Is the Fed unwittingly engineering a Recession?

The Federal Open Markets Committee (FOMC) increased the FED funds target rate yesterday, for the fourth time in 2018, by 25bps to take the Fed Funds Target rate to 2.5%.  Much of this increase was widely expected as the FED had been communicating the future interest rate direction through its “dot plot”, the latest of which from yesterday compared to the Sep 2018 view is given below:

Note: The dot plot is updated each time the Federal Reserve votes on whether to raise or lower interest rates. It plots where each member of the Federal Open Market Committee believes short-term interest rates, specifically the fed funds rate, will be over the next three years.

We can infer from the dot plot that a further hike of up to two times in 2019 is expected which has shifted from the previously held view of 3 hikes for 2019.

The Federal Open Market Committee released on Wednesday, the 19^th December 2018, the following statement (excerpts):

“Job gains have been strong, on average, in recent months, and the unemployment rate has remained low. Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier in the year. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Indicators of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee judges that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term. The Committee judges that risks to the economic outlook are roughly balanced but will continue to monitor global economic and financial developments and assess their implications for the economic outlook.

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 2-1/4 to 2-1/2 percent.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective.”

The Fed ignored repeated calls from U.S. President Donald Trump in the lead up to the decision to refrain from lifting borrowing costs again amid the volatility in financial markets.  In a way, Trump had put the FED in a bind as even if they wanted to pause, it would appear as if they succumbed to the pressure from the White House and that would have undermined FEDS independence in the eyes of market participants and caused serious damage to its reputation.

The markets reacted negatively with stocks across the world declining by ~1.5% to 3% following the rate hike. The Bond yields fell further with 10 years treasury yield now lower than 3m Libor! The bellwether 2-10s UST spreads (difference between yield on US Treasuries of 2 years and 10 years) now 5bps apart! A negative read is a harbinger of recession.

Market participants are sending the Federal Reserve a message that it might be making a policy mistake by raising rates at a time when inflationary expectations are tame.  But it’s not just about the policy rates.

A more burning concern is about the unwinding of Fed’s Balance Sheet, a.k.a. “Quantitative Tightening”. Since October 2017, the FED has been steadily reducing its holdings of Treasuries and mortgage-backed bonds that it bought during the crisis era post the collapse of Lehman Brothers.  The FEDS Balance Sheet has increased from $800m in 2008 to close to $4.5T in Sep 2017.

Post Lehman Brothers collapse, GDP was contracting and the economy was losing hundreds of thousands of jobs each month and the United States economy fell into deep financial crisis.  The Fed funds target rate was already close to zero with no further room to cut rates.

Not wishing to pursue a negative interest rate policy (NIRP) like the ECB, the U.S. FED took unprecedented steps to spur the economy and nine years ago embarked on a Quantitative Easing program buying trillions of dollars of government bonds and mortgage-backed securities to add liquidity into the economy. The Fed’s bond buying, or quantitative easing, pumped trillions of dollars into the banking system to support the economy after the financial crisis. (The Fed bought bonds from pension funds and banks and paid for them by crediting their reserves with the Central Bank). Between 2008 and 2015, the Fed's balance sheet ballooned from ~$900 billion to ~$4.5 trillion. 

Now, with the economy on much stronger position, FED is unwinding its bond holdings and effectively sucking out liquidity from the system. Since Oct 2017, the FED has reduced its Balance Sheet by ~$400bn from $4.5T to ~$4.1T.  The estimated impact of this QT is the equivalent of a ~50bps of rate increase. The Quantitative Tightening (“QT”) or the unwind of FEDS Balance Sheet has picked up at a pace of ~$50bn a month and is having knock-on effects in the overnight money markets, where the demand for short-term cash has been on the rise.

