How Safe are the Assets?

Much of the financial world’s problem is embedded in the supply chain of safe assets. When the demand of privately held safe assets zooms its supply plummets beyond a point.

This is acute when government debt is high. Net supply of government debt is strongly negatively correlated with the net supply of private near-riskless debt. Empirical studies have also shown that high supply of privately held debt when Government supply of debt is low actually leads to the crisis. This is where Ricardian equivalence does not hold.

A privately held asset, which is collateral against a loan, could well be termed unsafe, if information is known about its doubtful nature. Agents do have private information but when that information is public, it could well be the prelude to a crisis.

The recent MIT paper comes out with some insightful details, but I am first of all curious to understand how this works.

Imagine that there is surplus creation of assets, like housing, it would create a condition that higher supply of these will impact the prices of these assets. Once they reach the tipping point the fall in value of the assets will make some of the housing equity move to the negative territory, leading to foreclosures. When this happens in an isolated market, there are no issues. But in an inter-connected financial world where debt is packaged and sold in highly connected markets, the problem in housing in one part of the world could create problems in other parts.

Let me take the example to Gold. Just after the 2009 crisis, one would have noticed that the safe haven status was accorded to Gold. The prices of Gold zoomed to stratospheric levels till the October of 2011, after which the prices started to fall. The safe asset status of Gold could not be permanent as it reached a tipping point, exactly like ‘Housing’ assets.

Currently the world is going through the phase when the U.S. Treasury is providing the Safe asset Status. It is one which gives the biggest confidence to the financial world that when everything fails, this is one which cannot as it is underwritten by no other than the U.S. Government.

But when supply of any asset is too big and it keeps growing then the consequences of that cannot be ignored. In the case of U. S. Treasury, the consequences include the extension of the zero lower bound interest rates not only in U.S. but also across many other countries of the world.

Government debt as a safe asset has its limitations. Much of the developed world actually has to contend with this problem where growth is yet to take off. When debt is connected with growth parameters and it fails to take off, the debt of any country will become an unsafe asset for those institutions who have bought such debt.

The phenomenon of acute shortage of safe assets is all comprehensive across many countries and has become the number one problem for all central banks as well. The act of cleaning up banks which has to rely on many of these assets which are liabilities is not a simple problem. When such supplies of unsafe assets have increased all over, there cannot be too many buyers who could volunteer for rescuing.

As with most main street businesses, the value of the asset will depend on the relative scarcity and not on the relative abundance. When you have funds moving into one single asset class, you can be sure that its value will only reach its tipping point. With so much moving into commodities of the world it was always a matter of time when the prices would have brought back sanity to the flow of funds into the ‘Commodity’ asset class.

Thus when some assets, like commodities or stocks and bonds move from highs to lows, it is a signal that the supply of safe assets is well short of the requirement. This is the way the financial world brings back balance.

As with Says Law, Supply must find its own demand; for safe assets it is always true.

The world is struggling to find an investment avenue, because the number of such safe avenues is limited. That is the reason why there is so much liquidity in the financial system, but very little that can move into fixed investments.

China is one brilliant example, when the supply of safe assets seems to show no signs of abating the country had a safe ride to double digit GDP growth. Then the tipping point came and now the GDP growth is higher than the growth of safe assets. It must fall to balance.

For the Chinese balance sheet the ‘safe’ asset side will need some serious mending, if the growth has to be maintained. That is a lesson for India as well.