Stefano Gatti, is the Director of the B.Sc of Economics and Finance at Università Bocconi. On February 5, 2015, I had an opportunity to meet him and discuss his view on Europe and World Economy, while he was in Mumbai giving lectures at the Bocconi MBA institute.
Though my meeting was initially for a story but since the story was cancelled, I thought of sharing the full interview on this blog.
He also takes classes for Coursera and he is one of the senior advisor with B Capital Partners. Given below is the full transcript of that meeting.
Good Morning Professor!
Good Morning.
Should I ask you questions one-by-one or would like to make an opening statement as you would have seen my questionnaire and then I should ask you further more.
Let me give you a quick background first and then you may ask questions.
Immediately after the crisis of 2008 and then later on 2011, European countries had to deal with particularly severe crisis that ate the peripheral countries among which Spain, Italy and then earlier Greece, Portugal, Ireland, etc. were launched to a period of severe recession and consecutive quarters of negative growth have made the economy weaker and weaker.
When the economy becomes weaker on a constant basis then both entrepreneurs and consumer start thinking, that if the prices will not grow or even worse that prices will fall, ‘I will not consume it today or I will not invest today and I will wait for tomorrow.’ If this kind of expectations fulfil themselves at a certain point you create a vicious circle whereby no one makes consumption or invests and no one works, they do not consummate.
Therefore, Europe was moving towards a period of not-stability of prices but not in the sense that prices were going but in terms of prices that were falling. Given the fact that the ECB has a mandate to presence price stability, at a certain point Draghi said, ‘I don’t see any particular strange thing. If I use all my powers to stop the negative spiral that has been created this kind of reinforcing expectation towards a negative kind of prices.’
Compared to what happened in the US, where the central bank had decided to inject enormous amount of money into the economy. Now Europe is a strange kind of continent because we have a monetary union but we don’t have a political union so everyone is arguing that the right way of coming out of a recession different from the other. Germany is advocating that injecting money is not the right solution because it will reduce the pressure on economies, whose accounts are not so good, not to make reforms. On the other side the peripheral countries are saying, ‘no, if the ECB doesn’t help us then we will never be able to get out of recession.’ Look in the case of Greece, since Syriza has come to power.
Think about to a certain extent of Italy, where we are not able to come out of recession, this kind of approval. He got the majority but not unanimity inside the board of directors of the ECB, to start the quantitative easing. And you must understand that QE was the only final way you can inject sufficiently large amount of money in the economy. The only asset class that is sufficiently huge in terms of quantity of papers circulating in the market is the market for government securities. Yes, you can do the asset backed purchase program, you can do the covert purchase program, targeted long term refinancing operations, etc. but at the end of the end it’s a question of amounts.
Just to give you an idea, now a days the balance sheet of the central bank is around 1 trillion Euros, and the expectation of Mario Draghi is to bring the balance sheet size to 7 trillion Euros, three times as much. The targeted long-term refinancing operations 3 months ago was expected to be in the region of 400 bn Euros. So, only a tiny fraction of the total amount. The only way you can really boost liquidity in the economy was by buying government bonds. Hence, starting from couple of weeks ago, exactly 22th of January. Draghi said, ‘Well, we will start buying around 60 billion of government securities and this purchase will be proportional to the participation of every single stake to the capital of ECB.’ To give you a perspective the stake of the Italian government in the capital of the ECB is in the region of 13%. Countries like Germany, France has a higher share than Italy. This is a matter of paradox, countries like Italy and Spain, will receive less purchases not because they need purchases, but simply because the equity stake in the bank is lower than Germany or France, which paradoxically should be the countries that need the less of this kind of purchase intervention.
The ECB is expected to go on buying until recession is defeated and in any case until the end of 2016. So more or less the time-frame is about 2 years till this massive purchase of government securities. On the whole, if you count the number of months times the 60 billion euros, we are talking about 1.3-1.4 tn euros. This can really bring the balance sheet from 1 tn now to 2.5 tn plus additional 0.5 tn in other monetary interventions. So now the story is written and starting from the beginning of March the purchases will start.
So will it help? You just made a point, that Germany which requires less support will be flushed with liquidity and the other way round in case of Italy.
