Davos 2019 - When the Corporate Debt Bubble Bursts

good evening again ladies gentlemen that was very quick very quick three minutes thank you all for being here for this second it's a source of concern I think for significant number of people we've got a really good and diverse panel I think which who will be able to offer as various perspectives on the issues at hand and I very much hope obviously that you will contribute it's very important got a very good audience here both in terms of quality and quantity and I would very much appreciate it if you please do feel free to get involved and to interact just to frame the discussion and that the title is when the corporate debt bubble bursts and I was thinking as I was pondering this that there are at least three at least three is largest quite large assumptions in that title one is that we recognize a bubble and know what a bubble when there is one secondly that we have one right now and thirdly that it's gonna burst so I have a suspicion that some of our panel may take issue with one or some of those assumptions that are implicit in the discussion but we do know that there's been a dramatic increase in corporate debt around the world in the last in the last few years I've seen that steadily growing obviously since the since the depths of the financial crisis it's often cited as a major risk for the global economy people note for example that the total corporate debt levels are higher than they were now it depends how you measure it obviously is a in relation to GDP or in relation to equity prices but there's no question that there's been a significant increase in corporate debt driven of course by these extraordinary monetary conditions that the world has been experiencing for the last ten years and all of the all of the elements and all of the business decisions and all of the balance sheet decisions that that companies have been taken that go that go as a result of that and so I do want to get it the question should we be considered how big is it how significant is the corporate debts the the corporate debt expansion that we've seen how does it compare historically what are their elements about it that should a concern is over all other Ella is it is it is it do we have the makings of a bubble about to burst is it is it going to lead to a broader financial broader financial dislocation and sort of problems that we impossibly not on the scale of its hope not on the scale of 2007-2008 but but could we be in for something really quite unpleasant if not why not and won't explore to some of the specific trends within that some of the implications of the expansion in corporate debt diversified panel globally so geographically so we can look at some of the geographic trends some of the divergent Geographic trends we've got some policymakers on the panel and I think it'd be great to get a perspective of the challenges for policy such as they are or the the the need for policy responses if if there are need if there is a need for policy responses both at a national level and a supranational and multilateral level and we've got two extremely experienced practitioners who are directly involved in the corporate debt in corporate debt markets so let me introduce them it's use the panel and we'll get straight into our discussion to my immediate left Karen Fann who is the managing director head of America's fixed income currencies and commodities at Bank of America Merrill Lynch and Karin is also a young global leader of world economic forum welcome Karen left we have Philippe Lorraine the best Baskin Yan who is the finance minister of Chile it's been very busy today doing a number of events and panels and so we're very grateful to have him thank you very much for being in to his left we have Josh Friedman co-founder co-chairman co-ceo of Kenyan partners but there'll be no nope you know co-decision cocoa opinion sharing I'm sure it'll be all Josh's on this on this panel that thought very much Deering from him we've had an opportunity to discuss these issues before and I should say by remarkable coincidence because I understand his left David Lipton first deputy managing director of the International Monetary Fund very familiar with him all of you were regulars at Davos familiar with all of the panel actually but I discovered that I think this is true that David and Josh were actually it's elementary school the whole thing so if nothing else we can think of this gathering as a reunion for a couple of old school friends so we have a again there's a wonderfully obviously experienced the talented and diverse panel and I really want to draw out all of the questions that I raised and many many others that frankly I'm not smart enough to know about so I will start with if I may with Karen Fann Karen you give us a sense taking this question head-on of how how large is the how large has been the expansion in corporate debt go before debt over the last few years how does it compare historically what a what should we should we okay so you guys here okay so first of all I think let's take a look at us some numbers so let's take a step back and think about global debt a decade ago global debt which is largely dividing to sovereign debt corporate debt and consumer sector debt was a hundred trillion dollars give or take that's a decade ago ten years later we're basically looking at 170 trillion dollars of global debt so that's 70% higher but no number should be looked at you know in isolation when you think about that you get to GDP terms obviously GDP is growing we're slowing down in our growth but GDP is still growing so a decade ago debt to GDP was a hundred roughly call a two hundred seven percent global debt to GDP based on 100 trillion dollar number and today two hundred seventy trillion dollars are you 70 percent higher in notional debt terms the debt-to-gdp is roughly two hundred and thirty two percent so that's 25 percent higher this sounds a little bit more manageable now if you take a look look at the title of the panel is on corporate debt now corporate debt out of the 170 trillion dollars today is roughly sixty six trillion dollars so it grew by twenty nine trillion dollars in the last decade but sovereign debt has actually grown by more sovereign debt grew by thirty one trillion dollars so again everything is relative but sovereign debt had to grow because we had to you know stimulate the economy post financial crisis we probably have just gone through an unprecedented amount of quantitative easing and global central banks have really coordinated on the monetary easing to inject some life back into the economic and financial system so there's no wonder that sovereign debt actually grew more than corporate corporate debt so now dooming it on the corporate debt twenty nine trillion dollar increase in the last decade sixty six trillion dollars today that 29 trillion daily increase is broken down to ten trillion dollars in advanced economies and 19 trillion dollars in emerging markets and now that emerging market increased which is 19 trillion dollars is further broken down to four trillion dollars by 16 major emerging market you know countries including Chile X China and 15 trillion dollars of that increase came from China so if you look at again just zooming in because I think my job here is to provide some numbers is the Chinese corporate debt-to-gdp now is standing at an astounding 168 percent debt to GDP and the US corporate bomber a corporate debt market is roughly seventy four percent and the rest of the 16 emerging markets outside China is at a forty eight percentage of GDP so one might might say well that's China debt has you know corporate debt has gone up a lot should we be concerned I think you know again we can drill a little bit deeper into the subject a little bit later my personal view is that you had to get into the deep because if you think about it the China GDP is slowing down if you're still growing at 6:16 a percent a year it's one of the fastest in the world 95% of the Chinese corporate debt is denominated in the RMB and that's different from the rest of the emerging market countries that ratio tends to be 2/3 in dollar terms or foreign currency terms and why is that better because you have less currency mismatch risk because if you can generate your economy make earnings in R and B and you're paying your daddy R and B and you're not subject to the extra layers of