THE CASH DASH
nowhere left to hide
There is nowhere left to hide. That scary thought is provoked by the week's two momentous events: the collapse of the dollar and the bursting of the bond bubble. In a particularly alarming episode, dollar-yen trading at one point virtually seized up. The collapse in long-dated bonds is equally worrying. The dash for cash appears to have started.
The financial crisis has taken a new twist. In the first phase (post- Russia), investors fled from high credit risks. In the second, (post- Long-Term Capital Management), they fled from illiquid assets. Now they seem to be running away from long-dated assets too.
The week's developments are both a sign of instability and a potential cause of further instability. With markets so volatile, some investors will have lost pots of money. And, if they have borrowed money, there could be knock-on effects through the banking system.
Straightforward risk aversion is bad enough: the cost of capital rises across the board and poor risks can get tipped into bankruptcy. But the draining of liquidity is more virulent, as Alan Greenspan, the US Federal Reserve chairman, noted this week. If it gets really bad, it could potentially tip even good risks over the edge.
Where Mr Greenspan was less convincing was in describing the increase in risk premiums as rational and the liquidity lust as psychological. In both cases, there is a mixture of rational and irrational. During the bull market, investors paid too little attention to credit risk and the advantages of liquidity. But as ever, the danger is that investors will swing from one extreme to the other.
Holding illiquid assets in itself is not the real problem. A long-term investor - like Warren Buffett or most pension funds - can afford to wait for their fundamental value to show through. The explosive cocktail is when illiquidity is combined with leverage. That was what brought the east Asian economies and Russia to their knees; it was also what nearly sank LTCM.
Are more debt crises lurking? It is to be hoped not. But investors and policy-makers should be worried about two giant dominoes. The first is the US population. During the boom times, Americans seemingly discovered the free lunch; they were able to enjoy the prospect of a comfortable retirement (because share prices were rising) while saving barely a cent of current income. The circle was squared through borrowing. Any move to deleverage their balance sheets - while perfectly rational - would cause a big slowdown in the real economy.
The second potential domino is the Western banking system. Banks epitomise the combination of high leverage and a mismatch between illiquid assets and liquid liabilities. The fact that they are fairly well capitalised is some comfort. But it might not serve as protection against a fully-fledged dash for cash.
The popular policy remedy - that central banks should slash interest rates - does not quite hit the mark. Leverage and irrational exuberance are the source of the problem, as in Japan, not high interest rates. Fortunately, the binge was not as bad in the West. With luck, the hangover should be much milder too.
The Financial Times, October 10, 1998 |
