Part II: Roubini Talks Risk, Recovery And The Threat Of A Triple Dip Recession

Oct 21 2014 | 12:41pm ET

In the second half of our interview with Nouriel Roubini, FINalternatives editor-in-chief Deirdre Brennan speaks with the renowned economist about IMF policies, the risk posed by shadow banking systems, and the possibility of a hard landing in China.

In the first part of this two-part interview, which was published yesterday, Roubini focused on the U.S. economy, the end of quantitative easing and his outlook for the U.S. stock market. (View Part I)

The IMF recently lowered its growth projections for emerging markets and developing economies. What is your view on that?

Well, we started the year with projections that were similar to the ones that now the IMF has. So, we were more bearish than the consensus about global economic growth and we saw some of the weaknesses that would manifest themselves, say, in many parts of the world like emerging markets, the Eurozone, even some of the softness in Japan. And on the U.S. we believed that the recovery will be more anemic than what the consensus had it. So, I would say currently the [IMF] forecast for the U.S and for the global economy for this year and next year is quite close [to ours], with some caveats. So, I would say the consensus and the IMF [view] is moving in our direction.

The IMF report mentioned that some of the risks to stability no longer come from traditional banks, but rather the so-called shadow banking systems such as hedge funds and money market funds. Should we be worried about the ‘shadow banking system?’

After Dodd-Frank and Basel III, of course, the amount of leverage and risk taking in traditional banks has [been] reduced even if leverage ratios remain pretty high still in the U.S., but especially in the Eurozone and in the U.K. And for the traditional banks, I’ll make the caveat that official on-balance sheet leverage has fallen, but there are still plenty of off-balance sheet and derivative positions that are still humongous by any standards. But certainly, I would say that the shadow banking system is un-regulated or less regulated and most of the [regulatory] effort has gone toward traditional banks rather than shadow banks.

I don’t want to generalize because you have to be specific when you look at the amount of leverage [firms] are taking and separate what’s happening in hedge funds and which kind of hedge funds and which kind of private equity and which kind of other financial institutions that are going to be in this process of re-leveraging. But first of all, the re-leveraging of the corporate sector is already underway and a lot of it is more financial engineering rather than borrowing to do more fixed investment. An increase in M&A activity, leveraged loans, LBOs and you name it. And there is a growing participation of shadow banking institutions of one sort or another in this process of re-leveraging.

Take junk bonds. Each one last year was back to the 2007 level. Pricing is at very, very tight spreads and it’s not just pricing in quantity. You have things like PIK toggle, covenant light and other junk like that that is already back again like it was before. And this is just the beginning of the re-leveraging cycle. So maybe there is not a bubble today in the stock market. Maybe there is not a bubble today in credit. The question is not about today. If the Fed is going to end QE in October and then stay on hold until mid-June next year, and in the middle of 2016, policy rates are going to be, say, 1.5% based on the Fed votes, then what’s the risk that then we’re going to have the asset reflation becoming asset inflation, asset inflation becoming asset frothiness and asset and credit frothiness leading eventually to an asset and credit bubble. So the question is not today, but how a very slow exit from zero policy rate that is justified by the fact that the economies are still weak--low growth, high unemployment, low inflation--how much that may lead actually to a renewed asset and credit bubble in the next couple of years.

Now central banks tell us ‘don’t worry, we will deal with the asset bubbles if you exit slowly with macropru,’ but macropru may not work. And if it doesn’t work, for many reasons, then you have only one instrument, interest rate, and two goals, economic recovery and financial stability. And damned if you do and damned if you don’t because if you exit slowly, because the economy justifies it, you’ll have the mother of all bubbles. And if you said you’re using monetary policy to break the bubble because macropru is ineffective, then you’ll have a hard landing of the bond market and a hard landing of the real economy. So that’s going to be the biggest dilemma that the Fed and all the other major central banks are going to face in the next few years. It’s not when QE ends and it’s not even when it’s the exact month of first rate normalization or the speed of that normalization. There’s a more fundamental problem of how you achieve financial stability and that’s a problem not just for the Fed. The same problem is faced by the Bank of Canada, the Bank of England, the Swiss National Bank, The Riksbank, Norges Bank, HKMA, MAS, PBC.