you know debt service burden when your currency depreciates when your current economy doesn't do well and you depreciate depreciates against the dollar and your debt terms is actually denominating US dollars and then 10 percent of the debt in Chinese corporate debt is held externally so a lot of that debt is held locally so the triggers in the Chinese corporate debt market is you know has less contagion risk if you will into the overseas debt markets and last but not least I think in Davos we have heard from the Chinese regulator they're extremely responsive to market movements they just cut policy rates they cut bank capital reserves they have cut business taxes so rest assured I think there will be extremely responsive and use fiscal tools and monetary tools to stimulate the economy and the markets if they need to thanks Karen there's very very interesting a very good overview and provides a number of lines of inquiry and particularly that you know the the divergence between China straw rolled China clearly is played in the growth of corporate down the last few years I variant you to know and I'll come to the other other member of the panel as well in a second I'll be very sure to know how that I think is 160 percent of GDP compares historically with two there is something given the particular stances the Chinese economy particular profile of the debt both in terms like that's where that whether there's something to worry about but I'll come on to their I'm sure David but historical and geographical comparison but I want to come on to the minister um Karen talked a bit about the role of emerging market which is actually in which has been significant China obviously accounting for the bulk of it the vast bulk of it but from a policy perspective Minister as you look at this what are the what's on your mind what are the what are your what are your concerns well thank you very much pleasure to be here we look at it with very deep interest to what's happening with a corporate debt you know it's not that the wreck responsibility but it could create you know in the worst case it could create a crisis you know a financial crisis the first thing is I would like to going a little bit deeper into the numbers is that you have to distinguish incorporate that what is corporate debt that is owed to the parent company and corporate debt that is owed to banks to the banking system or financial markets in general that's a very important distinction because the corporate debt that is owed to a parent company is very likely to be rolled over it's unlikely that a parent company would like to create a service problem for a subsidiary and when you take a look at the Chilean numbers for example which we have done 50 percent of corporate debt is owed to parent companies so it's a way companies have a way for different reasons to send more debt you know and resources are incorporated and contributed more in terms of debt than in terms of just equity so it's an issue of how you divide equity and debt in terms of the resources that are spent a second issue which is very important a we are from their countries in this world where you have a luxury of issuing the debt your debt in your own currency there are other countries the normals the mortals you know of this world then we have to issue a large part of the debt in foreign currency and then the second distinction here is a very important to understand if you have a currency hedge or not because if you don't have a currency hedge you are under a an increased higher vulnerability than if you do in the case of Chilean our foreign debt owed in dollars we have over 90% is covered has an exchange rate hedge so in case the currency moves you know and the event of a crisis most likely will have a depreciation if you're hedged you know the situation is different the third thing is the profile of the debt now you have to distinguish countries by the different profiles if you're indebted at five months you know or a year it's very different that you have very long term there are no maturities of investment so I think this is the second look so my my first cut here is that don't take the rough macro numbers you know global numbers and just say okay your corporate debt-to-gdp so much you're in trouble well second view is all these issues corporate 802 you know parent companies currency hedge and maturity of course the conditions you know their countries of you you have a low low spread that's another that the terms at which you're dead are being so in let me take the policy view now the policy view is first we want to be as a government and you know I must say I must confess that I've been in office for nine months but this is my second time in office and you know so I've already been Finance Minister for four years my wife asks me why did I want to come back but here I am anyway Oh a the issue is that if you have a what do you do on the fiscal side on the fiscal side would like to have very low levels of public debt to GDP because overall you take a country and you say it's not only the problem the problem is not only corporate that is the overall level of debt so if you take a responsible view to public finances low deficits and I would also say if you have a structural rule we do have not just spending according to current income to structural income if you have fiscal institutions like we just approved in Chile a a fiscal independent fiscal Advisory Council and we have a sovereign fund you know so all these institutions help you low levels of debt and good fiscal institutions will help you cushion whatever comes from the private sector if things get more complicated I will also mention on the financial side a good you know if you have improved your legal and regulatory standards for example we just passed a new banking law three months ago in the new banking law we're going to Basel three standards so we have higher capital requirements and we have an improved regulatory scheming we have a collegiate body of five council members and to supervise the banking system with a systemic view not just banks but also the whole financial markets you know and and that's a different thing that having a superintendent of banks that looks only at banks so the this is one important to important changes of the new banking law also in terms of the regulation itself we happen we have by law a Financial Stability Council other countries do as well we meet once a month it's presided by the finance minister the central bank president and the heads of the different submarine tendency as the head of the Financial Market Committee come and meet and we follow what's happening on financial markets we look at corporate debt we look at public debt we look at different issues that could draw our attention it could be potentially source of instability so that we preserve financial stability that's the aim of that financial country a financial body the the other thing is to I would say in terms of the what we want to do in our country is to look at financial markets with a view to deepen for example liquidity we want to become and I hope I can convince at least some of my panelists here we want to become a regional financial center and we have a very deep financial market because we have a lot of institutional investors that play an important role among them insurance companies and pension funds and with that if we are able to create a deep financial market we would be in a different position than if we have a shallow market you know so I think all these are parts of a broad view of what the government and what policy should do on financial markets on monetary banking regulation and in fiscal policy to support you know whatever and we take a view that the private sector well they are free to to take debt but they can assume so much exchange rate risk they very limited in what exchange rate which they could thanks thanks mr. Josh becomes here so far we have a fairly sanguine view I think it's fair to say and I want to but I want to provoke perhaps see if I can provoke you a little bit but I mean I guess I guess one of the concerns that the reason that whatever we think of the current numbers and how they compare historically and what they are as a proportion of GDP we're at a point where aren't we we've had this extraordinary 10-year period of monetary accommodation extraordinarily low interest rates this debt has been taken on we are