Credit squeeze: What next?

Listen to this article


Mohamed El-Erian manages Harvard’s $35bn endowment fund, one of the most successful in the US, and will join Pimco in January.

He tackles the credit squeeze in an FT comment piece, predicting that the US economy will slow - but not enter recession - in the aftermath. He also argues that central banks and regulators are right to inject liquidity and crack down on fraud to bolster the financial system.

But he warns that “politicians must avoid the temptation of going too far” or risk “derailing a comprehensive repair job.” One risk he singles is that sovereign wealth funds, which could provide liquidity and assist the repairs, may be hindered by protectionist measures.

So how did the complex financial activities that led to the credit squeeze end up being hidden from sophisticated oversight and regulatory bodies? How are markets emerging from the turmoil and what are the prospects for the global economy? And what action remains to be taken, in particular, on sovereign wealth funds?

Mr El-Erian answers readers’ questions below.

To what extent do you think that the credit squeeze is a result of too complicated financial products and if so, who’s to blame? Buyers, sellers, rating agents, authorities?
Matti Virtanen, Espoo, Finland

Mohamed El-Erian: The welfare and efficiency gains enabled by the proliferation of complicated financial products, particularly structured finance, come wrapped in a new configuration of risks. And this summer’s dislocations illustrate two phenomena that have historically accompanied “technological shocks”: first, an initial phase of over-consumption and over-production; and second, a tendency for the newly-enabled activities to out-pace the ability of the system to accommodate and sustain them.

The first phenomenon was highlighted in the eagerness of certain financial intermediaries to shift to the “originate and distribute” model, thereby weakening an important component of due diligence in the system; and in the willingness of certain investors to capture higher “carry” by assuming complex risks that were not fully understood and transparent. The situation was accentuated by the outsourcing of some important internal due diligence responsibilities to credit rating agencies and other third parties who were facing their own challenges.

The second phenomenon entailed a classic sequencing problem as, in some cases, the willingness of portfolio managers to use new instruments/products was not matched by the ability of middle and back office functions to adequately support them. It also involved a migration of complex activities to jurisdictions lacking sophisticated oversight.

Is it realistic to expect China to grow at around 10 per cent in the next 10 years?
Vincent Tan, Hong Kong

Mohamed El-Erian: If China continues to grow at 10 per cent for another ten years, this would be a remarkable accomplishment on top of an already impressive economic achievement - both on a stand-alone basis and relative to other historical episodes of break-out growth performances.

It is likely that, absent an internal policy mistake and/or a contraction in the US, China’s growth rate will gradually slow though remain quite robust. It is also likely that the drivers of the growth will become more dependent on internal components of aggregate demand and less a function of export expansion.

Do you agree with the Greenspan/Bernanke prediction that inflation and long term real interest rates will start to rise globally within a couple of years as the disinflationary forces of China et al starts to wane? (If so, what would be the key early warning signs to watch out for?)
Cormac Leech, Beijing

Mohamed El-Erian: For the last few years, inflation containment policies have benefited from the impact of productivity gains in industrial countries and the influence of large segments of workers in emerging economies (and China in particular) joining the global labour pool. The result has facilitated the maintenance of low and stable inflation.

Looking forward, both these forces are likely to dissipate. As a result, the global tailwind for inflation containment will likely dissipate, thereby complicating the policy challenge and the outlook for interest rates. Moreover, the tailwind could even be replaced by a headwind on account of two factors: first, the impact on commodity prices of high growth in emerging economies; and second, rising wages as they gradually converge to world levels.

Given these considerations, early indicators of the shift include the evolution of production costs in emerging economies, the persistence of high commodity prices, and indicators of productivity trends.

Have the world’s major markets matured to the extent that they can now withstand what are considered major crises?
Immy Ryan, US

Mohamed El-Erian: Yes, but not entirely. The rest of the world, and in particular emerging markets, have developed a number of circuit breakers: Huge reserve cushions, strengthened institutions, improving governance, macro-economic stability, and real activity that is starting to benefit more from domestic components of aggregate demand.

As such, international markets are better able to withstand episodes of technical dislocations originating in the most sophisticated financial system in the world (the US), albeit with one important qualifier - that such technical dislocations do not contaminate the economic outlook to the extent of inducing a sustained US economic contraction that would pull the secular legs out from under the growth dynamics in key emerging countries.

Would you believe further interest rate cuts by the Fed are helping the US economy? If we all agree that the US savings rate is too low, shouldn’t one have to raise rates rather than lower them? Isn’t the US digging itself deeper in the hole?
Kees van Ravenhorst, Heemstede, Netherlands

Mohamed El-Erian: The recent reduction in US interest rates is a reaction to both the weakening of economic activity and the need to unclog segments of the financial system. As such, it seeks to avoid a “forced” upward adjustment in the US saving rate that could be disorderly, disruptive and involve significant collateral damage. The strategy, while understandable and appropriately designed, is not without risks - the main one being postponing rather than easing the required economic and financial adjustments, including by fuelling moral hazard and balance sheet over-extension.

Should a central bank’s central role be that of maintaining the purchasing power of its national currency, or should its primary role be to protect the economy and employment rate? The Fed is putting to risk the US dollar’s status as a trusted storer of wealth throughout the world. How dangerous is this?
Lewathan Asrat, US

Mohamed El-Erian: A central bank’s main role should be maintaining domestic financial stability which, operationally, is conventionally defined in terms of containing price inflation for goods and services. Depending on the institutional set-up, some central banks have other responsibilities - most notably in the US where the well-being of economic activity is a mandated objective, and the smooth functioning of the banking system is monitored closely.

