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"My concern is the consequences of pushing financial asset prices away...
Mohamed El-Erian on the need to moderate the overflowing liquidity spigot

N Mahalakshmi

Besides the time that he spends with his daughter, Mohamed A El-Erian’s waking hours are consumed primarily, waiting for two things. As the chief economic advisor at Allianz — which owns bond fund manager Pimco, which has $1.6 trillion under management — he is constantly on the lookout for the next domino that could bring financial markets to its knees. In fact, this early riser has been advocating setting aside dry powder for quite a while. Despite the latest rate cut in China and the resulting ebullience, he continues to advocate caution because of its excessive financial sector debt. The second thing El-Erian is waiting for is the final review of his latest book from his publisher. If the success of his last book, When Markets Collide, is any indication, El-Erian has another New York Times bestseller waiting in The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse. In this interview with N Mahalakshmi, El-Erian talks about the need to moderate the current overflowing liquidity spigot.

Why do you rise at 3.30 am?

I have found that my most productive time tends to be early morning. I tend to get up very early and, with a full cup of coffee, sit down to read, think and write. It is also a very good way to strike an even better balance between my professional and family endeavours.

You are the ‘consummate outsider’. Is that an advantage when analysing financial markets? 

I did not have the typical career in the private financial sector. Having completed my PhD in economics, I spent my first 15 years of work in the international public sector — only joining the private sector at a relatively advanced age of 40. I then spent time learning how to apply my skill set and experience to this new area. Because of my relatively unusual journey to the financial sector, I have tended to approach issues with somewhat of a different perspective. And I have been extremely fortunate to be able to combine this with brilliant insights from super colleagues.

You have focused a lot lately on the failure of economic systems. What flaws need to be fixed in order to have a sustainable economic model?

Most failures can be traced to two phenomena: Market failures and/or government failures. Sometimes the associated slippages are made worse by unanticipated shocks. There are many reasons why markets and government decision-making fail at times. They include incomplete and asymmetrical information, institutional weaknesses, certain human behaviours, and mindsets that adapt only partially or too slowly. 

It is hard to “fix” these issues fully and consistently. As such, it is important to have operational approaches, from both a strategic and a tactical perspective, that contain sufficient resilience and agility at multiple levels — particularly those of households, companies, governments and multilateral agencies. At the minimum, this translates into greater openness to gathering and understanding information, new learning, cognitive diversity, timely adaptation, and course correcting as needed.

In the context of what you just described, can Greece ever get its act together? 

The key challenge for Greece is to generate high inclusive growth while restoring financial viability. With an unemployment rate persistently at or above 25%, and with youth joblessness above 50% for many years now, it is an alarming and absolutely urgent challenge. And it is one that will only be addressed if four conditions are met simultaneously.

First, Greece needs to implement structural reforms that enhance productivity, jobs and growth potential. Second, it must combine this with a more intelligent approach to austerity which, up till now, has been excessive and implemented in too blunt a fashion. Third, it needs to mobilise greater immediate financial assistance, including restoring a functioning banking system. And fourth, Greece needs significant debt relief.

You are a lot less worried about contagion in Europe now; why is that and does that equanimity apply to the rest of the world?

Yes, I am less worried than I was in 2010 and 2012. Since then, significant steps have been taken to strengthen regional anti-contagion instruments, including through the creation of new institutions and emergency facilities. The European Central Bank is more engaged. And other potentially vulnerable countries — including Portugal and Spain — have taken domestic policy steps to enhance their anti-contagion defenses.

Are markets at the current level displaying active inertia? Is the Yellen Put now firmly in place?

Markets are over-reliant on central banks, viewing them as their best friends. They have also benefited from the deployment, via share buybacks and dividend boosts, of the excess cash held by corporations. These two factors have decoupled market prices from underlying fundamentals.

There are two paradigms now. One is Central Bank trade. The second is companies having too much cash, and giving it back to the market. If that changes, the system does not have the ability to absorb the repositioning. My concern is the unintended consequences resulting from pushing financial asset prices further and further away from fundamentals that are not improving. 