There are two factors at play as a result of FEDs QT:

1. The shrinking B/S is driving tighter liquidity conditions leading to higher short-term rates

1. The impact of QT is resulting in money moving away from financial assets like stocks to cash and bonds (for reserve maintenance) leading to lower yields on Treasuries

It remains to be seen whether the current rate actions and the pursuit of QT at current pace will ultimately trigger a recession. The early signs are pointing to that with the UST 2-10 spreads at 5bps (dropped to 1bp). 
One thing is becoming clear, volatility is like to increase, so brace yourself for a bumpy ride in 2019!
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With the introduction of Basel 3 liquidity regulations, Banks are now required to hold much higher levels of liquid asset buffers in the form of High Quality Liquid Assets (read Cash reserves and Highly rated Bonds) leading to a general increase in demand for Liquid Reserves and US Treasuries.

In many ways, it’s the reversal of the FED actions during the financial crisis when it adopted a combination of QE and rate cuts to stave off the economy entering into a depression. It will be interesting to see what this does to the credit spreads….conventional wisdom says that credit spreads should widen as the liquidity squeeze extends leading to increase in cost of funds for Banks.

Fed officials have discarded the notion that they are to blame for the short-term rate increases.  However, the market participants have a different view and are vocal in their comments that if the Fed doesn’t slow down or stop its unwind, it could end up draining too much liquidity from the banking system, causing excessive market volatility and ultimately undermine its ability to control its rate policies to maintain stability in the financial markets.

How does Quantitative Easing work? 

Through QE, the Central Bank purchases financial assets – almost exclusively government bonds – from pension funds and insurance companies. It pays for these bonds by creating new central bank reserves. The pension funds would sell the bonds to the Central Bank and in exchange, they would receive deposits (money) in an account at one of the major banks. Banks would end up with the new deposit (from the pension fund), and a new asset is created in the Bank’s Balance Sheet– Reserves at the Central Bank.

Quantitative Easing therefore simultaneously increases the:

a)      the amount of reserves at the central bank in favour of banks that can be used for lending by banks; and

b)      the amount of commercial deposits with banks

This in theory supports the credit creation process as only the deposits can actually be utilised in the real economy, as central bank reserves are just for internal use between banks and the Central Bank.  Fed officials contend their unconventional policy actions saved the U.S. from a crisis worse than the Great Depression.

GDP growth has bounced back since 2008 and has held steady near 2 percent over the past few years.

While many economists had opined that QE would lead to a runaway inflation but it has defied such predictions and has remained surprisingly low.  This has further called into question the need for the FED’s rate action in the present time when inflation is stubbornly hovering around 2%.  

The Fed's low-interest rate policy made it inexpensive for the government to continue to borrow and spend. U.S. public debt is near $20 trillion. Investors had hoped for a less aggressive approach after U.S. stocks tumbled into a correction zone amid concern that global growth is slowing.

Many think that the Fed has completely misjudged the situation.  Though they have signalled a less aggressive path for rate hikes in 2019, the quarter-point move on Wednesday and the recent market turmoil doesn’t unduly worry the U.S. central bank. Global stocks are set for their worst quarter since 2011, yet Jerome Powell in his press conference said that “we don’t look at any one market,” and that in the abstract “a little bit of volatility” probably doesn’t leave a mark on the economy.

The feedback into credit spreads as a result of the current sell-off in equities and bonds is yet to take effect and when that happens, there will be a lot more pain to endure and that will impact economic growth.

Besides the Fed’s monetary policy related impact, there are worries of global trade wars, domestic politics and the geo-politics. America and China are planning to hold meetings in January to negotiate a broader trade truce.  

What’s all this brouhaha between the RBI and the Government?

The current sparring between the RBI and the Government comes at a horrible time even as the Indian economy is facing headwinds from high NPAs, higher oil prices, weak banking sector, a weakening Rupee and crisis in shadow banking sector. 

While disagreements between Central bank and the Government are neither uncommon nor unique to India. Also, it is pertinent to note that several of the incumbent RBI Governor’s predecessors, like Raghuram Rajan, Duvvuri Subba Rao have had disagreements with the government on interest rates and other policy matters.                   

So, what is different this time and why is there so much brouhaha?

