2020 had around $16 billion of catastrophe bond and insurance linked-securities issuance. Around $47 billion capital remains outstanding. And No, there were no Covid-19 Cat bonds issued prior to the pandemic! I have concluded that these instruments indeterminate payouts have huge optionality which cannot be correctly modelled and therefore this security is not amenable to purposive inclusion – despite their non correlated characteristics – with the strategic asset allocation process. Certain other insurance linked securities may be, but even those are a stretch and should reside within the realm of tactical and opportunistic play.
What role can the financial system play in improving post pandemic global supply chains?
The pandemic has distorted and disrupted global supply chains. Shelves stand empty and inventory to sales ratios plummet. Manufacturing, construction, retail and wholesale trade are especially hit. Business activity is likely to reduce and prices are increasing in lumber, in consumer goods and other sectors. Scarcity in semiconductors and the auto sector is now very evident.
I have been dabbling off and on trying to properly frame and then answer a perplexing question : What role can the financial system, and in particular global banks, play in improving post pandemic global supply chains? I conclude that the biggest opportunity lies in capital structuring opportunities.
To support my conclusion I explain how i went about it.
UNCTAD has excellent reports and statistics on global and regional trade flows which provided a wonderful sense of magnitude and context. I also examined literature suggesting that supply chains have become global, fragile and sophisticated ever since China joined the WTO. The basic economics literature and bargaining theory outlines conflicts of interest in trade.
With this background, I now am able to demonstrate that there is a huge opportunity for capital structuring & cost of capital arbitrage within international trade. I explain this with a customer view and financing cost of supply chain perspective and then conjecture on the value-add a global bank (or financing institution) can bring. This value-add can be through participating in supply chain financing cost of capital arbitrage, providing as yet undiscovered financial solutions, creating new mechanisms for driving working capital, driving down cost of goods sold, as well as providing the lubricant to immunize supply chains – which in turn will drive more sales and promote global trade growth.
Managing taxes are clearly an important part of any investment strategy for taxable investors. Harvesting losses, timing decisions, deferring gains can certainly add value to a portfolio. But what impact, if any, do taxes have on arriving at long term strategic asset allocation?
Our conclusion: Having tested over 100,000 randomly generated unbiased portfolios with unbiased tax rates, we discovered that taxes have an impact not only on return, but also on risk. This fact mediates the impact of taxes on asset weights, as the relative efficiency of assets is roughly the same before and after tax. Tax optimization is important and adds value to tactical asset allocation, to asset location, but is largely irrelevant for determining ex- ante long term strategic asset allocation. On a risk-adjusted return basis taxes do not matter.
It has long been and remains my view that the US Treasury will not default upon its debt obligations- not even for a very brief period of time. Yet markets have been on edge for the past month as the date (October 18) by which the Treasury would have exhausted all extraordinary measures approached. Senate Majority Leader Chuck Schumer just announced a temporary agreement reached on increasing the debt ceiling through December. This is good for unless a political compromise was reached, the US Treasury would have been forced to switch to cash-only management in order to continue operations i.e. after October 18 the Treasury would have to operate on a cash-only basis.
The market implications from a technical Treasury default – a default in which bondholders would be paid in full but with some type of delay – are both wide-ranging and hard to anticipate. There are, however, two potential developments that would most seriously threaten the stability of financial markets: (i) a credit freeze in the short-term repurchase agreement (repos) market where Treasuries are used as collateral to secure short-term borrowing; and (ii) severe disruptions to the money markets since most money market funds (MMFs) invest heavily in US Treasury securities. The credit markets would freeze, if a handful of MMFs were to “break the buck” (where the net asset value (NAV) per share falls below USD 1. Even if the immediate impact was not dramatic, if a short-term default led investors to question the willingness of the US government to honor its obligations in a timely manner, then the impact could be both more far reaching and long lasting.
When the $480 billion debt hike is exhausted, the political gamesmanship from both parties will renew. Negotiations in Congress will likely heat up again towards the end of the year, as they renew attempts to forge a long-term deal. I think that the negotiations will continue and bleed into 2022 with rigidity on both sides to prove to their respective constituents that they stood their ground and boost their reelections chances at the next primaries. Congressional representatives have a strong incentive to fight until the last minute. Therefore, I again expect a last-minute deal to emerge, possibly as late as in late February or early March, when the Treasury will once again cease to be able to use book-keeping measures to operate under the ceiling. However, I don’t expect a drastic government shutdown.
In the U.S., the debt ceiling is once again making headline news. Government shutdowns and the thought of U.S. defaulting on its debt could have devastating consequences both for the U.S. and for the global economy. Meanwhile, India is a completely different story.
The Covid-19 pandemic after effects will test how much debt developing countries can bear. The attitude within OECD of course has been “don’t worry about government deficits so much and continue to spend”. Last year the U.S. Federal Reserve and other counterparts moved aggressively with sweeping emergency rate cuts and offers of cheap dollars, to help combat the pandemic. Emergency policy easing by central banks in UK, New Zealand, Japan and South Korea, Australia, too had provided further stabilization. But can non-OECD or developing countries pump ample liquidity into the markets too, and support fiscal stimulus?
Which brings me to India. India has around $540 billion FX reserves.
India’s overall fiscal deficit- the gap between expenditure and revenue for 2020-21 was 9.3 per cent GDP, a very high number which complicates the task of monetary policy. A fully discretionary fiscal policy framework will likely worsen this. India has had the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 which sets a target for the government to establish financial discipline in the economy, improve the management of public funds and reduce fiscal deficit. The FRBM has in the past incentivized the government to reduce the fiscal deficit by a percent of GDP each year, and gradually move to a position where current spending matched current revenues. The government would need to explain to Parliament any breaches of the Act. The discipline of this law was in part responsible for a significant improvement in government finances in the first decade but after the 2008 GFC, the general government’s deficit rose sharply from 4% of GDP to 8.3%. A pause in the FRBM and an expansionary budget thereafter contributed to the large increase in the deficit. Once the discipline of the FRBM was obviated, the urgency of imposing fiscal limits was no longer clear. After the stimulus, the economy did recover from April 2009 onwards, but the fiscal stimulus was not rolled back, and deficits remained high. Ever since, the government has continued to borrow. The lack of a rules-based system due to escape clauses in the FRBM has come alongside a sharp deterioration in government finances. A fiscal rule spending rule would increase the accountability and transparency of fiscal policy. A rule could be a variant of an “Expenditure Rule, or Revenue Rule, or Budget Balance Rule or a limit on Debt Rule”.
Of course, implementing any such fiscal rule would be much more difficult, as it involves the government and opposition coming together on spending issues.
But shouldn’t India have fiscal rules that outline its fiscal policy?
We spent a few years as active participants in the Non-Traded REIT industry. We now offer some insights, gleaned hopefully with the wisdom and humility that only comes with reflection and hindsight.