Let me come to the implications to the world-wide level, it is not just a question of Europe but also in some sense will have effect world-wide.
My personal view is that, if you inject such a huge amount of money in the economy then your currency vis-à-vis other currency will become weaker. So there should be boost in terms of sales, particularly for corporations which have a strong export-led current policy. If you think for examples, corporations in my country (Italy) that are strongly export producers. What you would have seen in immediately after the declaration of the quantitative easing, the stock price of these companies have increased a lot. Why this? Probably because the markets discounts the fact, that in the next few months a weaker Euro will help boosting the sales abroad. You have a weak demand internally but probably you can export more. So you can substitute a weak economy inside for a much stronger export oriented kind of policy.
This is not the end of the story because when you boost export in one country then you are stealing exports from others. So what I expect is that, for a certain period of time, all the other central bankers for example, Japan, US, etc. will not react. But if the stolen part of export will become particularly irrelevant. I don’t exclude a scenario where the central banks will be fighting among themselves. Something similar to a currency war. And this is pernicious for a simple reason, if you start reducing interest rate, you are right to a certain point and you don’t have any additional marginal manoeuvre, and you create a perverse incentives for bad behaviour in the market.
Take for example a case if a debt company, that is now experiencing a scenario that is very low interest rate, incentive to buy debt is very high and the risk for the central bank is that if for a long time you keep interest rate too low and you inject too much money then after a point you are in a catch 22 situation: you have a temptation of increasing interest rates because inflation is picking up again and then simultaneously you have this enormous amount of private debt that has been accumulated and this can create problems particularly for the weaker kind of firms that are in too much of debt.
So the idea is, we must be very careful as we are entering in un-known territory. The simple fact that in some cases, you have negative interest rate, which is a paradox, it’s like to say, I buy a German bond and pay Germany to accept my deposit. It is totally absurd. When you enter negative interest rate, who knows, what can happen? And guess what in the first week of Feb 2015 Nestle’s coupon 075 maturing on 2016 was available at negative interest rate, so its negative interest rates for corporation also.
Do you also expect along with consensus that US will be increasing interest rates by the end of the year?
I think so.
If they start increasing the interest rate, then will they be able to devalue the dollar?
You know, voicing expectation is very tricky but I can give you my personal point of view.
The economy in the United States now is recovering, indicators about the directors of procurement offices is getting well. Inflation, I would say, is on the positive side of the trend. Unemployment has been reabsorbed quite rapidly, so at a certain point now you have a scenario where it becomes difficult to justify a constantly accommodative policy. Somewhere probably by the end of this year they will increase the interest rate, which one side can attract more investment to US and on the other it will ensure an even more appreciation of the US dollar vis-à-vis all other currencies. This will require the Fed to be very careful to maintain the balance to avoid excessive inflation at one hand and on the other side not to kill the immediate growth, when the growth has just started. Meanwhile, on the export side, you can put a brake.
So finding the right match between the two opposite needs is not so easy.
When the liquidity program had started in USA, a lot of that money found its way to the emerging market. And stock markets zoomed in all the countries. Now with Europe also starting its own QE, will money also find its way to the emerging market?
For sure. If you go back more or less three years ago. When there was panic in the market, due to Italian crisis, Spanish crisis, etc. so people had to move their investment somewhere else. And emerging markets were the natural destination. But then all of a sudden confidence was reinstated, guess what all the flows to the emerging market at a certain point bounced back. And many of these emerging economies blamed the developed economies because at the end of the day it is a global economy. This was the case in Brazil, Turkey, etc. in order to defend the currency a bit, there was a devaluation from massive inflows and massive outflows. Now the situation is different, it not about the lack of confidence, there is no longer any panic. Yes, Greece is there and they are trying now to negotiate terms and conditions with the European Union. The problem is that now there is no value in investing for example, in bonds from Spain, Italy, Germany, France, etc. You can imagine for a 10 year bond I can get a return of less than 1%. If an insurance company sells an insurance life policy with a guaranteed capital and a guaranteed returns of 2%. How will the company invest at 1% and sell the policy at 2%, this is unsustainable.
Guess what the memory of man-kind is short, so again the flows are moving again from developed market to emerging market, and yet again the pendulum swings.
