«In many industrial countries, the cities are flourishing but the rural areas are not doing well at all. In some ways, you could argue that these are areas of underdevelopment in a fully developed country.»Photo: Simon Dawson/Bloomberg

«In many industrial countries, the cities are flourishing but the rural areas are not doing well at all. In some ways, you could argue that these are areas of underdevelopment in a fully developed country.»
Photo: Simon Dawson/Bloomberg

Das Interview

«Leverage Has Been Building Up»

Raghuram Rajan, Professor of Finance at the University of Chicago, warns of defaults in the credit sector. To dampen the repercussions of the coronavirus pandemic, he argues for targeted economic measures, and he explains why he views Switzerland as a role model for the revitalization of growth in the industrial world.

Christoph Gisiger
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Few economists enjoy such a great international reputation as Raghuram Rajan. The former Governor of the Reserve Bank of India says what he thinks and is not afraid to deviate from the consensus. For instance, in the run-up to the collapse of Lehman Brothers, he warned early on about the risks in the banking system.

Raghuram Rajan

Raghuram Rajan is the Katherine Dusak Miller Distinguished Service Professor of Finance at Chicago Booth. He was the 23rd Governor of the Reserve Bank of India between September 2013 and September 2016. Between 2003 and 2006, Dr. Rajan was the Chief Economist and Director of Research at the International Monetary Fund. Dr. Rajan’s research interests are in banking, corporate finance, and economic development, especially the role finance plays in it. The books he has written include «The Third Pillar: How the State and Markets are leaving Communities Behind» (2019), «I do What I do: On Reform, Rhetoric, and Resolve», (2017), and «Fault Lines: How Hidden Fractures Still Threaten the World Economy», for which he was awarded the Financial Times-Goldman Sachs prize for best business book in 2010. Dr. Rajan is a member of the Group of Thirty. He was the President of the American Finance Association in 2011 and is a member of the American Academy of Arts and Sciences.
Raghuram Rajan is the Katherine Dusak Miller Distinguished Service Professor of Finance at Chicago Booth. He was the 23rd Governor of the Reserve Bank of India between September 2013 and September 2016. Between 2003 and 2006, Dr. Rajan was the Chief Economist and Director of Research at the International Monetary Fund. Dr. Rajan’s research interests are in banking, corporate finance, and economic development, especially the role finance plays in it. The books he has written include «The Third Pillar: How the State and Markets are leaving Communities Behind» (2019), «I do What I do: On Reform, Rhetoric, and Resolve», (2017), and «Fault Lines: How Hidden Fractures Still Threaten the World Economy», for which he was awarded the Financial Times-Goldman Sachs prize for best business book in 2010. Dr. Rajan is a member of the Group of Thirty. He was the President of the American Finance Association in 2011 and is a member of the American Academy of Arts and Sciences.

Another accident in the financial system threatens the world today. The spread of the coronavirus is causing severe turmoil in the stock market, and risk premia in the credit sector are skyrocketing. Central Banks are starting one emergency intervention after the other, with the ECB now launching a massive stimulus program, too.

«An all-out attack on the virus by testing and containing is the first and most important element. At this point, Central Bank action is merely saying: ‹we are here›», says Dr. Rajan in an in-depht interview with The Market/NZZ.

The high-profile economist, who teaches Finance at the University of Chicago’s Booth School of Business, also advocates for supporting companies and employees with direct measures to alleviate the economic consequences of the pandemic. Currently, he sees some of the greatest financial risks in the corporate credit markets.

Professor Rajan, in reaction to the ongoing market turmoil, Central Banks are flooding the financial system with liquidity once again. What are your thoughts on these measures as former Governor of the Reserve Bank of India?
In times like this, monetary policy can be useful in providing some confidence. But targeted measures, both against the spread of the virus and against the consequences of the disease, are really the first element of government action. Once there is more stability, perhaps some stimulus may be warranted. But at this point, you want to think about corporations being hit and having cash flow problems. So there might be some ways to alleviate their access to credit, perhaps by targeted lending schemes. Also, there could be some value to working with companies to subsidize absent employees, especially with regard to virus related issues. But an all-out attack on the virus itself by testing and containing is the first and most important element at this point.

And what about the global situation?
Since this is a global pandemic, it’s also useful to think about countries that don’t have significant medical facilities to make sure testing is available as well as medical equipment to cure people who have the disease. Such measures seem important because you want to contain the virus on a global basis. So at this point, Central Bank action is merely saying: «we are here».

