are voters who are being offered cheap money and a motivation to spend it, to show progress in reducing unemployment. Pundits are talking about inflation but the economy has massive slack in most areas. The housing market remains soft and general consumer liquidity is restricted, making large customer payments very hard to acquire.

In this environment, the UK debt buying market is entering a new phase because the macro-economic imbalances and forecasting challenges outweigh the micro-economic challenges by a sizable margin. This should lead to innovation and opportunities to cleverly design client solutions that manage the macro-economic risks and not just the specifics of individual debt obligors. These imbalances tend to take a long time to unwind. As John Maynard Keynes once said:"Markets can remain irrational longer than you can remain solvent".  

Hopefully, the UK debt buying market can rise to that challenge in 2011 and deliver value to the marketplace, rather than being just another example in the era of imbalances. 

Zach Lewy, chief executive of Arrow Global

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