CRISIL Young Thought Leader
RISK AVERSION AND RECESSION: A POST 2008
VIEW
Siddhartha Gupta
PGP-2, IIM Ahmedabad
Table of Contents
Executive Summary.................................................................................................................................. 2
Introduction ............................................................................................................................................. 3
(A) Have Risk Aversion Levels shifted upwards? ...................................................................................... 3
Trends shown by Risk Aversion Indices ............................................................................................... 3
CDS Spreads, Counterparty Risk and the Regulatory Environment ...................................................... 4
Savings, Consumption and Investment Trends ..................................................................................... 5
The Money Market and Bank Financing Patterns ................................................................................. 5
(B) Increased Risk Aversion Leading to Prolonged Recession? ................................................................. 6
The Expected Burden View: Drawing Parallels from Japan .................................................................. 6
Relating the Expected Burden View to the current global situation ...................................................... 8
Evidence of Lowering of Expected Long-Term Growth Rates......................................................... 8
Evidence of Liquidity Traps ............................................................................................................. 9
Conclusion ............................................................................................................................................... 9
Works Cited ........................................................................................................................................... 10
1
Executive Summary
It is well known that the 2008 financial crisis has changed both the structural and regulatory
landscape of the global financial markets. However, this paper seeks to explore if the 2008
financial crisis has caused a behavioural change in terms of an increase in risk aversion
levels of the investors. Also, if risk appetite has decreased, is this the primary cause of a
prolonged recession that we are staring at?
The analysis in this paper is divided into two sections. The first section includes a study on
some key indicators that establishes the assertion that there has been a non-temporary
increase in risk aversion levels post 2008. The indicators studied include a novel risk
aversion index developed by Federal Bank of Kansas City economists, global CDS spreads,
money markets and savings and investment trends.
The second section links this increase in risk aversion levels to being the cause of a
recessionary environment. Using the “Expected Burden View”, a study on the deflationary
Japanese economy by BoJ economists, the paper extends their findings on the global
economy at large. By highlighting some key recent phenomena observed in global markets,
the paper contends that the advanced economies have lowered their expected long-term
growth rates due to increased risk aversion which in combination with a liquidity trap
situation in advanced economies are causing a long term recessionary pull on the global
economy.
[Summary: 233 words]
[Report: 2396 words]
2
Introduction
The 2008 financial crisis, spurred by the US housing bubble has undoubtedly brought upon a
structural change in the global finance and investment markets. While comparisons to the
Great Depression are unjustified due to the differences in the pre-cursors to both these events,
the sluggishness of the economic recovery to the stimulus measures by the affected
Governments seems to imply that there has also been a fundamental shift in certain
behavioral aspects of investors.
This paper seeks to assert that there has been a marked reduction in risk appetite of investors
globally and this has led to a prolonged recession. The analysis in this paper has been
divided into two parts:
(A) Validation of a non-temporary increase in risk-aversion levels globally post crisis.
(B) Could the increase in the risk-aversion levels lead to the prolonged recession?
(A) Have Risk Aversion Levels shifted upwards?
Individual Risk Aversion can be very difficult to measure in a classical economics sense i.e.
through indifference and utility curves. However, there are macro proxies that can capture
risk aversion levels in the economy and in financial markets. Discussed below are some
noteworthy trends that reflect a non-temporary increase in global risk aversion:
Trends shown by Risk Aversion Indices
The most comprehensive indication in my view is a study by a group of Federal Bank of
Kansas City economists (Hakkio C, 2009) who have enumerated some key risk aversion
indicators that were statistically combined to form a Risk Aversion Index called KCFSI.
Some of these indicators are:
a.
b.
c.
d.
e.
f.