Additionally, we’ve witnessed a steep drop in crude oil prices. What are the implications for financial markets?
To some extent, the oil market reflects the lack of international cooperation. Particularly in the oil market, all participants are incentivized to be as cooperative as possible to support prices. The Saudis breaking with the Russians and cutting prices further doesn’t bode well for oil prices, since there was already pressure because of the curtailment in demand. As a consequence, there certainly will be pressure on the indebted parts: Many producer countries have a need for $50 or $60 oil prices in order to meet their budget requirements, Saudi Arabia is one of them. If oil prices stay low for some time, especially the indebted countries will be in difficulties. Big price volatility is in nobody's interest.

Speaking of leverage: What are the implications of $24 crude prices for the oil patch in the United States?
The shale industry is one of the more highly leveraged parts of the US corporate system. There are a lot of high yielding bonds that have been issued by shale explorers. Certainly, the junk bond market is already feeling quite queasy because of the size of these exposures. In the financial markets, there has been an intense search for yield. Nobody wanted to be left behind, and Central Banks have kept rates really low. So the search for yield has gone into low quality areas of the credit market, and we see some of the consequences now with an expected rise in defaults.

You were one of the few experts who warned about extended leverage in the financial system before the credit crisis in 2007/08. How healthy is the system today?
Leverage has obviously been building up, even after the financial crisis. It’s not in the same places: Banks and US households have deleveraged somewhat, but there are new areas of leverage like the corporate sector which is more leveraged than it used to be. And, some places look just like they looked before the financial crisis, private equity for example where a lot of leveraged loans have been issued. Multiples in private equity are back to where they were before the financial crisis and the earnings are sometimes not even as good as then.

Where else do you spot cracks in the financial system?
The problem is that everybody is trying to maximize yield. One area for significant concern are firms with a credit rating just at Baa or BBB. Many institutions can’t hold bonds below investment grade, so they have focused on entities that are just Baa. In a downturn, a lot of these bonds will become problematic and their rating will be cut and go down to a level that cannot be held by institutions. So if many institutions have to sell at the same time, you could have a plunge in the prices of those bonds. That’s something we didn’t pay as much attention to in the past, but is something to worry about.

To what degree are Central Banks and super low policy rates responsible for these new excesses in the credit markets?
The question is why is growth so weak and why are real interest rates so low despite so much accommodation from Central Banks and governments. Unless we have the answers, it’s not clear whom we should blame. Central Banks will simply say: «We’re just following the real rate down. And, if we hold the policy rate too high above the equilibrium real rate, then we will be overly tightening the economy.» So the Central Banks will argue that environmental factors are keeping real rates low.

How credible is this argument?
Part of the reason for keeping real rates low in the industrial world are factors like low productivity and aging populations which may constrain demand somewhat: Low productivity because wage growth is not as strong as it used to be, and aging populations because the propensity to save is higher and the desire to buy and spend is lower as populations age. But we don’t understand why growth in the whole industrial world is slowing down so much. What is true, again and again, is that when Central Banks attempt to keep rates low frictions in the financial sector are building up.

From the dotcom bubble, to the housing bubble, to today’s market turmoil. Each time economic growth has been stimulated by financial engineering. Why aren’t industrial countries able to grow organically?
There is also a regional or local aspect: In many industrial countries, the cities are flourishing but the rural areas are not doing well at all. In some ways, you could argue that these are areas of underdevelopment in a fully developed country. Every country seems to have them, maybe with the exception of Switzerland. But if you look at France, many areas outside the big cities are underdeveloped. Today, you see the big rush by the conservative UK government to try to develop the small towns in the north which have been left behind and have been part of the Brexit movement. Country by country, there’s a sense that people haven’t benefited from economic growth. Even in the big cities, disparities are growing and people without a strong education typically tend to get lower quality jobs of which there are plentiful. There are lots of Uber drivers now, but they’re not earning tremendous wages.

How come?
To my mind, it’s the technology induced differences in economic outcomes and economic opportunities that hold back some economies and create the kind of political differences and tensions that have become so central to our countries today.

What do you mean by that?
Automation has been a very important factor everywhere and trade has been a big factor in many of the small towns where big employers closed down. In small towns, often there used to be a big manufacturer in the past. But when the biggest establishment closes down and jobs are getting outsourced, there is very little activity left. And, as economic activity disappears, social dysfunction moves in: Families are breaking up, crime, alcohol and drug abuse rise. Various local institutions such as schools and local clinics are all breaking down. As a result, when economic activity leaves, the whole community starts breaking down. That puts the community even further behind and makes people unable to take advantage of the growth that is emerging. That’s why in the US, in Europe and in Japan, we have this paradox that unemployment is very low but nobody is happy.