clearly entering already have in the United States a period of steady monetary tightening which can be expected to go on both in terms of short-term policy rates and also quantitative tightening by the Fed we're gonna see more of that in Europe presumably in the course of the next year or so so I think the Pacific concern is not hey you know what are we worried about by you know historic standards when maybe we were at the you know we were at different stages in a cycle but we're - we're at a point in a cycle where we can expect we're already in the early stages of a tight of a tightening cycle which could be quite significant and certainly the amount of easing that is to be unwound is a combination of you know rates again and central bank balance sheets is unprecedented what are the potential risks with this high level of corporate debt that could result as we as we see this as we see is easy on whelmed we did get a little preview of that in the beginning of 2016 the end of 15 the feds started raising rates people were worried about deflation from China oil prices were going down and we saw quite a correction in the market although it then found its footing and recovered more than recovered and we got another preview of it last month I wouldn't a bubble as something to conversed my entire career and I suspect everyone's lifetime in this room bubbles that burst at financial calamities usually take place when you have a combination of excessive leverage with a liquidity mismatch so you own illiquid assets and you have liquid liabilities and there's gigantic leverage on it that was the banking and Jack that was the global financial crisis and then those things get leaked out into not only in the banking system it's in the banking system is particularly bad but even if it's not in the banking system itself if it's in other institutions what's happened since 2008 has made that much less likely and that doesn't mean that we don't have a lot of overheating for all the reasons you said which I'll come back to the reason that's less likely today is that in the last 10 years thanks to regulation thanks to the desire of Bank of bankers not to have a recurring nightmare commercial bank balance sheets are awfully awfully good if you look at the high-yield market commercial banks used to own between 10 and 20 percent of all the product and they made very active markets using their own capital today those banks use none of their own capital to take positions and it's not just because of the Volcker rule they don't do it anywhere and they act as actual agents for their clients as opposed to competing with them as principals so there's good and bad to that the bad news is so structurally they're pretty solid the bad news is that if you look at the consumers who do own these products mutual funds ETFs hedge funds and others the the desperate search for yield against a zero interest rate standard for governments has caused passive vehicles to do very well and there's been this one way train of capital into vehicles that want to look like the high yield index the benefit from going down and as long as you keep ringing the bell and and feeding the dog then it'll keep salivating every time you ring the bell and we've been ringing the bell non-stop with mutual funds to own fairly illiquid assets because the issue of mismatch ie we have to honor daily requirements for capital if we have redemptions even though we have illiquid assets hasn't been an issue because it's been a one-way flow of capital in and the capital comes in those buyers have to buy because they want to look like the index or something measured off the index so that's what happens when you artificially set interest rates at a very very low number the the flip side of that is when an that when that reverses you get to see the the consequences of owning illiquid assets with liquid liabilities and it's even it's exaggerated by the fact that the commercial banks aren't making markets with their own capital so if you're seeking a bid suddenly and we saw outflows of beginning a 16 we saw it again in in in the last month you get some significant problems with pricing along the way you do get some of those debt bubble type characteristics so for example there there becomes incredible competition among institutions who have pension funds and endowments and others who need that yield to survive to buy things and you get all that kind of late cycle overly bullish behavior that causes miss pricing you get poor covenants you get you get the debt markets version of fake news which is pro forma earnings you know note and covenants are not set off v beta they set off of some fake e Batak and that manufactured band back god only knows what you have you have a frenzy of purchase of leveraged loans with with that our covenant light they literally have no covenants and and and then on top of it when there is a problem because the markets are so forgiving and they really want to they want to be able to build money out the the private equity controllers of the companies can act particularly abusive toward the creditors and then in the very late cycles is like it's like when the fall of civilization happens and people start killing each other you get creditor on credit or violence and you start getting CDs war is another kind of you know credit default swap wars and other things so we def definite we had a healthy dose of that which made the par loan market and the par high yield markets at least for us not very interesting places to reside but that's very different from a bubble a bubble is when you have mismatch and leverage when you have when you have mismatch spread out through a bigger and bigger part of the system but you don't have the leverage everybody bears the brunt of that adjustment and it doesn't damage your financial institutions so you're less likely to have those extreme consequences Thank You Josh we will come back to and they've got some other things to say too David you've lived through a significant number of debt cycles both the public and private sector in the US Treasury and the private markets and then lastly of course within the IMF give us a sense of where you see this particular issue in from that historical perspective Thank You Gerry I think we've heard I think all very important and sensible things none of which I disagree with so when we try to give you what I think is the bottom line I think the topic of when the debt bubble bursts is a good topic I think we need to think about that I think there are risks out there Karen laid out the numbers I think when we look this subject carefully we'll find not the aggregate while the numbers are sexy in there Hugh I think it's Karen explained when you look at the distribution of where the debt is and what's going on you find that it's not that the aggregate number that's the issue first we have to remember not all debt is bad dead it necessarily bad people borrow for good reasons and make good use of debt the public sector borrowings that Karen described helped provide recovery the corporate sector be in much worse shape if the public sector hadn't done that and hadn't provided a in the United States a way for the private sector to deliver and that happened and you also have to look at the setting in which people borrow people who borrow interest rates so you can't when interest when interest rates are low with debt to GDP when interest rates are high because it's serviceability that really matters so the composition of this day across countries but also looking within a country at what the debts been used for and what the serviceability really matters so to me the bottom line is that there are pockets of problems in countries the aggregate numbers apart from China China the debt numbers are high I think there are reasons to believe China will keep that under control but let's talk so I'm not hugely worried about that but if you look apart from China the the aggregate debt numbers in debt to GDP numbers with today's interest rates don't seem to be worrisome but I think there are good reasons to be concerned there are pockets of debt that are held by companies that really don't have much servicing capacity we use as a proxy interest coverage ratios Abbott what kind of coverage there is of interest that you owe and there are countries where there are pockets where that's right and I think that's going to be a problem there is as