The Government and the RBI are not seeing eye to eye on many issues, some of the important ones are as under:

• Proposal on setting up a new Payment and settlement systems regulator – RBI is opposed to the idea
• Forbearance norms to be relaxed for Power sector and other SMEs to promote credit growth – RBI is focused on cleaning up the Bank’s Balance Sheet and improving financial stability
• Interest rate policy – government is pressuring RBI to reduce interest rates on the bank of controlled inflation.  RBI does not agree with this view as outlook for inflation given the increase in oil prices is set to increase
• Liquidity support to the NBFC sector – RBI is tightening liquidity norms for NBFCs and is not prepared to play the liquidity backstop role
• Easing of reserve requirements – Government wants reserve norms to be relaxed while RBI doesn’t want to change
• Higher dividends – Government is seeking a higher dividend from the RBI to ease fiscal pressure
• RBI is seeking more powers to regulate public sector banks in particular it wants a say in the appointment of management and Board members of these banks. Government is not conceding and maintains it has sufficient powers to regulate them.

While debates and disagreements on such issues are to be expected and even healthy to reach a well-reasoned decision, the manner of public sparring has left everyone stunned. The Finance Minister publicly rebuked the RBI by laying the blame for high NPAs squarely on the doors of RBI citing poor regulatory supervision and easy lending norms.

    

Incidentally, Indian banking sector NPAs is one of the highest amongst large economies at 11.6%.

As the Government faces reelection next year, it wants banks to extend loans at cheaper interest rates quickly to keep the economy firing as a way to secure its re-election campaign.  But the RBI is wary of already high levels of bad debts and weak rupee threatening to add to inflation, and hence has different priorities i.e. to ensure financial stability.

The stand-off between the government and the RBI started with some non-official directors reportedly pressing for relaxation in the prompt correction action framework for weak banks, increased flow of credit to micro, small and medium enterprise sectors, and a special liquidity window for non-banking finance companies at the RBI’s last board meeting.

Frustrated with the unbending approach of the RBI, the Modi government has apparently sought to invoke a little known Section 7 that undermines RBIs autonomy, and perhaps a provision reserved for extreme circumstances.  Hence, this little known provision has never been considered in the past and this is something that has never been used even during Emergency, the economic 1991 crisis, the 2008 Global Financial Crisis or the 2013 regional crisis!

What is Section 7 of the RBI Act?

Section 7 of the RBI Act, when invoked, allows the government to consult with and give instructions to the Governor of the RBI on certain issues that it believes are serious and are in public interest. The relevant section is reproduced below:

Section 7.            Management.

1. The Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest.
2. Subject to any such directions, the general superintendence and direction of the affairs and business of the Bank shall be entrusted to a Central Board of Directors which may exercise all powers and do all acts and things which may be exercised or done by the Bank.
3. Save as otherwise provided in regulations made by the Central Board, the Governor and in his absence the Deputy Governor nominated by him in this behalf, shall also have powers of general superintendence and direction of the affairs and the business of the Bank, and may exercise all powers and do all acts and things which may be exercised or done by the Bank.

The Government, it appears, has sent the central bank letters seeking to overrule the RBI in a bid to push through measures that would potentially support rapid credit growth.

The Central Bank, which is meant to function autonomously and independently, has alleged that the government has been trying to interfere in its functioning. Tensions between the RBI and the government went into public domain after Deputy Governor Viral Acharya said last week that undermining Central Bank independence could be "potentially catastrophic", indicating the authority is pushing back against government pressure to relax its policies and reduce its powers ahead of a general election due next year.

In a speech last week, Deputy Governor, Viral Acharya said, "Governments that do not respect central bank independence will sooner or later incur the wrath of financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution.”

In the wake of the above developments, there were strong indications that the RBI Governor was considering resigning from the position, a move that would have dented the government’s image severely with catastrophic effect on the financial markets, at least in the short term.

In an effort to limit the damage, the government issued a statement saying it “respects and nurtures” central bank’s autonomy.

