I was traveling in China when the 9/11 terrorist attacks happened. My parents live in northern New Jersey, not far from New York City, and knowing my mother would be terribly worried about me, I called her to assure her all was well. “It’s not safe,” she told me anxiously. “You must come home.”
This put me in a bit of an awkward position. I was perfectly safe, sitting comfortably in a lovely hotel room in the fascinating Chinese city of Xi’an. Do I point out that she’s the one facing a terrorist attack, not me? That I was safer than she was? That home wasn’t as safe as she thought anymore? My mother had always believed that there was no safer place than home. The rest of the world was a raging mass of disorder, bombings, wars and riots. It took a while for the meaning of 9/11 to sink into my mom’s view of the world, since that view had been fostered over decades. Home wasn’t the safest place in the world. It is something that was hard to accept, from my mom, and for many Americans.
Why, you ask, am I recounting this story? Because I think a lot of investors these days think the same way my mom did after 9/11. When financial markets grow uncertain or panicked, investors rush into the same “safe havens” they have for years – usually U.S. dollar assets, or Japanese yen, and other rich country financial instruments. And they tend to pull out of markets and investments perceived as “risky,” such as emerging markets.
But in this new world economic order, are those tried and true safe havens really as safe as in the past? After the damage done by the 2008 financial crisis, something of an economic 9/11, is it time to reassess what is truly risky and what isn’t? And what happens if investors start to rethink the safe haven? Here’s what I’m talking about:
I’ve been thinking about this issue for a while, ever since the collapse of Lehman Brothers in 2008. There have been several times since then that panicky investors have engaged in what’s called a “flight to quality.” We’ve seen investors yank money out of places like Brazil, India or South Korea to buy U.S. dollar assets instead. But I’ve wondered: Does that make any sense? Sure, a country like India has its own economic issues (a fiscal problem, for example), but it also has some of the most promising growth prospects in the world. Wouldn’t I want my money there? And look at South Korea. The country didn’t even experience a recession in 2009, and it has ample currency reserves. From an investment standpoint, why sell out of South Korea or India or Brazil and buy into a country like Japan, which has experienced 20 years of economic malaise, or the U.S., in the middle of a housing bust and financial crisis, with a deteriorating fiscal situation? Are the U.S. and Japan any safer in reality than India and South Korea? What exactly is “quality” in today’s economy?
The current debates about the financial health of many developed countries only makes it more important to ask that question. I had a very interesting conversation with Michael Purves, Chief Market Strategist at BGC Financial in New York. He talked about the disconnect between the financial positions of Japan and the U.S. and the way investors are treating their bonds right now. Japan has a government debt to GDP ratio of about 200%, the highest in the industrialized world, much higher than even Greece or Ireland. Japan, says Purves, has to refinance a staggering $3 trillion in debt this year. But based on bond markets, you’d think Japan was a paragon of fiscal virtue. The yield on 10-year Japanese government bonds is a mere 1.3%. The situation is similar with the U.S. Though America’s financial standing isn’t as weak at Japan’s, debt and deficits have been on the rise, but borrowing costs for the government nevertheless remain quite low.
What’s going on? Purves says that Japan and the U.S. are each benefiting from unique circumstances. The U.S. benefits from the dollar being the world’s currency, and the fact that dollar assets are incredibly liquid. Japan “has the luxury of a loyal, patriotic investor base,” says Purves, that continues to place its savings in government debt. Some 95% of Japanese government bonds are owned by locals. But Purves believes that it is unlikely these unusual circumstances can continue on forever. Eventually, the numbers have to win out, he argues, and investors will look more carefully at the actual fundamentals behind the assets they are holding. The result will be “a sea change in how developed world sovereign debt is considered,” he says. There will be “a much more critical assessment of what it means to be a developed market,” Purves adds. “All the rich countries are not that rich anymore.”
What Purves is talking about is a major shift in the way investors perceive risk, and that would bring a major shift in the way money is allocated around the world. How does that shift play out? Purves believes the process will be a slow-moving one, in which investors adjust to the new realities of the developed world’s financial position over time. That would, however, mean rising borrowing costs for countries like Japan and the U.S., which would make their fiscal reform even more difficult. Harvard’s Kenneth Rogoff warned in the Financial Times that such rising costs would be extremely painful, and limit the options government have to adjust:
According to my recent research with Carmen Reinhart, debt-to-income ratios are already at, or near, postwar highs across advanced economies. Many are close to the roughly 90 per cent debt-to-income threshold which, historically, begins to be associated with lower growth. And this does not account for the adverse demographic trends or hidden debts that inevitably jump on to the books when a crisis unfolds. Unusually low interest rates currently keep the carrying costs of these debts modest, and make it seem as if the day of reckoning is far off. Sadly, debt can be worked off only slowly, while rates can rise suddenly. Such a rise, if sustained, would be extremely painful for the national budgets of many countries… Research on sovereign default shows that markets also seldom anticipate problems in advance. By the time they lose confidence, it is too late: the option to tighten from a position of strength has evaporated.
What could set off this reassessment of the riskiness of the developed world? Purves speculates that it could start in Japan, the financial state of which is increasingly coming into under the scrutiny of investors. Though Purves doesn’t see Japan tumbling into an immediate debt crisis – he believes the government can continue to finance its deficits, even with the added burden of reconstruction after last month’s devastating earthquake – he also believes it is inevitable that Japan’s borrowing costs will begin to rise, perhaps over the course of the next year. That, he says, could be the catalyst for an overall reassessment of the riskiness of the developed world.
How vulnerable is Japan? More on that tomorrow.