Does the weak first half US GDP data worry you? What is your outlook for the US economy for the next 18 months?

The US economy will continue to bounce back from its disappointing first quarter growth performance, registering an annual growth rate in the 2.5% range. While this rebound is welcome, it will continue to fall frustratingly short of the “escape velocity” that the economy is capable of, and needs.

What is the biggest threat to asset markets now? Do you consider a potential Fed rate hike a risk?

The biggest risks come from a policy mistake and/or a market accident. The former incorporates the possibility of a pre-mature central bank tightening, a hard-landing in China, and a disorderly exit of Greece from the Eurozone. The latter could be a function of decoupled financial asset prices and the risk of illiquidity when/if many investors look to reposition at the same time. 

Central banks remain very stimulative and tonnes of cash has been put to work in the market. So long as that continues, markets are not going to think about wild cards much. I think we are heading to a T-junction where this period of low growth, artificial pricing by central banks can handoff to two different things, one is a true recovery and better policies or it can handoff to low growth and financial instability. I think the probabilities are relatively equal, but I cannot see this path continue for another five years. Central banks cannot be the only game in town. The capitalist system will break at negative normal yields.   

Anything else that you worry about? 

What I worry about is that we are collectively mispricing liquidity. There has been a fundamental structural change in the market. In the old days, the broker-dealers were big and end-users were relatively small. Today, broker-dealers have been shrunk and end-users have gotten a lot bigger. If everybody believes in the same paradigm of central banks, it is fine. 

The minute it changes and we try to reposition ourselves, then you discover that there is no price at which we can reposition ourselves fully. The question then is not if we will get the equity risk wrong, it is whether we will get the liquidity risk wrong. I remember the frantic phone calls from central bankers in May 2013 when taper was first mentioned asking how can one word change the paradigm so radically and pressure the market. That was because everybody was on the same side of the trade and there is no countercyclical absorption function. 

Can China manage a slowdown and can Brazil, Russia, South Africa get their act together? 

Yes, China can and, I suspect, will manage its slowdown and avoid a hard-landing. If you want to bet against China, understand that you are betting against a massive war chest. Understand that you are betting against a closed system, it means it is very hard to impose market pressure. So you cannot force China to de-lever, which is very different unlike a western system. Understand that you are betting against a regime that has a history of learning and course correcting. China is going through a middle income transition and there are only five countries that have successfully achieved that and none of them have been as large and complex as China. If the political consensus disappears, then it is a totally different story.

The situation is trickier in some of the other systemically important emerging economies such as Brazil, Russia and Turkey. They face considerable economic and financial challenges which are compounded by political issues.

When you juxtapose the fact that the governments of the world are not united in their approach to growth, and that market forces play a very large role in reconciling economic divergences, how do you see the future of currencies? 

I suspect that we will see greater currency volatility in the period ahead, if only on account of two realities: increasingly divergent central bank policies, with the Federal Reserve gradually reducing its exceptional accommodation while the European Central Bank and the Bank of Japan keeping their foot on the stimulus pedal; and multi-speed growth dynamics. 

We also have a demand problem. There is a fundamental mismatch in the world between the will to spend and the want to spend. If you look at Europe, Germany has the wallet but not the will, Greece has the will but not the wallet and they can’t solve that. We have seen in the US what income inequality and repressed wages have done to the ability to stimulate aggregate demand. The only way then we can end up stimulating demand is by pushing up financial asset prices higher, which makes inequality worse. So, we have structural, cyclical and secular issues all pushing towards greater inequality and I wonder whether this amazing run of profits is going to end up hurting corporates themselves. 

In Europe, they are finding it enormously difficult to address. Most of the private sector investors have transferred their risk to the taxpayer. Hence, the ECB will do more QE, it will flood the system. They can continue this extend and pretend because nobody wants to go into the history books for having caused this. 

How close are you to finishing your latest book? You are a prolific writer — what urge of yours does writing fulfil?

I have submitted the first draft to the publisher. While it may sound strange to many, I find writing quite relaxing. Importantly, it also helps me discipline my thoughts; and I benefit from the feedback I get from readers. 

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