3 month LIBOR/T-bill (TED) spreads
High-Yield – Investment Grade Spread (Credit Spread)
Macro Volatility Indices (VIX)
Negative Correlation coefficient between Equity and Treasury
On the run Treasury (10Y) spreads
Idiosyncratic volatility of bank stock prices
The levels of the composite KCFSI were back-tested to validate its robustness and then
calculated for 2007-09. The results shown indicate a sharp rise in Risk Aversion Levels post
the crisis (circled in red):
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CDS Spreads, Counterparty Risk and the Regulatory Environment
CDS Spreads are on an unprecedented high after the 2008 crisis. Although their volatility has
decreased, but its absolute levels have settled at much higher levels than the pre-crisis levels
and this indicates a persistent shift in the credit risk tolerance and perceived default
probabilities (PD) levels as shown below (Grossman, 2012):
Another indication of higher risk aversion is from the higher margin requirements from
counterparties. Both face value of collateral and asset quality has become more important in
financial markets and trades based on Counterparty Valuation Adjustments (CVA) have
increased in the face of higher counterparty risk.
In the regulations space, the Dodd-Frank and MIFID regulations for central clearing
requirements and increased transparency indicate that there is a lot of caution in the OTC
swaps and IR/FX derivatives markets. As a result of these regulations, the risk appetite of the
once mushrooming structured products desks of banks is being contained and returns
generation through complex payoffs is giving way to searches for newer sources of alpha on
one hand and volumes businesses due to margin squeezing on the other.
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Savings, Consumption and Investment Trends
Post the crisis, America has witnessed a marked increase in the savings rate and a
proportional drop in the consumption (as a % of disposable income). The savings rate has
been projected to increase to 5-7 % over the next few years from an average of around 4% in
the previous decade. Although there has been a boost in consumption from emerging markets
(EM), the growth of these markets is still insignificant compared to the consumption levels of
the developed markets (DM). The decrease in the consumption rate of DM economies is also
compounded by the fact that personal wealth per capita of the DM economies have declined.
Today the world is much more integrated by trade and services flow than it was during the
Great Depression (where trade was restricted due to the Smoot-Hawley Act). Long term
Investment has also declined due to lower growth expectations in the advanced economies.
Although this has been counterbalanced by demand from China and other EM’s, we are
seeing the slowdown in these economies as well due to the lag effects being transmitted by
lesser consumption by advanced economies.
The increase in savings is not being translated into investments due to the individuals
mistrust in investment vehicles and the banks themselves are not lending forward deposits
due to the uncertain business growth outlook and their need cover their own capital
adequacy ratios and NPA’s.
The Money Market and Bank Financing Patterns
Post the 2008 crisis, the money markets collapsed. Tensions in the money markets led banks
to seek to replace money market funding with central bank funding. Central banks have, since
then increasingly become intermediaries for interbank transactions (Cœuré, 2012). There is
huge decline in inter-bank liabilities and erstwhile safe banks are not regarded safe anymore
(swaps being calculated on an OIS rather than a LIBOR basis are a prime example). Banks
are also resorting to retail funding that comes at a much higher rate as compared to money
market funding Below are charts on the inter-liability to asset ratio and retail funding trends
to highlight the point of money market scepticism (European Central Bank, 2012):
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All of the above indicators along with other indicators such as term structure of volatility in
the global markets and fund flows into and out of safe havens indicate that the risk aversion
levels in the economy have shifted to a much higher mean than they actually were.
(B) Increased Risk Aversion Leading to Prolonged Recession?
Having established the higher risk aversion levels post the crisis, one needs to look at its
implications on the real global economy. Governments have tried reducing bond yields,
quantitative easing, outright money transfers on the monetary side and a host of measures on
the fiscal side. However, the increased risk levels the additional linkages through
globalization has made the economic recovery a challenging and unsuccessful task so far.
A group of Japanese Central Bankers have studied the long-term deflationary trends in the
Japanese economy and have come up with the Expected Burden View (Kimura, 2010) to
explain the specific findings in their economy. In this dissertation I extend their study to a
global context and link risk aversion levels to a prolonged recession.