has been mentioned by others vulnerability to macroeconomic changes it's it's one thing in this interest rate environment but if interest rates were to rise say procyclical it's not really happened but if procyclical expansion in the united states had pushed up had forced the had pushed up inflation and forced the Fed to tighten sharply that would change the debt servicing situation very substantially a recession would change the debt servicing situation very substantially if you're in another country like Felipe's on you and you've borrowed in in dollars then the question is not only the what's the interest rate but what's the exchange rate and so you have interest rate and exchange rate risk again to really know what's going on you have to ask whether companies who are borrowing have natural hedges or not in their places where people are borrowing in dollars but there in Turkey the construction industry borrows in dollars but it's building houses and other kinds of commercial real estate so one does have to look I think at the composition and at the vulner is more closely then there's the question abilities of the lenders and it really makes a big deal I mean we care about corporations of course but when court if they're if if the consequences of a decibel bursting is that your banking system collapses and you have to go through again what we went through that's one thing if the consequences are that a lot of people who put money into through asset management companies into corporate bonds there may be reasons that that the the decline in prices will be amplified and so the wealth effects will be amplified but it's a different category of problem that investors wealth will go down then that say your banks collapse and you'd have to bail them out so you know when we look around the world we look at what as an important aspect of whether the corporate debt is risky whether the banking system in the country is exposed and what kind of capital covers they have and what's likely to happen there so again I think then when you when you get to the point that you asked Philippe about the policy questions I think the the kind of bottom line that I'm talking about of looking where the pockets of vulnerability are tells you what policy makers should be looking at I think not only not only would a reset bad in this respect but the world is ready really to fight recession we don't have the monetary policy space the fiscal policy space we don't worry you know in the United States and Europe there are legal limitations on bailing out banks it's important not to have a recession it's also important if you're worried that there are large pockets of corporate in your country of corporations that might not withstand a recession to keep your mont your macro policies on a steady keel and that means not not having procyclical fiscal policy if you're if you're banking system is weak and you're worried that a weakness in corporations defaults operations will cause a banking crisis you do something to strengthen the banking crisis and you want to do it now if you know the many countries are thinking about or experimenting with procyclical capital buffers policies in that area can make a lot of sense and the harder one is about movements of the dollar there I think we believe that currency fluctuation is really a part of providing buffers for changes in the global economy so we certainly wouldn't want to monkey around with that but we would like to see countries like Turkey other countries that have a lot of corporate dollar borrowing be taking a very close look at what the business models of the borrowers are whether they are exporters who really are essentially hedged well thanks David um we'll want to open up for comments and questions in a minute but I want to come back on a couple of quick things actually both of David enter and - Philippe administer after the financial crisis 2008 an extraordinary amount of regulatory apparatus was put in place which was largely directed obviously at ensuring that the banking system was properly capitalized properly potentially regulated that we would avoid the kind of risks and disasters frankly that occurred 2006 2008 and picking up a little more Josh said you know that that's reflected in the fact still you know Bank Bank the bank the banking sector generally in much of the world varies from place to place the United States probably particularly strong Europe has less so but it's clearly and clearly in broader much more sound condition than it was then and it's probably been at any point in the last generation or so I'm wondering Minister and David if everyone could bring comment briefly on this if you would whether given some of the things that David has talked about some of the risks that there could be depending on adverse macroeconomic developments or some other aspects is there a need for tougher regulatory prudential measures in this area in particular has enough been done i mean i again no one thinks this is gonna be on if this does burst in the in in the terminology and I take Josh's point that we're not we don't have the conditions that would lead to that but if we did get to that no one thinks I'm gonna have another two thousand eight presumably but it could be it could have very adverse consequences does is there a need for heightened regulatory activity to to deal with this I think that for the most and I this cannot be completely generalized answer but I don't know the realities of all countries but I think countries have been moving in the direction of a higher standards for banks like this base of three Basel 3 is a very significant increase over the the previous standards and most countries are moving in that direction so to have better capitalized Bank better regulated banks to have issues potential regulatory measures like for example loan-to-value you know if you David point rightly that you have to look at the debtor and you have to look at the the you know the borrower and the creditor and if you if banks are reckless in terms of lending if they lend a hundred percent of the value whether you have a small Inc decrease in the value of property let's say could create a banking crisis if you have loan-to-value in in our country for example we have at twenty eighty twenty percent you know equity that you need to have at least so you you'll end up to eighty but you don't prohibit but you just make it very expensive to lend more you know because of the provisions that go if you go over eighty percent of the value so in that sense you're providing the market with some guidance so that they would you know consider this issue one other issue and again David mentioned the issue of Turkey I think it's reckless that a banks borrows in dollars to to lend to house you know because a currency crisis will will render those loans and collectible and then it will likely trigger a banking crisis so I think that you know loan-to-value currency you know reducing or you know or maybe eliminating currency risk some cases you you make the decision to lend but the but the currency aspect of this could create a financial crisis of had wider repercussions that just on your bank Joshi mentioned I'm struck by what you said about that would drawn up that sound a little bit like the kind of corporate bond version of the kind of laia loans that we were familiar with in the US housing market infamously in the late 90s and 2000's now look I realized that this is a different and David points that out very well that the the risks here are not of a systemic not don't seem to be systemic in nature again as they were in 2008 concentrated in major financial institutions which could literally collapse the world economy but they may be exactly the way that David points out through very you know that the spread very thinly but nonetheless potentially very painfully for a lot of savers around the world is it I mean is it is it I'll ask you first does Josh know us David I mean how is it is it a big enough problem is the market dealing with itself or does actually do eh does the regulator's need to take a closer look at some of these things I don't think regulators need to look at it at all I think the market I think it's just a pricing problem there's a price for risk investment-grade loans never had any covenants by and large nothing they can loan scan go down in value and they pretty much can't go up in value unless they're non