In such a framework, the value of the dollar would become a major consideration for the Federal Reserve if its recent weakness were to adversely impact inflation, growth or banking stability. This is not currently the case.

Your question also suggests that the Federal Reserve is behind the recent weakness of the dollar. While the reduction in interest rate has had an impact, this should be put in a broader context that incorporates the reality of the high current account deficit in the US, the gradual diversification of reserves away from a very high concentration in dollar-denominated assets, and the growing economic disparity between the US and the rest of the world.

Last quarter in the middle of the subprime fallout you commented that leveraged plays on illiquid investments was over. If this was the source of outsized returns pre-subprime - where do you see returns coming from in the post-subprime market?
Eric Guichard, Washington, DC

Mohamed El-Erian: As global liquidity normalises over the medium-term after years of exuberance, leveraged exposure to illiquid segments in industrial countries (for example, via private equity and real estate) will no longer be the primary driver of investment out-performance. Indeed, the outlook for out-performance depends not only on seeking new return opportunities, a significant part of which will have an international dimension; critically, it is also a function of enhanced risk management approaches, including the ability to navigate market pull-backs, institutional failures, and liquidity “sudden stops” that are likely to periodically occur in the period ahead.

Would you agree that the answer lies in greater transparency and quicker access to information? It appears to me that the central issue is a lack of understanding in the markets and the big banks over who was carrying the can, leading to a lack of trust and a subsequent drying up of liquidity. The markets had to wait until the earnings season until these institutions started confessing up, and now confidence is returning to the market. Would you agree that the time is right for a renewed investment in up-to-date Business Intelligence and Insight Discovery systems for financial institutions of all sizes? Systems that can share information and quickly analyse pools of risk?
Dan Hawker, London

Mohamed El-Erian: I agree that timely information is key to the proper and smooth functioning of a market system. Information failures create discontinuities which, at the extreme, can inhibit buyers and sellers from coming together - as was the case this summer in several market segments. The result is market turmoil and liquidity dislocations, including the possibility of disruptive “sudden stops.”

This summer’s debacle has illustrated the extent to which complex activities have migrated to jurisdiction outside the purview of sophisticated supervisory oversights and robust information dissemination mechanisms. It has also illustrated the danger of investors outsourcing due diligence responsibilities to rating agencies and other third parties who face their own challenges. As such, I agree that the financial industry will witness renewed interest in strengthening information flows, risk management, and portfolio analytics.

With global liquidity still fragile and higher financing costs both for the consumer and corporate feeding through the system, why are equity markets so resilient? On one level it seems the opportunity for large scale private equity bids is hampered by the overhang in the leveraged loan market and consumer growth feels like it should be stymied by tighter lending conditions, yet equity markets appear able to shrug off any of these concerns.
Andrew Bristow, London

Mohamed El-Erian: The equity markets are taking comfort for the moment from three factors in shrugging off the impact of higher financing costs and a more subdued “private equity bid:” first, the general resilience of the global economy, including robust growth outside the US (particularly in emerging economies); second, the willingness of monetary authorities in industrial countries to effectively re-liquefy the system through interest rate cuts and emergency liquidity injections; and third, the availability of fresh capital on the sidelines looking to gain risk exposure.

How different will the investment management business be in the next 10 years, from its current structure? What are the primary forces of change that are driving the transition? What are the critical success factors that are needed to become a successful player in an emerging market?
Adnan Soufi, Jeddah, Saudi Arabia

Mohamed El-Erian: The likely evolution in the investment management business in the next ten years is likely to be driven by three major trends: first, an expanded use of modern portfolio management tools; second, more efficient and cost-effective delivery of market returns (“beta”) and true value added (“alpha”); and a better understanding of client needs as they relate to return objectives and risk tolerance.

In the process, these drivers are likely to induce institutional re-alignments. Among other things, we will experience a blurring of the current boundaries between “traditional” investment managers and “alternatives.”

As regards your question on emerging markets, the most successful players will be those that are able “to complete market segments” rather than continuously chase returns in the most popular instruments. This can be done in several ways. It can involve linking an existing asset (e.g., the housing stock) to a more robust source of demand (such as that associated with the growing influence of the middle class); it can entail the application of modern portfolio management techniques to under-exploited opportunities; and it can take the form of opening up market segments that were previously inaccessible due to an inhospitable macro context and/or weak enabling conditions.

If you have to choose one label, do you see SWFs as asset bubble creators or investors of last resort?
Phil Uhlmann, Boston

Mohamed El-Erian: Neither! If I were forced to use a simplifying label, and I generally resist doing so, I would use “diversified investors” for some SWFs and “maturing investors” for others.

What are your expectations regarding growth for 2007-2008? Will the US experience a recession? Also, what are your expectations regarding commodity prices?
Patricio Morat, Charlotte, US

Mohamed El-Erian: My baseline expectation is that the US economy will slow appreciably but not contract, and that the rest of the world will continue to decouple gradually led by continued robustness in key emerging economies. In such a scenario, commodity prices will remain elevated given both the growing demand from emerging economies and their relatively less efficient use of commodity inputs. I would also expect a considerable degree of price volatility as the impact of higher physical demand interacts with some supply responsiveness and fluctuating financial demand on the part of asset diversifiers (acquiring larger commodity exposures) and more speculative flow.

The balance of risk to the growth and commodity baselines is tilted to the downside. This is on account of the fragility of the US housing market, over-stretched consumers, and the gradual pick up of inflation in emerging economies.

Copyright The Financial Times Limited 2017. All rights reserved. You may share using our article tools. Please don't copy articles from and redistribute by email or post to the web.