Markets punish economies if Central Bank independence is not respected

The situation in India is similar to the Central Bank spats in countries as varied as the US, Argentina, Turkey, and this is unlikely to go away soon.  Trump has been openly criticising the FED for raising interest rates and is blaming the FED for the recent stock market decline.  Recently, Turkey got severely punished for interfering with monetary policy of the Central Bank and its currency plunged by over 50% within a short period of time dealing a severe blow to the economy.

The government is playing with fire and is treading on dangerous ground that could severely dent the external perception of the RBIs autonomy which will damaging effect that will hurt FDI, borrowing costs and eventually economic growth.

Earlier this month, the government removed the chief of the Central Bureau of Investigation in a dramatic late night order. Such actions undermine the institutional framework and cause severe long-term damage to the economy.

What next?

RBI Governor has called a board meeting on November 19 to discuss the outstanding issues that created a rift in its previous meetings.

The Finance Ministry has said that both the government and the RBI “have to be guided by public interest and the requirements of the Indian economy. The government, through these consultations, places its assessment on issues and suggests possible solutions. The government will continue to do so,” the ministry, concluding statement said.

Having recently won 23 positions on ease of doing business, the government should not fritter it away by scoring a self-goal.  International investors seek to exercise their investment decisions and draw comfort from matters such as autonomy and the credibility of the Central Bank to steer the economy and maintain financial stability.  

Let’s hope that better sense prevails and the Government exercises discretion as this has far reaching consequences and could potentially derail the economy.

IL&FS debacle – Have the lessons from the 2008 Global Financial Crisis been learnt?

September 2018 marked the 10^th anniversary of Lehman Brothers’ collapse and one can’t be faulted for thinking that the regulators would have upped their game by learning from that experience and implemented sufficient regulatory safeguards to avoid a similar situation requiring a taxpayer funded bail-out of some shape or form.

But the reality hit hard for several Indian investors when India's leading infrastructure finance company IL&FS defaulted on payments to its lenders triggering a minor panic in the markets.

Infrastructure Leasing & Finance Services (IL&FS), is an investment holding company with business operations through separate companies which form an ecosystem of investments across infrastructure, finance and social and environmental services.  IL&FS was founded in 1987 with equity from Central Bank of India, Unit Trust of India and Housing Development Finance Corp to fund infrastructure projects.  Besides this, IL&FS has institutional shareholders including SBI, LIC, ORIX Corporation of Japan and Abu Dhabi Investment Authority (ADIA).  As on March 31, 2018, LIC and ORIX Corporation are the largest shareholders in IL&FS with their stake at 25.34 per cent and 23.54 per cent, respectively. Other prominent shareholders include ADIA (12.56 per cent), HDFC (9.02 per cent), CBI (7.67 per cent) and SBI (6.42 per cent).  Another important investor in the company is the Employees Wealth Trust (EWT) owing about 12% stake, which is now at the centre of the storm owing to several sweet deals executed by it to enrich a small group of senior executives. This reeks poor Corporate Governance standards where the executive management was brazenly securing deals for the benefit of a small cabal of senior executives.

What caused the panic?

IL&FS Financial Services, a group company, defaulted in payment obligations of bank loans (including interest), term and short-term deposits and failed to meet the commercial paper redemption obligations due on September 14. On September 15, the company reported that it had received notices for delays and defaults in servicing some of the inter corporate deposits accepted by it.

Consequent to defaults, rating agency ICRA downgraded the ratings of its short-term and long-term borrowing programmes. The defaults also jeopardised hundreds of investors, banks and mutual funds associated with IL&FS. 

·         The rating agencies downgraded the long-term ratings of the parent entity IL&FS multiple notches from AA+ to BB on 8^th September and then to D on 17^th September.

·         The short-term rating was also downgraded from A1+ to A4 on 8^th September (4 notches on a single day!) and then to D on 17^th September.