callable for a period of time so I'm not that worried about that they do you think they're just priced very fully do you agree that the market is essentially taking gig together I don't know entirely what to think about the leverage loan covenant light segment in the u.s. it's a trillion that's a big number but it doesn't feel like a big enough number to bankrupt banks unless it unless the scenario is really a a very substantial change in macro conditions I think the loss exposure on that trillion frankly is a pretty small yeah I think that's probably right I come back to the core I wouldn't want to warrant that we won't have a banking crisis but I think the more put it this way the more we make banks safer the less likely it is that we have a banking crisis I think that there's been a bit more attention to the question of what could go wrong in this ever-growing non-bank what people used to call shadow banking sector we're a lot more a lot more of the intermediation is now taking place and it comes back to the very important point that Josh made is their liquidity transformation and I think is their leverage in that segment or not that we know large parts of it are really very simple you know someone puts their money into a you know a mutual fund and they buy the S&P 500 or they buy some US Treasuries but there are many other parts of it that are getting increased that are part of the reach rule that Josh talked about and where we and and I but the one the one thing I would say is the question is whether people know what they're getting into you know we have the suspicion that everyone believes that your money in Vanguard or Blackrock or any of those other places can be called but it may well be that if everyone does at the same time and those institutions to liquefy start selling their assets that you get a kind of amplified asset price decline that leads to a kind of run you know a problem a problem that would be rather similar to what made the banking problem much bigger than it needed to be that that it was very hard to value the assets or to know whether the asset price movements were fundamental or part of a of a kind of a run mentality so then you come to the question of is you know should the regulator's be doing something more with respect to the non-bank sector I'm not convinced yet I think it's worth knowing more information I think it's worth making sure that you know in in the in the case of the complex mortgage products part of the problem was customers didn't really understand the complex products that they were being sold they didn't understand the implications of the puts in the in the auction rate securities market and various other segments it may be that we look back on this ten years from now and see that people investing in some complex products didn't know what quite what they were getting into and so helping people wise up would be helpful now on the other hand you know in a search for yield environment to some extent people know they're taking a flier and and and and so it may be on a board can please so just a couple points I think banking regulations been brought up quite a bit I'm the probably the only one on the panel has lived with banking regulation for the last decade I will tell you there has been regulation on leveraged loans that has been leveraged a lot of regulation on you know capital right so Basel three advanced is not enough we have to have a puzzle three standardized and you have to take the worst of two to measure yourself against and that's not that's not good enough if you are globally systemic systemically important institutions she said you have to add an additional capital buffer and most US banks were pleased to report a well above that buffer so you have that and then as if that were not enough we have to look at a supplemental leverage ratio on the capital side and then liquidity this is actually a very important point to the subject liquidity coverage the Kuti coverage ratio was also introduced liquidity coverage ratio really only give you credit if you hold extremely Liberty on angstrom it's really sovereign bonds or agency bonds and things like that so corporate bonds owning core bonds on the balance sheet is a stupid idea to satisfy your liquidity coverage ratio so that got that taken care of then you look at the Volcker trading rule which Josh brought up basically say you have to have this Rendy limit what is that Riis we'll expected near-term demand so you can't really hold more inventory on your balance sheet unless you can justify that's for reasonable and near-term customer demand you're now supposed to be doing proper trading we got that so a variety of that those regulations contributed to less inventory on the balance she always say liquidity gaps but when you think about leveraged lending in particular OCC we have three regulators in the u.s. we have the Federal Reserve we have OCC we have FDIC so when you think about OCC they have introduced extremely stringent leveraged lending guidelines which if you look at the corporate spectrum basically the bottom third we're not really supposed to learn the hold on balance sheet so if you look at the bank's balance should be C in the US it's quite pristine so the assets are extremely high quality and and very conservative so and and I guess the last point if you think about it I just I've proof is in the pudding so who owns these US corporate bonds it's roughly ten trillion dollars number one you're not gonna guess this because I didn't know this before foreigners and that roughly is twenty six twenty seven percent of US corporate bond market right now and I can point out a few Asian countries for example number two you chew funds and ETS and we have a debate about if ETF is actually helping or not helping because I think the jury is out and number three you know be sure is companies and number four pension funds banks not on that list we're not owning these corporate bonds so I think the financial crisis has taught us a you know a really important lesson and financial crisis I think Josh just hit the nail on the head is that we own mortgages on the balance sheet those are a long term illiquid assets when the kwid ecaps occur and we have shorter term liabilities so we own mortgages at the time but now it's a totally different environment we're don't really own these instruments before this particular subject I think you know the asset liability mismatch doesn't really exist thanks Karen I'd like to open it up there already some hands shooting up the first one I saw was gentleman at the back yes if you'd wait for a mic that'll be kind could you identify yourself please sound problem maybe you just shout hello yeah sorry could you identify yourself please yes Daniel Saks I ran the credit investment firm in Northern Europe so I have two questions for the school friends it's Josh if we look at the Covenant light phenomenon not from a from a systemic point of view but if we do our example before over seven five to ten percent workers cab lights away to 11 we had 0% cab light lastly we had 87% cab light in the leverage anymore then the bond market is similar this also means that we'll have less defaults in a crisis because non-payment is really the only thing to wait for how do you think that's going to affect credit markets if we get a cycle we kind of walk walking dead and then just to David on the regulation of non-bank lending and I'm part of that market I agree with you that there's not a lot of systemic risk but there's also very little transparency in terms of leverage and maturity transformation that could be another reason to regulate is there what is the discussion with your peers in the regulatory community is this something that is likely to happen or not thank you the numbers I I know are a little bit different from yours and I think have light was hitting around 30% in oh seven before the crash but it doesn't really matter what's interesting though is that the CLO market which actually owned tons of cuff light bank debt on major leverage ten times leverage but there was no mismatch sailed through the financial crisis without a default pretty remarkable including some pretty mediocre managers in my humble opinion I mean there are some mediocre they have to be by law of Statistics with so many of them but none of these things defaulted but that's because their liabilities never got called now you could argue