Cai Jin

Sunk by ultra-low interest rates

The late Nobel Prize laureate Friedrich August Hayek once observed that low interest rates interfered with economic calculations, causing businessmen to invest in projects that otherwise would not have appeared profitable.

I wonder what Hayek would make of the efforts by the world's major central banks in the past eight years to fight poor economic growth and weak demand with ultra-low or even negative interest rates.

At first blush, extremely low interest rates should have provided the badly needed cure to the world's economic ills.

This was the prescription used by former US Federal Reserve chairman Alan Greenspan, who did such a great job regulating rates that he was credited with creating the great 1990s economic boom.

But that remedy doesn't seem to work anymore. Take Singapore. If salvation indeed lies in keeping borrowing costs negligible, our economy shouldn't be stagnating - interest rates have languished at almost zero levels for years.

Some politicians even blame ultra-low interest rates for anaemic economic growth.

US Republican presidential nominee Donald Trump has accused the Fed of keeping rates far too low for what is healthy for the economy.

Across the Atlantic, new British Prime Minister Theresa May used her Conservative Party conference to attack the Bank of England's quantitative easing.

She said: "While monetary policy provided the necessary emergency medicine after the financial crash, we have to acknowledge there have been some bad side-effects. People with assets have got richer. People without them have suffered. People with savings have found themselves poorer. A change has got to come."

Still, these worries tend to go well over the heads of ordinary folks like me, though I dare say, like many other savers, I would be delighted to get a higher interest rate than the paltry 0.05 per cent I now earn on my POSB account.

But the reality really sank in for me when marine services firm Swiber recently went kaput under a mountain of debt. I then learnt first-hand the warped effects that low interest rates can have on people only slightly better off than me financially.

Take the lady who came to pour out her woes after getting tripped up by the escalating bond debacle. She is in her late 40s, with school-going children. Until she started a small business, she had worked in various banks for about 20 years.

The easy credit made available by the ultra-low interest rates had turned her into a big risk-taker; she invested in as many as eight properties six years ago. Each time a property she owned went up in value, she would get an extra credit line on it to make a down payment on another. And credit was usually cheap - about 1.5 per cent or less - as the additional loans were secured on her properties.

When high-yield bonds became the craze, she hopped onto that bandwagon as well. "I would use the credit lines from my properties to subscribe to the bonds. For each dollar I put up to buy the bonds, I could double up by borrowing another dollar from the bank. It was leverage upon leverage."

It had seemed like an easy way to make money. For some bonds, the returns were fabulous, working out to as much as 14 per cent, after deducting interest costs.

But even before the high-yield bond market began to turn sour, her house of cards had started to collapse. She said: "One day, my RM (relationship manager) called to say I had to top up on the loan that I took on my house because its value had fallen. I was given only two hours to come up with the cash."

Her case represented one of the most perverted instances of how cheap and easy financing can turn otherwise sensible people into credit junkies in their quest for yield, causing them to take what we know, with the benefit of hindsight, to be extreme risks.

It is an outcome not anticipated by the world's major central banks as they depressed interest rates to try and get investors to take risks and put money into companies.

On the flipside, the cheap credit caused firms to take on highly risky projects whose promised rosy returns never materialised. As banks are willing to fund only up to half of the project cost, these companies would use the money raised from selling the bonds to make up the difference, turning themselves into yet more cases of "leverage upon leverage".

Somehow, behind all this merry-go-round of cheap financing is an implicit assumption that the borrower could always go back to the bond market to get fresh financing to repay existing debt issues when they matured. No questions were raised as to whether they would be able to use operational cashflow to repay their maturing bonds.

But when the mood turns sour like now, though interest rates have stayed stubbornly low, investors would rather sit on their cash and earn almost zero return, than be suckered into putting up fresh loans needed by these floundering companies.

Banks which helped the companies to issue the bonds are not entirely blameless either. Without their army of private bankers and relationship managers who were incentivised well beyond their regular commissions to push the sale of the bonds, it is unlikely that the bond-issuers would have succeeded in their fund-raising efforts.

Therefore, it is just as well that the Monetary Authority of Singapore stepped in three years ago to ensure that home owners do not overstretch themselves financially. The authority requires banks to check before approving a property loan, that a borrower's monthly mortgage repayments, combined with all other debt obligations, do not exceed 60 per cent of gross monthly income.

Since so much lending is tied up in properties because they are one class of assets banks are happy to accept as collateral, the move stops property owners from succumbing to the same temptation to make the sort of risky wagers made by the woman I just described.

Relying on the self-correcting power of the market to weed out bad credit risks may turn out to be too much of an article of faith. Even Mr Greenspan conceded as much after failing to anticipate that the wanton mortgage lending triggered by his low interest rate setting almost caused the world's banking system to collapse during the 2008 financial crisis.

Against that backdrop, we are now confronted with a sense of deja vu as we survey the massive debt issued by companies around the world taking advantage of the cheap credit in recent years. What happens if those debts turn toxic in a market downturn?

A version of this article appeared in the print edition of The Straits Times on October 31, 2016, with the headline 'Sunk by ultra-low interest rates'. Print Edition | Subscribe