Daily Equity Report

The Reserve Bank dropped their key repo rate by a further 1%, led by the exceptionally weak economic data released 2 days back. Across the globe the direction has been the same – i.e. not a response to inflation, but a response to a rapidly slowing economy with a high element of financial gearing

The concept that greater and greater use of debt will cause instability in an economy was proposed by the late Hyman Minsky, a mid 20th century American economist (1919 -1996). He articulated a theory on financial instability in 1986 – called the Financial Instability Hypothesis.

With the recent collapse of credit markets, his theory has proved, in the words of Paul McCulley from Pimco, “unnervingly prescient in explaining the rise and fall of shadow banking – and the dizzying journey of the global financial system over the past several years.”

His theory provided a framework for distinguishing between stabilising and destabilising capitalistic debt structures.

In the theory he provided 3 financial stages of increasing fragility with respect to debt.

• Hedge financing (no relation to hedge funds) where income flows meet all debt repayments (i.e. interest and principal). This is typical of so called self liquidating debt. I.e. debt that finances assets that produce income.

• Speculative financing where income meets interest obligations, but is unable to meet principal repayments. In these cases the principal obligations need to be rolled over, i.e. extended.

• Ponzi finance, where the cash flow from operations is not sufficient to fulfil either the repayment of principal or interest. Here assets need to be sold to make repayments.

Over a longer period of time economies will move from financial structures dominated by hedge financing to structures dominated by ponzi financing. Conventional wisdom is that economies are naturally stable, but Minsky observed that capitalism is inherently unstable.

The longer people make money by taking risk, the more imprudent they become in risk taking. Risk premiums decline, asset prices are driven up, and gearing levels are increased. I.e. stability is ultimately destabilising.

The financial system progressed steadily but surely up his risk scale moving from traditional financing to riskier financing such as subprime loans, mortgage backed securities, structured investment vehicles, negative amortisation loans etc.

Paul McCulley notes that since the peak of the credit crisis, late 2007, early 2008 we have been in a reverse Minsky Moment with assets prices falling, risk premiums getting higher, leverage being scaled back and economic growth being squeezed.

In sum a debt deflation environment.

In a delevering environment we have what Keynes coined as the paradox of thrift. I.e. great at a micro level, but very negative for an economy when all citizens are acting this way.

If we understand that greater and greater access to debt helped asset price inflation, we also understand that the excess and unstable debt needs to be worked out of the system before the cycle can turn again. We will need some patience.

Kind regards

Ian de Lange
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966