today that there being more aggressive in terms of the way bank that's being structured that there's more flexibility of sponsors to do things that are abusive to the bank debt then poor quality companies that's that's the business cycle as long as you don't have those key central institutions that are carrying all that leverage owning things that are a problem there's a limit to how much the the government should be protecting investors from their own foolishness it in my view you you just have to be highly discriminating on what you buy and I think the pricing wasn't very good at protecting you from the types of consequences of giving that kind of latitude to a borrower and so the power loan market wasn't so interesting we saw we saw a little bit of that correction take place in December and we saw prices for bank loans all over the place dropped by five points and and now you add the discount plus the spread off of off of a LIBOR that's actually a real number instead of zero and you have the the extra margin and all of a sudden there's an enormous rate of return that you can earn on some of that bank debt if there's just a little tightening in the market so yes there's a risk but there's a pricing of that risk and and I think that's the nature of the of the market I think markets are pretty good at correcting those things generally speaking it's a little more difficult to have the markets correct those when the government is constantly and and for good reasons and well attention reasons constantly in the market with quantitative easing programs and with the Fed buying paper it's very very hard because that's what people are competing against when the Fed backs out a little bit all of a sudden the market has to find the prices of risk assets it without that sort of independent standard sitting there do you want to respond particularly to the regulatory question I just basically said that if you're acting like a bank and you caused systemic risk you brought the regulatory perimeter but that said I don't see much of a move to broaden the regulatory perimeter very substantially to cover well for them the main categories of non banks because we're seemed to be much leverage and there doesn't seem to be I mean there's maturity some maturity transformation but it's the risk stands with the investor Blackrock doesn't put its capital at risk and in one it invests so I don't I don't I don't I don't see we always want to know more and look more closely more and more on nature of maturity transformation quiddity transformation in the non-bank sector we learned that there were emerging risks we probably want more questions comments please yes sir here please identify so yes hi I'm Daniel Belfer from Jay suppressors in I think the panel made a very clear point about the banks balance sheets and how they've improved to what extent should we really worry about the market structure I mean the amount of passive investing in fixed income has gone up a lot but training volumes have gone down a lot and the amount of triple B that relative to high-yield for example has gone up tremendously one investment bank says it's gone up from two and a quarter times to three times in the US and three point five times in the in Europe so to what extent when the recession comes and we got the usual down grades we usually get do we have this indiscriminate selling affecting markets can't sure i think i think i think you know make no mistake we're definitely not saying on the panel that you shouldn't worry about I think all the points that you made are extremely valid investment great universe in the u.s. is roughly seven trillion dollars forty percent now is triple B and that's roughly close to three times leverage to your point it's gone up relatively quickly it used to be you know one point seven one point nine times so that is a pretty alarming increase in terms of just the leverage that's English Ruby space and obviously we've seen multiple defaults directly out of the investment grade out just directly to default I mean you see Iran you see Lehman Brothers you've seen a Mobil and not you know just a few weeks ago we had a potential a PG&E so I think when you see this type of you know trends on you know in vice premier suppose I go to high-yield if you get downgraded you know when you go to record to fall you do get a little bit worried about the fundamentals right I mean GDP growth is coming down earnings growth I mean that's actually I don't know you know if you knew this that the q3 I think the u.s. earnings growth EPS growth was 20% you slowed to 6% potentially in q1 so that's a drastic you know slowdown so in terms of earnings obviously there's a lot of tail risk concerns we literally have four brinkmanship going on right now in the macro basis you have you know government shut down in DC that's a brinksmanship you have brexit you have the yellow vet you know yellow vest versus you know the Makua and then you also have the us-china trade war so macro definitely drives micro right now you can definitely do a lot of fundamental analysis but I think any of these mackerel tail risk factors move your markets move but to answer your direct question on so we definitely think there's concerns default rates are picking up I think high-yield default is it you know highest market size quadrupled in the last decade and that's two trillion dollar market and that default rates probably picking up from 2% two and a half percent to now potentially four or five percent so that is being you know that's already 20 realizing right because fundamentals are getting worse but when you think about supply and demand the reason I went through the different categories of purchasers and holders of these debt is that you know mutual funds and ETFs to your point and I need Josh made an excellent point and potentially for sellers because obviously they have inflows and outflows a very technical thing to manage but obviously they're not a you know largest group and you have three other groups potential potentially balancing that and I think the market structure is evolving you know the electronification is happening twenty-five percent of investment grade bonds are traded electronically which you know depending on which side you stand on you don't does that exacerbate problem seeing a downturn or does it help with liquidity and provide a circuit break I mean that's again I think the debate debate is is ongoing right now and 15 percent of the high-yield bonds are traded electronically so we have to think about you know banks use to provide liquidity and make markets now it's not just the banks it's ECS its market access it's all a lot of these electronic trading venues so we have to think about the fundamentals you know on a macro basis we had to think about supply and demand and think about the trading venues and think about potential ease you know these technical issues as well so I think it's it's a pretty complex issue Karen thank you well let's move over yet we've got some more questions yet another gentleman in the back there hi CEO of Nova Holdings just Karen picking up on your point I think there are red flags out there but it strikes me that there is every reason to make sure that we have a soft landing rather than a bubble or a crisis the reason is growth is slowing down but we still have growth tightening is taking place but much slower than anyone thought interest rates will probably not rise as fast in the US as we'd for a few months ago Europe they probably seemed on hold like China you've mentioned so there's a real you know it seems to me that there's a period we have a long time to adjust so isn't this isn't this really a test now for regulators for central banks to step up and say the red flags are there but thankfully we've got time to adjust isn't this time too and I'm not sure how it would work but to send signals to a be of a and say no debt issuance to a sub investment great company that takes it to seven times coverage or what have you maybe there's some other measures but it strikes me that if we use the space that we have to make this adjustment in a gradual way then I think we could be in a pretty good place do you want to respond quickly others are - it was addressed to you Karen but you want I you know I I definitely agree with you I don't think there's a systemic crisis I think you know maybe the panel agrees as well I definitely think there's going