The Expected Burden View: Drawing Parallels from Japan
A brief background about the study:
The “Money View” derived from the Quantity Theory of Money states that there is a positive
correlation between money growth and inflation rate (i.e. MV = PY). It can be assumed that
Japan’s deflation and low inflation resulted from the low growth of money. However, the
correlation between money growth and inflation rate in advanced countries including Japan
has declined since the mid 1990s as shown below (Kimura, 2010):
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Furthermore, during this period, a strong positive correlation between the potential growth
rate and the long-term inflation expectation was observed in Japan (because the two are
generally uncorrelated), and these facts are not consistent with the Money view (Kimura,
2010).
Japan’s potential growth rate declined sharply in the past two decades in contrast to other
advanced countries, and as a result expectations for future economic growth also declined,
which could be the cause of a prolonged deflation and also periods of recession in Japan
(Kimura, 2010).
The connection between growth expectation and deflation can be explained by the Expected
Burden (EB) View, as proposed by the economists. The EB view proposes the fiscal theory of
price level: (Kimura, 2010)
1. A decline in growth increases the future burden on the private sector
2. Private sector accounts for it by cutting current expenditures and investments to save
for those future burdens
3. The result is that aggregate demand falls and leads to a fall in inflation and growth
leading to possible deflation and recession
To explain the above EB transmission mechanism, the concept of the Inter-temporal
Government Budget Constraint (IGBC) needs to be introduced:
Using the balance sheet of the Government and the private sector and using some algebra we
can derive the expression for IGBC (Kimura, 2010):
Market value of government bonds = Discounted PV of fiscal surplus *
B = market value of govt. bonds, P = Aggregate Price Levels, S = Fiscal Surplus (assumed
constant in every period), R = discount rate (real interest rate)
This condition must hold true in equilibrium for the Government to remain a solvent entity.
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Using the above expression, we can explain Japan’s periods of deflation/mild recession as
below (Kimura, 2010):
1. The stock market crash of 1989 and the decline of Japan as a competitive export
economy led to a decline in growth, and the deflation in this period (1990-95) can be
explained by the standard quantity theory of money.
2. By 1995, low growth expectation started kicking in (real GDP decline) due to
decrease in TFP (lower investment) and financial intermediary function deterioration
and decrease in labor force.
3. Using the IGBC expression r began to ↓ leading to B/P < S/r. According to the EB
view the current expenditure of the private sector also ↓ and hence the aggregate
demand began to fall resulting in drop in P till B/P = S/r condition was restored. The
fall in Aggregate demand also meant that the economy experienced periods of
recession.
4. Rearranging the expression we get P = B*r/P. Notice that initially, when the r begins
to ↓, there is a ↑ in B and prices remain stable. But beyond a certain threshold of the
long term rate, the economy enters a “liquidity trap” and B cannot change any more,
leading to a long term deflationary and potential recessionary spiral.
Relating the Expected Burden View to the current global situation
As derived above, we can see from the “Expected Burden” View that an economy can enter
into a period of deflation and recession if the below conditions begin to co-exist:
1. The periods of low growth are long enough for the economy to lower their expectation of
long-term growth rate.
2. The economy begins to enter a liquidity trap (i.e. Long Term yields are very low)
It took Japan a period of approximately five years (1990-95) of continuous low growth to
lower their expectations of long-term growth rate (Kimura, 2010).
Since 2008, the increased levels of risk-aversion have meant that the growth rate of the
advanced countries (US and the Euro-zone) has been low or in some instances negative. This
has persisted for a period of 3-4 years now and now the transmission of these low growth
rates into expectations for future growth rates is taking place.
Evidence of Lowering of Expected Long-Term Growth Rates
1. Growth Rate of M2 and Monetary base in the Economies: With numerous capital
injections in the advanced economies, it was expected that the economy could be
pumped into a high growth mode. However the difference between the Monetary
Base growth and actual circulation (M2) growth rate (a difference of more than 100%
in later 2009) meant that banks did not lend forward due to both, an increased level of
perceived risk and lack of suitable business growth opportunities to lend to.