You mentioned that you have a meeting in Washington with the IMF tomorrow. What will you talk about?

I’m usually in a listening mode trying to understand what they think, first of all. I would say that Christine Lagarde is correct, we might be at risk of a ‘new mediocrity’—that is a different word today for ‘the new normal’ that PIMCO was talking about or the U-shaped, anemic, subpar, below trend recovery of the global economy and advanced economies that I’ve been talking about since 2010. So they’re just different words for the same problem—in advanced economies recovery, is not exceptional…the global economy looks fragile.

Turning to geopolitical risk, what are your biggest fears? What keeps you up at night?

Well I would say geopolitical risks for now have had limited economic and financial impact in part because central banks have suppressed volatility with very accommodative policies in part because there has not been a shock to the supply of gas and oil and in part because markets believe that these tail risks are going to remain tail risks. They’re not going to materialize or escalate in a more virulent way. So, I do worry about geopolitical risks, but I don’t think any of them so far are going to explode in any serious way.

I worry about these mediocre recoveries. I worry about the risk of secular stagnation, especially in Europe and Japan, a bit less so in the case of the United States. I worry about both advanced economies and emerging markets needing to do structural reforms to boost growth. And the political reality is that reform occurs more slowly than is optimal. I worry about the fact that we still have huge legacy private and public debt in advanced economies and now in emerging markets, and that that dynamic interacts poorly with a strong growth recovery…but I argue that QE, credit easing, forward guidance, and zero policy rates were necessary because the alternative would have been a global depression rather than a great recession. So I’m not among those who say QE was bad. Things would have been worse.

I see that quantitative and credit easing has led to asset inflation and a creation of credit in the financial system, but not real credit creation for the real economy. And that asset inflation as I said, down the line, could lead to credit and asset bubbles that could go eventually bust. So those are some of the things I worry about.

None of these trends, in my view, that are downside risks—whether a renewed problem in the Eurozone, the harder landing of China, frothiness in financial markets, geopolitical risks—are going to materialize in real tail risk to the global recovery and to financial markets in the next 12 months. But I would say over the 24-month horizon, I can see how many problems [that] remain unresolved can eventually lead to financial and economic stresses over a two- to three-year horizon.

What is the risk of a hard landing in China?

Our view at Roubini [Global Economics] is that there are two extreme views about China and they’re both wrong. One is the official Chinese government view, which is also the market consensus, that China can maintain 7% or 7.5% growth for the next few years. And then you have the Jim Chanos view of China of a total hard landing, growth collapsing to 3%, economic and financial instability, and even political and social instability. I think a real hard landing is unlikely, but I think the idea that China can maintain growth at 7.5% for the next few years is total wishful thinking because if they’re serious, and they have to be, about the increasing leverage that has occurred in the last few years and stop it, growth has to slow down.

So our baseline has growth this year is barely above 7% reaching 6.5% by next year and 5.5% by 2016. Now 5.5% is not a real hard landing, but it’s not a soft landing. The financial market has not priced in a growth rate of China of 5.5% two years from now as opposed to 7.5%, and the impact on commodity prices, on Chinese equities, on Asian equities and on global financial markets has not been priced in.

So, I would say people are worried about pricing in worries about the Eurozone, but they don’t expect China to grow at 5.5%. If we turn out to be right, and we believe we’re going to be right, that’s a bumpy landing. That’s a rough landing, but not a formal hard landing. So I would say that would be our baseline for China.

Read Part I of the interview—which focuses on global growth, IMF policies and geopolitical risks—will be published tomorrow.


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