to be fundamental issues out there to your point and we do I personally am NOT you know I'm always optimistic I definitely am nodding the you know end of xix recession camp for sure and I think we do have time to adjust and they think of many of these macro factors have to play out as well and I think regulation obviously can always be tweaked but you know I think regulation has played a very important role so far but on leverage get you know lending guidelines all that yeah I mean none of you seems to think to responding to that question that there is as Karen says however how we characterize what's going on there is systemic risks that require regulatory in a significant regulatory action beyond two is that is that fair look I think there is there is a I think a rather fundamental question about public sector role Josh raised the question of whether you should protect investors against making mistakes you know the approach that was taken before the last crisis which didn't work was to try to regulate the banks you know Tim Geithner went through a whole project the Corrigan project to see after LTCM it was clear that there were hedge funds that were gonna get in trouble and the question was do you regulate hedge funds well hedge funds are individuals and if they want to risk and lose money they can was the philosophy so what you want to do is you want to regulate the banks who lend the money to the hedge funds to make sure that the banks don't go broke well we we missed an awful lot of things that banks were doing that were risky and so that approach failed but you still have the fundament the same fundamental question to go to the opportunity to address what was asked do you do something about corporations that go on borrowing even though they don't have very substantial earnings borrowing money from people who are willing to lend them money or do you just hunker down and make you know make sure that the banks are sound maybe maybe put in place counter-cyclical capital buffers or type you know batten down the hatches in other in other respects to make sure that when people go broke it's their own losses and it doesn't become a systemic problem I'm not saying that that's the right emetic we we failed before I'm just wondering what I'm a because what's the public interest if a bank is if sorry if if a company is continuing to you know borrow excessive amounts and people continue to willing to lend to it what's the you know what I mean what were you expecting a true what's the what's the what's the regulatory obligation there I think you have to do exactly what David says who do you bring within the regulatory circle there's no prohibition on allowing an equity mutual fund to pay some insane amount for some stock right and then watch it decline 50% we don't say oh my god we should regulate the mutual funds over the government ensure these poor investors you know they we do say that you can't have fraudulent financials we do regulate what you say to the public when you're the CEO and when you're not the CEO we're in the CFO and you're making we have regular we have all sorts of regulatory system just label it's just a quick sentence sorry look the economic the conceptual point is if there's an externality you regulate if the banks were providing leverage thinking about their own survival and profit and losses but not realizing that if everyone was doing it and the whole system was going to collapse there's an interest in trying to make sure that they internalize the externality but if it's just company a borrowing from investor B and there's no externality there's I think there's less of a public role leave a you want to say quickly yes I think the the first thing is that yes will you regulate when you think there's an external you also regulate in particular you have special regulations if you regard there is systemic risk one thing is a failing I mean either if a company fails you know but maybe that's nothing to do with public policy the failure of a company unless it becomes big enough that is your part is the system which organizes the banking the financial system I would like to do you know point out to a couple of things non-regulated you know financing I think shadow banking but also you know whether in a in a concept there are many countries like you have seen the explosion of car loans car loans and and they are unregulated and suddenly they may be a bubble on Carlos so you have to be always looking at where you should need to be to have an eye and to bring it into the regulatory circle on the issue of David mentioned the issue of counter cyclical you know buffers well based on three has counter cyclical buffers you know you have special types all right you know it's the question of whether people were invoking you know central bank's have to decide - oh sure so so maybe if you have the Basel three that's the first start and then you of course there are periods - I would just like to say one more thing which is important it when we look at this sometimes there is certainly a role for public policy here and I don't take the view that we should regulate everything that moves you know we should let private enterprise you know move and try to create and and and not be a hurdle on the way but there are ways in which you know the unregulated markets you know will bring a problem to the system and so and one other thing that we have not discussed we're thinking about a recession I and we say well yet we're not in a recession was just in a growth slowdown so nobody in the panel really thinks that we're on the verge of collapse you know or a debt or or a bubble that will burst but we should also take the view as and I take the view from public policy that we should do more to reinvigorate growth because after all this is debt to GDP it's not just about the absolute increase in debt numbers well whether you're really doing to do some structural changes in the economy that will increase your potential growth and your current growth so that the debt GDP numbers you know you probably won't cut that GDP numbers just stabilize you know them in time maybe you know you don't cut the absolute debt but the debt GDP if you're able to reignite growth thankfully but we got time for a few more questions and I didn't want to get anyone very very quickly yet so I think the other thing that we didn't talk about which is actually probably elephant in the room is that actually private right so you look at you know private debt and when you think about private debt the reason this actually keeps me I keep thinking about this this this question is because I don't know the answer to it is that when you look at the number of US public companies to 20 years ago it was roughly eight thousand today forty-three hundred so it's roughly half so you talk about finance shows we talk about governing you know looking at corporate leverage whatever so there's a lot of companies are private and the dry powder in the private equity sector right now for the next five years of investment period is roughly 1.2 trillion dollars and there's private debt growth as well so there's a lot of debt and equity that's actually even away from the public space when you actually have you know probably we just don't have a lot of transparency so when you think about that and you think about the overall size I think there's something to consider thank you thanks so uh gentlemen there with a beard hi Henry Kerr from The Economist magazine I was just wanted I was interested want to take on this idea that the reason that you would care about the banking system about systemic risk is just you know the failure of the banking system and they have a corporate gets into trouble it's not a problem if it doesn't pose systemic risk isn't it the contrary isn't the reason the social purpose of regulation of the banking system that you if it goes down you might get a credit crunch which cuts cuts off a credit supply to corporates which might then go bust and cause problems and if that's the case is the distinction between the banking system and the rest meaningful I mean the idea that investors should bear losses you could apply that equally to bank creditors and it didn't have happened last time around but further to that even if we did buy the view that it's just the market can sort it out in advance what should the appropriate policy response be after a shot with pricing of risk is the