This is not normal for any issuer and is usually the jump-to-default cases are rare. This points to the weakness in the rating agencies standards and their lack of rigour as such a sharp downgrade in a single review shows that they failed to pick up early signs of weaknesses in their liquidity risk management. 

This may also call into question the sanctity of the ratings of other bond issues and it is likely that several other issues may face downgrades when the rating agencies pull their socks up and conduct a thorough review and tighten their ratings criteria.

Market Impact

What followed its default was a knock on effect on several mutual funds that had exposure to IL&FS and its group companies in their portfolios. The Mark to Market (MTM) impact on these bonds, resulted in a sharp drop in NAV of many of these funds. While bond prices move as a result of credit spread changes, the speed and the extent of the downgrades hit their holdings hard and the pain may yet continue due to a contagion effect. As many of the funds will have an investment mandates to hold bonds of issuers above a certain ratings threshold, further sell-offs are likely to keep the bond prices low.  Besides Funds, several Public-Sector Banks have exposure in IL&FSs bonds and loans (~$ 2.5bn) and the impact of the failure of IL&FS will have a telling effect on an already weak banking system which will further impact credit growth that may slow down the economic growth.

The Bail out

The Life Insurance Corporation of India (LIC) is expected to once again come to the aid of a distressed ‘systemically important’ firm (after bailing IDBI recently) as struggling infrastructure major IL&FS is set to receive some form of financing from the insurance major. LIC, which holds the largest stake in IL&FS, is expected to purchase IL&FS’s non-convertible debentures.

What ails IL&FS? 

IL&FS is afflicted by several factors, the principal ones being poor Corporate Governance and even poorer regulatory oversight.  NBFCs have been performing shadow banking services, yet the regulatory regime was inadequate for the systemic risk that they collectively pose to the regulated banking sector and to the wider economy.

The management of the company is facing several allegations:

·         Poor overall risk management disciplines in general and liquidity and funding risk management in particular (excessive maturity transformation, leverage)

·         Poor corporate governance especially around disclosure of conflicts of interest

·         Enriching a small group of employees at the expense of the company

·         Nepotism by offering jobs to family, friends and relatives

As infrastructure became a prime focus for successive governments in the past two decades, IL&FS, with its prime mover position in this segment secured several of these projects. Over time, the company funded its growth through a series debt issuances and commercial borrowings which resulted in a leveraged Balance Sheet with debt-to-equity of ~17 and resulted in over 169 subsidiaries at last count.

While this in itself may not have posed as much trouble if the projects went on-stream in a timely manner allowing for mini-perm refinancing to kick-in, the delay in execution of projects and the consequent delay in cashflows required to service these debt issuances was severely dented.  This adverse cashflow position was further compounded by excessive maturity transformation that added to the funding requirements as repayment of maturing debt came in quick succession.

The Group has a debt of about $12.5bn (Rs. 91,000 Crore) of which about $5bn (Rs. 37,000 crores) is short term and due to mature within a year.  About $9bn (Rs. 60,000 Crores) of the debt is project specific, including road, power and water projects.

As the nature of business is long term projects and capital intensive, the business model is predicated on refinancing of projects (mini-perms) as risks are mitigated with project completion and revenues are stabilised. A major reason for delays in project execution was due to the complications and delays in land acquisition which is an endemic issue in infrastructure projects.

The 2013 land acquisition law also made many of its projects unviable as the compensation for land acquisition increased considerably. Delays in project completion, cost escalation and poor funding profile led to a squeeze on its resources besides poor risk management that did not consider the consequences of several incomplete projects. Lack of timely actions to stabilise and diversify funding exacerbated the problems. 

Regulatory landscape - RBI regulations on Asset Liability Management (ALM)

While maturity transformation is an important part of financial intermediation as it contributes to efficient resource allocation and credit creation, the risks associated with it needs to be carefully monitored and managed with sufficient safeguards in the form of contingency funding actions.

The RBI had put in place Asset Liability Management (ALM) regulations for Banks in 1999 and for deposit taking NBFCs in 2002 (DNBS (PD).CC.No.15 /02.01/2000-2001 dated June  27, 2001) which was expanded to cover all NBFC in 2011.