2. Scepticism of Quantitative Easing 3 on rallying up the Commodity Prices: When
QE2, announced, commodities was the biggest gainer (DJUBS rising to 12%)
(Barclays, 2012). However, in the long term, QE2 failed to achieve its objective and
the spike in commodities returned back to normal. This time around there is already
scepticism in the market and commodities have performed as expected post the QE3
announcement.
3. Austerity Measures doing more harm than the proposed good: The short term
austerity measures that several European nations have further dampened growth
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expectations. After the IMF proposed belt tightening in Oct 2010, it was expected that
the spending cuts in the economy would be substituted by private expenditure and the
economy would end up growing nevertheless (Economist, 2012). But the private
expenditure growth has not been significantly observed yet, linking the risk aversion
levels to a lowering of growth expectations.
Evidence of Liquidity Traps
1. Ineffectiveness of QE2 and Operation Twist and Relative Success of the ARRA:
Although QE1 was meant to kick-start the US economy into life, QE2 was meant to
bring it back towards normalcy. However as we observe, the long term rates in several
countries still remain low. The ineffectiveness of monetary responses and the relative
effectiveness of fiscal programs like the ARRA mean that the US economy could be a
strong indicator that the US economy is in a liquidity trap.
2. QE3 operation to operate as an interest rate target rather than a money supply
target: This is also evidence that governments have by simply injecting tons of money
in the economy, the desired affect is not being achieved. Hence the interest rate target
approach is being used as the economy is suffering higher uncertainty on the money
market (LM) side rather than the goods and services side (IS).
3. Growth of M1 versus Monetary Base in Europe: As explained earlier, the same reason
that contributes to lower growth expectations also signifies the existence of a liquidity
trap in Europe as German economists believe. The monetary base versus M1 is
growth has been recorded at 65% versus 4% respectively (Times, 2012).
The above factors highlight the existence of both the conditions required to send the global
economy into a prolonged recessionary phase (in accordance with the Expected Burden
View)
Conclusion
It can be thus seen from the above analysis that the increased risk aversion levels are
gradually leading to a lowering of future growth expectations in the global economy. Also,
record low long term rates also suggest that major economies are already or on the brink of a
liquidity trap. These conditions forebode a phase of a global recession as seen from studies on
the Japanese Economy.
As Keynes suggested in the 1930s, if private spending is absent then it must be substituted by
public spending. Major spending by the US Government and the eventual onset of WWII
meant that the economy then was coerced out of recession. In the current scenario, conditions
are vastly different and the inter-linkages through globalisation make the situation even more
complex. To avoid a prolonged recession, the paper suggests that the actions of the
policymakers must be geared towards increasing the long term growth expectations of the
economy.
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Works Cited
Barclays, W. R. (2012, September 15). Barclays on QE3 impact: Are Commodities poised for
gains this time around? Retrieved November 16, 2012, from Commodity Online:
http://www.commodityonline.com/news/barclays-on-qe3-impact-are-commodities-poisedfor-gains-this-time-around-50367-3-50368.html
Cœuré, B. (2012, June 16). The importance of money markets. Retrieved Nov 15, 2012, from
European Central Bank: http://www.ecb.int/press/key/date/2012/html/sp120616.en.html
Economist. (2012, October 27). Free Exchange. The Economist , p. 70.
European Central Bank. (2012). Changes in Bank Financing Patterns. Frankfurt: ECB.
Grossman, R. (2012). Debt Defaults and Sovereign Risk: CDS Spreads as a Leading
indicator. CFA Society in Association with Fitch Ratings .
Hakkio C, K. W. (2009). Financial Stress: What is it, How can it be measured and How does
it matter? Economic Review .
Kimura, S. (2010). The Role of Money and Growth Expectations in Price Determination
Mechanism. Tokyo: Bank of Japan 10, 12.
Times, G. (2012, July 14). German Economies see liquidity traps in Eurozone. Global TImes
.
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