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Panos Mourdoukoutas
Panos Mourdoukoutas
Articles (6) 

The Twisted Mind of the Credit Market

Credit markets are getting in a twisted state of mind these days. Investors are willing to lend money to the heavily indebted Japanese and American governments at ultra-low returns

July 06, 2020 | About:

Credit markets are getting in a twisted state of mind these days. Investors are willing to lend money to the heavily indebted Japanese and American governments at ultra-low returns.

As recently as last week, the US 10-year Treasury bond was paying a yield of 0.66%, while the Japanese 10-year Treasury bond was paying no yield at all.

There seems to be a disconnect between risk and asset prices of all kinds, Professor Christos Giannikos, who teaches options and futures at Baruch College and Columbia University, said. With bank deposits paying next to nothing, investors chase after stocks, bonds, and any asset offering some yield, ignoring risks.

Lower Treasury yields in the face of soaring national debt contradict basic finance, which argues that soaring sovereign debt usually boosts the demand for loanable funds, and eventually the yields of the bonds issued to finance it.

The performance of the U.S. Treasury market back in the late 1980s, when a rising national debt was associated with rising T-bond yields, attests to this theory.

Whats different this time around? Several things.

One of them is that the central banks of the two countries have been major buyers of their own Treasuries, helping maintain credit market liquidity high and yields low.

Under normal circumstances, this situation would result in inflation and higher bond yields. But inflation is nowhere in the offing as the economies of both countries operate below full capacity. U.S. capacity utilization has plunged from 79% in 2015 down to 65% last month. Japans capacity utilization dropped from 105% to 96% over the same period.

Then theres a spike in personal savings in recent years that has raised the supply of loanable funds. U.S. savings rates have risen from 6.3% in June 2015 to 13.1% in February 2020, while Japans savings rate stands at 17.1%.

And theres the status of America and Japan as safe havens for savvy investors from all over the world that boosts demand for the U.S. and Japanese Treasuries.

That begs the question: How did America and Japan maintain this status as their sovereign debt soared? Because the debt situation of the rest of the world is in worse shape than America and Japans.

Americas debt to gross domestic product ratio is 106.80%. Japans debt to GDP ratio is 238%. While these are record numbers, they are well-known as the American and Japanese governments do not own banks and productive enterprises to hide additional debt.

That isnt the case for other governments around the world, where its hard to figure out what their true indebtedness is. Like China, where the official government debt to GDP ratio is 48%, but the unofficial rate is anyones guess.

For a good reason: piles of loans from government-owned banks to government-owned enterprises, which makes it extremely difficult to figure out what the debt of the broader government is.

Compounding the problem, the simultaneous government ownership of both the crediting and the borrowing institutions concentrate rather than disperses credit risks.

That creates the potential of a systemic collapse -- as the Greek crisis so colorfully established.

Meanwhile, government ownership complicates creditor bailouts. The reason why the haircut of Greek debt had such a pervasive impact on the Greek economy is that government-controlled banks and pension funds were the creditors of the general government and government-owned enterprises.

Simply put, one branch of the government lent money to another branch. And the haircut shifted losses from one government branch to another.

The situation is even more dire in China, where the outright simultaneous government ownership of banks, pension funds and common corporations have yielded an odd state in which both the creditor and the borrowers are government branches.

Government-owned banks lend money directly to government-owned corporations, which usually function as welfare agencies; and to land developers, who are behind the countrys investment bubble, one of the engines of the Chinese economy.

Could you imagine what would happen to financial markets in China if the country undergoes a Greek-style crisis one day? Shouldnt investors hold American and Japanese government debt rather than Chinese government debt when that day arrives?

In a world swimming in debt, its better to lend money to governments who know what they owe, how much they owe and to whom they owe.

Credit markets may not be of a twisted mind after all.

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About the author:

Panos Mourdoukoutas
I’m a Professor of Economics at LIU Post in New York. I also teach at Columbia University. I’ve published several articles in professional journals and magazines, including Forbes, Barron’s, The New York Times, Japan Times, Newsday, Plain Dealer, Edge Singapore, European Management Review, Management International Review, and Journal of Risk and Insurance.

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