The regulatory requirements currently require submission of liquidity maturity mismatches for various tenors with a mismatch cap for the first month at 15% of cumulative outflows within one year.  This kind of blunt approach considers neither the unique funding needs of a business model nor its funding profile, allowing for excessive maturity transformation.

The regulations governing NBFCs are not fit for purpose and the risks have been accentuated further by inadequate regulatory oversight.  The lack of appropriate regulations to mitigate funding and liquidity risks allowed for these risks to mount unchecked.  The rating agencies also failed to assess these risks as their approach places excessive reliance on Parental Support (Qausi-sovereign) which allowed them to assign high credit ratings.  This further contributed to the complacency within the system that allowed several mutual funds to invest in IL&FS bonds as it met their investment mandate.

Basel 3 liquidity regulations

Basel and other regulators like the EBA, PRA developed liquidity regulations in the wake of Lehman collapse to address risks emerging from excessive maturity transformation. In order to address both short term and structural liquidity risks, Basel developed a framework for short term risks with its Liquidity Coverage Ratio (LCR) with its BCBS 238 and the Net Stable Funding Ratio (NSFR) for structural liquidity risks.  The Basel guidelines for LCR (BCBS 238) was issued in September 2013 and was effective from January 2015 with transitional provisions up to 2018 and for NSFR (BCBS 295) in October 2014 effective January 2018.

RBI followed the BCBS guidelines on LCR for Banks in June 2014 (DBOD .BP.BC.No.120/21.04.098/2013-14) and NSFR in May 2015 (DBR.BP.BC.XX/21.04.098/2014-15) with similar timeline and transition provisions.  It is important to note that none of these applied to shadow banking world of NBFCs which perform similar functions to that of a Bank except for its deposit taking activities. 

NBFCs have largely relied on funding from banks and capital markets for its core business assets besides public deposits in some cases.  Collectively they pose a systemic risk to the banking sector and to wider economy.  RBI making an exception for NBFCs from complying with these liquidity regulations was imprudent.

What next?

One might wonder what is the great hullabaloo over a debt of $12 billion? As many of these debt is owned by public sector banks and mutual funds, the potential of a contagion is significant as that will lead to further deleveraging resulting in an even slower credit growth.

As an immediate step, the government sacked the current board and replaced it with a new seven-member board headed by Uday Kotak, MD and CEO of Kotak Mahindra Bank.  This should be followed up with an independent forensic investigation is required to ensure there is no conflict of interest in the investigations as well as to determine the impact from conflict of interest that allowed the senior management to enrich themselves.

But these actions alone will not be enough.  Several other steps are required to put the NBFC (and the banking sector) on a firmer footing.  These include, but not limited to:

1.       Appointment to the Board of significant financial institutions to require financial risk management domain expertise and should not be used to reward pliant bureaucrats

2.       Enforce high level of Corporate governance standards and conflict of interest rules.  Conflict of interest is endemic within the financial sector and needs to be stamped out with a vengeance.

3.       Enhance liquidity risk regulations on NBFCs by tightening the ALM framework and imposing LCR and NSFR requirements

4.       Stipulate stringent stress testing standards to assess capital and funding requirements under stress and impose sufficient counterbalancing capacity requirements in the form of capital and liquid asset buffers.

5.       Finally, hold Rating agencies to account by reviewing their ratings criteria and practices.  They cannot continue to rely on parental support of quasi-sovereign entities to support a higher credit rating. 

In conclusion, RBI needs to up its game and tighten its Supervisory regime of the financial sector.  This is not merely about issuance of regulations but requires follow up with a Pillar 2 - Supervisory Review Framework that examines the risk management framework and disciplines of major financial institutions in a more systematic and programmed manner.  If the RBI has inadequate skilled resources to conduct such reviews, it should seek external support of experts to perform such roles on its behalf, much like the Section 166 - Skilled persons review by the FCA in the U.K.