Now within the emerging market there is a problem with Russia, there is even an embargo over there, Brazil has a problem, China too is facing slow down, etc. And then there is so much of liquidity. So where do you see the money move?
Don’t you think it is a mounting bubble? At the end of the day, there is such a huge level of liquidity, and I have to use it regardless the quality. Everyone buys everyone. Everyone buys everything. This is one of the worst scenario that you can imagine because the risk perception for falls, and in a desperate for yield. Very recently, I was looking at cases of investors that couple of years ago had never conceived the possibility of investing in a certain company because it was a very high risk company, but guess what they are now investing. When the understanding of risk loses ground, this is the first signal of a mounting bubble. If the discrimination of good and bad is not so clear, we should think about bad times coming.
In your view what could be the trigger point for the bubble going bust? Will it be the Fed increasing interest rates or when the QE ends in Europe?
The mechanics of bubble is pretty regular. In the sense, the bubble starts typically with a period of euphoria in the market. Everyone is particularly happy, liquidity is abundant, cost of funding is not particularly high, etc. and so everyone is going on buying without thinking too much about the future.
The trigger point, can be very different but it would very well be some unexpected event come out. I don’t know, in the case of Lehman, at a certain point the mechanism of setting up some prime mortgages is broken down. But investors start thinking, if we have done the correct move or not. And this is the first signal that we are very much close to the bubble getting burst. If this trigger takes place, at the end of the day you have an immediate revelation of the trend because now everyone understands that what we had done in the past was wrong. And so it is exactly like a horse race. In order to get out, as early as possible from this kind of position with a sort of avalanche that is multiplicating, this kind of thing.
If you look at a typical crisis, the bubbles: internet 2000, Asia Crisis 1997, Russia-Mexico 2002, and Lehman 2008, all of them were triggered by an unexpected event. I expect a correction, for sure, how part is difficult. To make a guess could be a default by an emerging economy or it could be a string of defaults in high-yield bonds. Be sure, whatever the reason, exactly as the way interest rate has been dropped, it will rise dramatically, when it trigger is enacted.
What is your view on the Japanese and Chinese Economy?
China is probably the leading economy world-wide by GDP. It has now overcome United States. Although USA is recovering, but in size of GDP it is world’s first economy. We have seen that compared to double digit growth rate in the past, now China is struggling, what we would consider as fantastic growth when compared to us; but compared by their standards it is definitely sub-optimal. Recently the communist party has declared the growth rate of 7.8% but opinion is some treatment of the accounts, typically claimed for a much lower growth in the region of 6.8-6.9%.
And it is obvious that unless the government doesn’t like using a big public deficit – infrastructure investment, subsidies, etc. the risk is that the growth will decrease. On top of this there are two elements, the Chinese economy is experience right now.
The first one is over debt because local authorities are under scrutiny of the central authority. The state authorities had a cap in terms of maximum debt but they found a way to sidestep the rule, by creating vehicles that took debt in order to carry out the investment at a local level and this was overlooked by the central government. This was a proliferation of that at a local level. So now the economy is facing a problem of massive over leverage that at a certain point must be taken into account. But if you deleverage an economy this could be painful.
Second element is the mix city, there is an excess supply of real estate. They have kept building infrastructure, which is investment that is not exported because it is investment which should ideally increase internal demand. But if you see some peripheries of some cities like Shanghai or Beijing, etc. You will see rows of sky-scrappers that are completely empty. How can you repay the debt that contractors have used to build these kind of building and then not be able to sell or rent these places?
Many economists are of the opinion that Chinese economy is over-invested and over-leveraged, let’s see what happens. There is one chance the government will increase fire power in the balance sheet to take care of this kind of a problem.
Japan is a bit more controversial because the thing is, the three arrow policy of Shizoma Abe so far haven’t brought to the expected result. The idea of Abe was to spur up a bit of inflation, where massive monetary policy, reforms, etc. but at the end of the day it seems Japan is still struggling in terms of low growth, low market economy performance, very low interest rates. Very likely the third arrow, which is the arrow of reforms that Japan must introduce in the country must produce their effect and you must be aware of the fact that one thing is injecting money in the economy, this is easy and the second thing is structural reform is particularly difficult to be enacted
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