Genuine Risk-Free Assets Are Dwindling: Choudhry

Moorad Choudhry, Head of Business Treasury, RBS
Monday, 16 May 2011 | 1:59 AM ET

Finance and economics are, by definition, dry unemotional subjects. One could almost say “boring”. It is always amusing to see the vitriolic reaction that emanates whenever one discusses the markets.

Why do people get so emotional about finance? It isn’t as if we are debating the Middle East peace process or abortion rights here....the direction of Cable (pound/dollar exchange rate), or the “value” of gold, they are hardly in the same emotional space.

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From the strictly orthodox finance viewpoint, one cannot value an asset if there is no cash flow. That is simple textbook logic. By all means assign whatever value-judgement (pun intended) to any asset one wishes, be it based on sentiment, superstition or any other factor.

But this is a blog on macroeconomics and finance. Its defining background is a firm belief in the "Chicago" school and the risk-neutral, no-arbitrage valuation logic exemplified by the work of Fama, Markowitz, Merton, Black-Scholes and others. We need a very good reason to depart from orthodox here. But the mind boggles at the discourtesy that arises from individuals whenever one has a contrary opinion on a financial product!

Emotion needs to be off the agenda this week more than most. Just why are developed country sovereign bond yields quite as low as they are, given the fiscal deficit worries in so many of them? With the exception of obvious candidates such as Greece and Ireland (the former saw its S&P rating cut to “B” this week), yields on certain sovereign debt would appear to offer little reward against perceived default and inflation risk.

Spain is a case in point. Its 5-year and 10-year debt is trading at 4.56 percent and 5.28 percent respectively. Given the continuing fall-out in its real-estate market, and its extremely high level of unemployment, are these yields sufficient return for risk incurred? And this is to ignore the contagion effect were there to be a Greek or Irish sovereign debt default.

Debt Restructuring Coming?

Default in the euro zone appears to be an increasing possibility by the week. Whether it is in the form of a debt-servicing moratorium, or extension of maturity date, or write-off of a percentage of face value, market prices are pointing to some form of restructuring sooner rather than later.

And yet euro zone yields outside the affected countries and immediate periphery (Portugal) are not rising significantly. As we noted last week, US T-Bill yields in single digit basis points shows the high demand for risk-free assets, despite the obvious budgetary pressures that the US administration is currently struggling with.

The continuing low sovereign debt yields suggests not only continuing demand for them, but also a shortage in supply. Genuine “risk-free” assets are a dwindling group. The spectacular export performance of the Asia-Pacific region, not to mention the foreign exchange earnings of oil-exporting countries, creates a large demand for risk-free investments.

At the same time, these countries themselves suffer from a dearth of domestic assets that might be considered as safe. Hence the demand for Treasurys, euro sovereign bonds, and so on. Pre-crash, this phenomenon helped to create the conditions of liquidity surplus that were a causal factor behind credit crunch. Post-crash, it helps to create a false sense of the sustainability of fiscal imbalances.

In other words, one needs to get into a great deal of trouble budgetary wise, a laGreece or Ireland, before the market decides it can’t invest in your bonds anymore unless at painful rates. But this is a dangerous position to get into, and argues in favour of the kind of fiscal rebalancing that the UK government, for example, is attempting to carry out. In other words, don’t wait until it’s too late before deciding to tackle one’s deficit.

In the long term the imperative is for there to be a wider range of safe assets for risk-averse investors to place their funds in. Some rebalancing on this side would help the global economy on both sides of the equation; overseas domestic investors would be able to select from a wider range of assets, including those at home, and Western sovereigns facing lower foreign investor demand would have a greater incentive to run balanced budgets. _______________________
Dr Moorad Choudhry, Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland, and Visiting Professor at London Metropolitan University.