Commentary: The Minsky Moment
Hyman Minsky was a post-Keynesian economist at Washington University who focused on the credit cycle.
Economic oscillations have been the purview of classicists for centuries. The roles of weather patterns, political instability and wars were the subject of endless treatises and dissertations.
However, Minsky focused on the role of financial credit in determining the fluctuations of the business cycle. Ironically, he argued that prolonged periods of economic prosperity lead to declining yields, as the perception of risk evaporate.
This forces investors to rely on more speculative investments and non-market practices to boost returns. The result is the formation of asset bubbles, where market valuations are misaligned with fundamentals.
Eventually, as returns become unsustainable and incidents of corruption come to light, investors begin to exit. The sell-off turns into a rout, as investors are forced to divest some of their higher quality assets. The result is a generalised sell-off. In 1998, former UBS chief economist Paul McCulley coined the phrase, the Minsky Moment, describing the combination of financial scandals and collapsing asset values as evidence of a cyclical peak.
Since then, there have been several Minsky Moments. But, the most memorable was the Bernie Madoff scandal, which coincided with the 2008 financial crisis. The question is whether we are in the midst of another Minsky Moment.
The global economy has been immersed in a sea of liquidity for the past seven years. Trillions of dollars were pumped into the economy through various quantitative easing programmes. Much of the funds were channelled abroad, with a good chunk flowing into the emerging world. This manifested itself into a tidal wave of consumer and corporate credit that appeared in Chile, Colombia, Peru and Brazil.
A sense of euphoria swept the asset class and an air of arrogance was in plain view. However, a series of scandals, swindles and incidents of corruption began to surface. Although it was not the first scandal, the collapse of Eike Batista's OGX highlighted the market's vulnerability to marketing hype. The company's downfall was Latin America's largest corporate default. Unfortunately, it was a prelude of a much bigger scandal.
The allegations swirling around the so-called Car Wash scandal is sending shudders across Brazil's political and corporate spectrum. Many of the country's leading political figures and companies have been implicated. Not only has it tarnished Brazil's reputation as a leader of the so-called BRICs, and Petrobras' legacy as a world leader in corporate management, it raised serious concerns about its viability.
The company's leverage is reasonable, but Petrobras is in the midst of a major capex programme and it needs to access the international capital markets. Failure to do so will constrain its income generation and balance sheet. For now, Petrobras plans on cutting capex and divesting assets. Nevertheless, the scandal has been a blow to the company's aspirations.
Some people wonder whether there are other similar scandals lurking under the surface. Colombia went through its fair share of corruption investigations, when the Nule scandal came to light. Now, Panama is going through a similar ordeal. Although hard to believe for such a small country, the Panamanian swindle could reach into the nine figures.
Is this evidence of another Minsky Moment, or is it just business as usual in Latin America? So far, there have been no signs of panic and market dislocation. Part of Minsky model was the contagion that was produced when investors were forced to divest their higher quality assets to pay down the liabilities produced by their more speculative positions.
This time, there has been a segmentation of the market. Assets affected by the scandals have sold off, but the contagion has been limited. Indeed, sovereigns and high-quality corporates continue to access the financial markets. So what is going on?
According to Minsky's model, the precursor to the change in phase is a shift in liquidity conditions. The US has ended its quantitative easing programme, but the Europeans just embarked on theirs and Japan just expanded its own. The fact that issuers are running to the euro-market confirms that liquidity remains strong.
The question is whether the raising of Fed funds at the end of the year marks the final condition needed to precipitate the change in phase? It all depends on what will happen in Europe and Japan. If their central banks decide to taper during the latter half of the year, then we will need to prepare for a new Minsky Moment and what typically happens next.
Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.