A brief “thought” on debt defaults, asset prices, MS velocity and consumption expenditure risks.

When a private non bank debt collapses the money supply itself is not impacted.  There is however a collateral impact on future expenditure and the velocity of money supply itself.

Asset values are extremely sensitive to portfolio cash allocations.  A given reduction in preferred cash holdings relative to other assets, all other things equal, raises asset prices by a much greater magnitude and vice versa. 

However not all transactions represent closed loops: a disposal of an asset for future consumption transfers asset focussed money supply to consumption focussed money supply.  With money also being transferred in to the asset portfolio the net impact on asset values of consumption related transactions tends to be much smaller.

A default in non bank debt, or loss of any asset, should therefore have an impact on future MS velocity and expenditure while also possibly increasing the asset focus of money supply (all else being equal).  In the event of default, assets/collateral are no longer available for sale in exchange for money for consumption expenditure purposes (and of course investment expenditure purposes) and the potential velocity of money supply falls, specifically with respect to consumption and possibly also with respect to assets. 

Likewise a fall in asset values, especially the significant declines seen in recent decades, also impacts expenditure and MS consumption focussed velocity. Typically asset price declines have been short lived and given the fact that marginal transfers out of the global asset portfolio for consumption purposes has tended to be small in % terms, the impact of price declines etc on expenditure has also historically been small – this is especially so where asset focussed money supply growth has been expanding, demand for assets have been expanding (+ve population growth and demographic dynamics), where there is increasing income inequality (less MS flows out of the asset portfolio etc), but much less so in the reverse scenario.  

QE on the other hand has tended to focus primarily on supporting the financial system and high quality assets with minimal risk of default.   Whether it impacts expenditure decisions depends on the liability profiles of asset holders in general.  In a world of increasing income and wealth inequality asset price support may have only declining marginal benefits for consumption expenditure even though the resulting increase in asset focussed MS has affected a much wider range of asset prices. 

QE and low interest rate policy may well have supported potential expenditure based relationship loops from assets to consumption via asset price support based solely on asset valuations (not re yields) but may also, via increased risk taking within the higher yield/shadow banking asset spectrum, have increased the consumption sensitivity of assets; higher yielding assets are likely to be more consumption sensitive than lower yielding equity type assets.  

QE and lower IRs may well have increased the exposure of consumption and possibly also investment expenditure to future asset price shocks via two routes:

Increased exposure to leveraged loans, emerging market debt, high yield bonds, collateralised debt/loan investments, “wealth management products” (China) etc, exposes future consumption expenditure to higher default based risks, especially in high debt/low growth environments.  This depends on the extent to which QE has pushed investors out of lower risk higher yielding assets into higher risk/relatively higher yielding assets and the changing composition of the market portfolio especially with respect to those investors exposed to higher future liability demands.

Higher asset prices in low growth environments with increasing debt to GDP ratios also exposes consumption and investment expenditure to greater asset price volatility: we have seen quite extreme fluctuations in asset prices since the late 1990s.  As populations age the sensitivity of expenditure to asset prices increase.

The issue of default and asset price shock is compounded by issues of liquidity, especially with regard to many shadow banking products that investors may confuse as being cash like and therefore exposed to greater liquidity risks in risk events.

It is probable given the higher debt to GDP ratios, slower growth profiles and the many transition risks in the global economy, that global asset price consumption risks are not insignificant.  Another reason to support asset prices, another reason for QE and negative IRs, but not necessarily a solution.

Other reading:

Global dollar credit and carry trades: a firm-level analysis

“When the availability of external Financing from international capital markets varies with global liquidity conditions, the surrogate Financial intermediation activity of non-financial Firms in emerging economies will react (at least in part) the ebb and flow of global liquidity conditions themselves. Consistent with this hypothesis, we find that the extent of the intermediation activity of non-financial firms is closely linked with their borrowing in US dollars. In particular, we have found evidence of divergence between emerging and advanced economy firms, with emerging economy firms being more susceptible to carry trades and the associated surrogate financial intermediation activities.”

Bond markets and monetary policy dilemmas for the emerging markets

International bond issuance by EM companies:

“..about $1.2 trillion debt issuance on international markets over the 5-year period from 2010 to 2014. Such issuance has been consistently dominated by Chinese companies ($377 billion). Net issuance by Brazilian companies has also been large ($179 billion), but has fallen since 2012. Turner…Moreover, some borrowers have increased foreign currency borrowing to finance local currency investments (notably in local property markets). Currency mismatches have increased. In less developed currency or bond markets, such mismatches will often be unhedged (because of the absence of a suitable market product) or only imperfectly hedged….Other borrowing was to finance increased production of oil and other primary commodities – with projects often predicated on commodity prices remaining very high. In addition, the balance sheets of many EM corporations have become more leveraged (Chui et al. (2014)). Declining earnings and a stronger dollar make it harder to service international bond debt. Wider recognition of such vulnerabilities, and a drop in dollar commodity prices, contributed to a fall in EM corporate bond issuance in the first half of 2015. Note that this happened at a time when many advanced economy borrowers had increased issuance to take advantage of unusually depressed long-term interest rates (especially on euro-denominated paper – in which the term premium, as shown in Graph 2, was unusually negative)

SHADOW BANKING Policy Frameworks and Investor Perspectives on Markets-Based Finance CFA Institute


China’s money supply growth dwarfs the rest of the world – http://www.ft.com/intl/cms/s/3/c85cb7b0-62a1-11e5-9846-de406ccb37f2.html#axzz3n42tpJqr

OFR Publishes Working Paper on Liquidity Dynamics During Crises http://centerforfinancialstability.org/wp/2015/09/22/ofr-publishes-working-paper-on-liquidity-dynamics-during-crises-3/ …

Leave a Reply