How can we solve these problems?
I would like to borrow a little bit from Switzerland. To me, there is some value to the kind of decentralization and principle of subsidiarity that is followed in Switzerland. Obviously, it’s very difficult to take a system and just implement it lock, stock, and barrel elsewhere. But this notion of delegating more power to the locality is something that we haven’t paid enough attention to over the last few decades. Too much power has gotten centralized: Either in Brussels, in the national capitals or in international organizations and meetings. So thinking about what really needs to be centralized and what doesn’t is actually quite important as we try to rebuild more agencies within the communities that people live in.

Why is this balance between competitive markets, honest governments, and healthy, local communities so important for durable economic growth?
Some people may find it strange that in a globalized world I’m going back to the community as a way to find answers. But in a globalized world where we see the growing disease of loneliness, many of us feel powerless and unable to affect anything. If nothing else, the community can give us a sense of identity but also a sense of power. So even if we can’t fully address the forces that are hitting us, we have some small ability to address them. That itself can make us more engaged and willing to accept globalization more broadly. So in a sense, I’m trying to see how we can have both: A strong community helping people cope with markets and a more bureaucratic government, but at the same time benefiting from the tremendous choice markets give us as well as the more arm's-length governance that comes from a modern government.

What else could be done to revive communities?
A community has to be attractive for new investors. Typically, that requires a leadership group that emerges and tries to find out what is going to make a place attractive to new service companies. The second thing is creating infrastructure locally which makes a place easier to access and more attractive. Many places in the US for example don’t have broadband. Another important thing is getting the community socially engaged so everybody feels to be part of the solution. And then, funding is very important. If you solve the chicken and egg problem and create some assets which make a community look better, make people want to be there, then you start a virtuous cycle: More firms come in, they start to create activity, more people can get out of low quality jobs or stop hanging out on the streets which makes a community more livable. So we need to create these virtuous cycles, and I have some solutions for that in my latest book entitled «The Third Pillar

And what kind of role can healthy communities play when it comes to a global disease like the coronavirus pandemic?
To some extent, the coronavirus is a social disease which we can tackle best as a community. Yes, we understand the dangers of coming together, but we also understand the dangers of not acting. So we should all take responsibility because of the effects the virus has on other people within our community. That means getting ourselves tested, and if we test positive stay quarantined for the appropriate time. Conversely, people who don’t care if they carry the virus and are not going to quarantine themselves are the people who require a centralized and very authoritative response.

Will this outbreak further reverse the process of globalization?
I can certainly see that. But we have to be aware of the fact that no country can be safe alone. You cannot be safe if the virus is raging in Italy, Iran, China or Spain. Healthy precautions are needed, but you can’t erect high enough walls because the virus figures out a way around it. In this integrated world, we need to think about integrated solutions. That means that if the virus spreads to Africa, we should all be part of the solution since many countries there simply do not have the capabilities in their health care system to do an all-out assault against it as we’ve seen in the case of Ebola. To put it more broadly: Your temptation is to keep out people from other countries, but it’s even better to bring down the disease around the world rather than have places of red-hot epidemics.

How big is the risk of a global recession right now?
Some of the countries that had low growth to begin with will show consequent quarters of low growth if this doesn’t get fixed soon. There will be recessions elsewhere. Key, however, is how bad does this get and what are the ways we come out. Certainly, it’s important to slow the outbreak. But there is also a risk that firms are declaring bankruptcy and people are unable to put food on the table because they can’t go to work. This is why targeted measures are very important: That you don’t have large scale bankruptcies, especially amongst small and medium sized enterprises. And then, once the basic problem has been fixed it’s important to get people to have some confidence that jobs will be back and spend. At that time, some elements of fiscal as well as monetary stimulus might be warranted. But at this point, the first order of reaction is the fight against the virus.

Is it possible that the global economy suffers a similar setback as during the financial crisis of 2007/08?
It’s hard to know and to be categorical. It’s possible that we get vicious cycles where poor economic output gets exacerbated by leverage which then creates even worse economic outcomes and so on. But again: If the coronavirus episode lasts just a few weeks and things start stabilizing, everybody knows it’s going to be over and there is no deep cut in consumption, we could have an economic rebound later in the year. That’s everybody’s hope. But if the slowdown lasts for a significant amount of time and there is no direct aid to firms or to individuals who are exposed then things likely will get worse.