implicit view it's just monetary policies job to sort of start by cutting interest rates enough thank you if the I think you're absolutely right that the reason why we care about the soundness of the banking system is that if and when it fails it affects the economy more broadly now if all corporations were had so much debt that they were about to fail one can make an argument that the whole economy would come crashing down but I think it's more likely that we will see pockets of problems there are a set of companies in the United States and several European countries where the interest coverage ratio is a low one and a half and they're you know I think the problem you could assess the probability of default for those those the failure of those companies is not something that would you know it would affect the GDP but it's not something that would be systemic to the to the economy so I think it does make sense to try to [Music] make sure that the banking system is sound that's where leverage can be we know from the past leverage can be granted without anyone taking account of how it all adds up to increase systemic risk I just you know I don't think that the that the corporate debt problem in advanced economies and in most emerging market economies right now is of that same order magnet thanks David any more questions comments observations no just very quick summary then if I may I correct me if I'm wrong my overall impression is that again as I said earlier we understand the scale of this of what's happened to corporate debt because of the very nature of corporate debt because of the disintermediated nature of debt there doesn't seem to be a systemic risk financial risk risk systemic risk to the to the financial system what are the just very quickly from the panel as we go through this next year and we do expect I mean we could see we could see some of those macro events that we've all been talking about we could see we could see higher interest rates although there are expectations of that are dimming slightly but you know if we don't see that then the risks of a demand shot of a recession could be quite significant very quickly each of you've got a skew as we go through the next year what are the what what what you'll be looking out for in the course of the next year in the corporate bond market are we can we expect to see the kind of some of the sort of short-term distress that we did see in 2016 and if so what's what what's likely to be what I'd like to be the implications are the mind the policy responses Taran Clinton sure so I think you know one thing that that David brought up that's very very important is I think and now it's the era of fundamentals you have to really look at you know it's not a beta you know rising tide lifts all boats anymore you gonna have to understand the corporate balance you have to understand the fundamental fundamentals of a corporate credit that you're actually buying have to really do work you know and you look at developed countries I think you know that the the companies with less than 1/2 using David's number debt service coverage ratio is roughly 10 percent when you look at emerging markets corporates you're looking at roughly 20 25 percent the issue is what if the Fed is not on pause what if we come out with all of these macro events you know fantastically and we all of sudden are going back on a hiking cycle any interest rates go out 200 basis points and that's what I think about and I think that's when you potentially have companies being pushed into a risk year category and using that again using a 1/2 debt service coverage ratio as a guideline then USC develop countries having tempers right right now it's 10 percent of the companies that will go up to 20 percent or even two markets they'll go from 20 25 percent of the corporates to 35 to 40 percent so that's where I I'm worried about this interest rate sensitivity we talked about currency hedging we talked about so you have to understand interest risk you have to understand currency risk credit risk and all of those things and I think that's that's very very important Philippe you're a policy maker you're paid to worry what what do you what do you worry about well first of all I would look at the issue of how is a you know growth moderating how fast is growth moderating because if you have a very you know substantial moderation of growth and you have a significantly slower growth the things are gonna get more complicated the issue of interest rates that you mentioned current is very important what's the pace of increase of interest rates if there is this you know moderation in the pace of it will help also you know to cushion the circle and to cushion this the this cycle the other aspect and I would take the view for all emerging markets are not only emerging but are commodity exporters a slowdown in China that has significant effect on commodity prices will be a cause of concern you know so this is the kind of thing that we would be looking in not only in my country Latin America with a very few exceptions there mainly commodity exporters and if you look at Middle East and in Africa commodity exporters so you have even industrial countries which are having you know Australia New Zealand commodity exporters so I think the issue China has such an amazing and you know a big effect on commodity markets that is way beyond the weight in the global economy that for us is a very important issue I I would expect continued volatility and maybe much more heightened volatility especially in the non-investment grade markets I think you continue to have the structural fragility of the market that you saw driven by passive funds and index funds so I think you have that mismatch of assets and liabilities not leverage so I don't think it's the system systemically bad and not located in any of the intermediaries but in effect some your talk about regulation a little bit and to some extent the regulations prevent the banks from performing one of the jobs they perform which is providing liquidity so when you have less liquidity and you have mismatches of assets and liability and mutual funds the the fragility gets exposed quickly when rates start to go up and and so you have to watch those exact factors in the real economy and that laundry list of unaddressed problems you know from brexit to trade to and so on and so on and you left to look at growth and you have to look at commodity prices and I think the effect of those can actually have a pretty material effect the last thing I would say is that one thing that was demonstrated with the Fed raising rates was that the the ability to fine tune from the government's point of view is actually somewhat limited I don't know what fiscal arrows left in the quiver after the tax cut it's you can't all of a sudden I mean you have to watch government debt too we talk a lot about corporate debt but you know government debt is the place where the debts been accumulating and and and clearly if you take your foot off for even a second in monetary policy it has a pretty extreme effect so so I think we have to be more focused on those real those real factors and the structural factors of the market thanks Jules lost would David briefly I think Josh is right that fragility is really risen but as in many things in economics the macro usually matters the most we've been saying that countries should fix the roof while the sun is shining that's all the more the case when your corporations where corporate debt is a fragility as it's all the more the case when you know that policymakers have less policy space whether monetary fiscal or otherwise so the the most important thing is to keep economies on an even keel as Philippe said we'll try to provide a better growth environment and avoid the next recession certainly avoid if and when it comes being something worse than a garden-variety recession thank you very much we'll be back next year then with when the sovereign debt bubble bursts but in the meantime I'd like to ask you to join me in thanking our panelists a very long day [Applause]

Channel: World Economic Forum

Views: 28,269

Rating: 4.5539036 out of 5

Keywords: economy, AI, tech, work, technology, automation, World Economic Forum, democracy, leadership, WEF2019, Davos 2019, finance, Davos, 4IR, politics, education, future, news

Id: VM47yu5GdHI

Length: 71min 2sec (4262 seconds)

Published: Sun Feb 10 2019