What Is a Safe Asset?
Last month, David Beckworth at Macro and Other Market Musings had some interesting thoughts on the global shortage of safe assets. His essay got me thinking about what is a safe asset? Beckworth alludes to two definitions of ‘safe’: (1) a credit being AAA-rated, (2) satisfying a certain level of liquidity to be used in repo markets (an important aspect of US credit transactions). I would agree with (2), but not necessarily (1).
Why does a ‘safe’ asset need to be AAA? To be sure, the share of AAA sovereigns of 76 developed and developing/emerging sovereigns fell by 3% in 2011 compared to 2007. This should hardly be surprising, given the weak recoveries and leverage that exists in the developed markets. But it’s liquidity, and to a lesser extent, sovereign risk that matters, not the rating, per se. Furthermore, ‘safe’ is a matter of perspective.
Liquidity is a pre-requisite for a ‘safe asset’ so that investors can purchase this asset in even the harshest of times. The United States runs the most liquid bond and currency market in the world; it can satisfy demand from flight-to-safety in times of stress. But one can think of liquidity in another manner: the ability to print fiat currency that is used to honor the debt instrument (asset). The US government issued just 8% of its external government debt position in non-dollar form. Better put: the US is a ‘safe’ assets because it’s a market large enough to satisfy broad demand and the US government is always going to be able to honor its debts. Liquidity is the most important definition of a safe asset, rather than the rating.
Norway prints its own currency, in which most of its bonds are denominated. However, it will never be a ‘safe asset’. The bond market is just not capable of satisfying broad demand during times of stress. So while Norway has enjoyed AAA status since 1975 (according to Bloomberg), it’s never going to be a safe-haven bond market for the global economy. Norway may be perceived as ‘safe’, though, due to its AAA status; but that’s of secondary concern.
And now I get to my second point: perception of safety. On December 5, 2011, S&P put the entire Euro area (EA) on credit watch negative, including Germany. If Germany were downgraded to AA+, does this mean that it is less ‘safe’? I would argue quite the opposite. Specifically, for all EA investors – using external debt statistics from the World Bank/IMF, I calculate that EA government debt held outside the EA amounts to 24% of GDP – the bund market (the German sovereign bond market) would enjoy an increase in safe haven status relative to other European economies. The reason is, that EA investors are likely euro investors, and Germany is the most liquid and perceived safest debt market in the EA. So unless you want to take currency risk, which detracts from the ‘safety’, then EA investors are likely to flock to safe within the EA.
Until the German investors themselves start to seek non-euro assets, the German bund market is likely to increase in ‘safety’ from the perspective of euro (as a region or the currency) investors without regard to the rating of the sovereign. This goes against intuition that safe assets have higher ratings.
More on safe assets in another post. That’s enough for today. Rebecca Wilder
7 Responses to “What Is a Safe Asset?”
You're not wrong, it's just that if you're defining (3) as being necessary, then you're going to run into one problem or the other.
The one problem is that you have limited your definition of "safe assets" to be virtually pointless. (Your Norway example highlights that.) So you would require larger and larger CA deficits (debt issuance) among the Established "Safe" Countries–not a growing area due to (2)–if you're going to decide it's a Global Demand. (Norwegian Sovereign debt gets sold, therefore there is Domestic Demand for it. Any Excess Norwegian Demand for more safe assets would have to be satisfied, in the Beckworth/Wilder definition, by debentures from other large, safe sovereigns. Expand that issue to 190 other countries, and you soon get to the point where (3) goes from being a definition to being a constraint, and the claim becomes tautological. (To satisfy Global demand for UK debt, the UK must issue enough debt to make "sufficient aggregate national income" problematic at best.)
Hey Ken, I am a small blog, so I can do this. I agree with your point. In fact, Beckworth didn't define sufficient nominal income growth as a measure of safety, rather a way to reduce the shortage of safe assets. Thus, I've deleted (3) from the discussion. I hadn't referred to it in the entire post anyway.
In another post I will point out how I view the fed's bond purchase program of safe and liquid assets as interfering with the private sector's demand for liquid assets. Essentially households, for example, demand liquidity to pay down debt, and sell risky assets in order to do so. This is what causes risk assets to sell off. Why doesn't the fed simply buy risk assets? By purchasing the safest most liquid assets, the Fed essentially crowds out the private sector from the liquidity that it craves. Under the current program, some investors will rebalance their portfolio in favor of risk assets, based on the Fed buying 'safe' assets; but the effect is only secondary.
What I suggest is clearly controversial. But the BoJ is buying risk assets (to a much smaller degree, of course).
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The other problem is yield-related. If I expect the Norwegian economy to grow at 4-6% p.a., investing in Safe Assets that yield 3% and carry currency risk can only be done if you have a severe math impairment. So I demand "safe assets" to the extent that I am balancing my portfolio, but I demand the highest-yielding safe assets I can find–that is, those that are, cet. par., most likely to lose their AAA rating.
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The legendary "AAA graph" of recent lore shows that my fellow UGA graduate has it backwards–there was too much "AAA" paper out there that was rated such based on its Collateral, not its value. (It's easy to create "AAA" paper–take $100MM in mortgages and issue a bunch of MBSes with the first few tranches overcollateralized and the last few for yield-mongerers. Or consider the paper of firms that are "rated AAA" that yields more in the B/BB range. The so-called glut was based on Collateralization, which was itself a product of "searching for AAA yield." Not even a UChicago economist–and certainly no sane UGA alum who worked with George Selgin–could believe that those 5-6% yields in a 4% environment were truly "AAA.")
In the discussion of liquidity, a key element of safety is control over the printing press. Any collateralized product (even the EFSF bonds) faces rollover risk and financing constraints. The US arguably faces neither. Thus I would agree that there's a host of AAA paper that is a mirage of safety.
On the yield issue, I guess that I'm seeing the the safe investor problem as maximizing yield based on liquidity and default risk tolerance, rather than maximizing yield based on a credit being AAA.
Of course safe havens are in short supply; that is why they are over-valued (US T, G Bunds, Gold etc.). On gold this comment is not really to do with your post; but can you tell me if you think gold imports/exports should be classified as a trade account item or a capital account item? In India its classified as a trade account item which I feel is absurd since buying gold is sort of like buying a perpetual, zero coupon deep discounted bond (or even a currency assuming that people in the world treat it as such – at least it is still considered gold a store of value by many; though I suppose it does not serve as a medium of exchange or unit of account).
Classifying gold as a trade account item really has a huge impact on the trade deficit – if it is incorrectly classified as a trade accout item (for example if it were a capital account item), the trade deficit would be far lower. The resulting distortion from a trade account classification adds opaqueness to already unreliable data – cross border clarity and consistency would be nice in our global world. Correct classification also has a pretty significant impact on long term exchange rate expectations since inflation and interest rate differentials are impacted more by trade balances than capital account transactions in the very, very long term.