The Bank of England on the UK's “Financial Dark Matter”
(December 14, 2006)
Dear Subscribers and Readers,
I will be quick with this mid-week commentary, since I have a flight to catch later this afternoon at 3pm out of LAX! As many of you may know, my fiancé and I are flying back to Houston to see family and friends for the upcoming Christmas holidays. While Houston, Texas certainly does not sound as “exotic” as places like Hong Kong, Shanghai, New York, London, or Buenos Aires, it will certainly do for me – as it is always nice to catch up with family and friends. Moreover, Houston is a great place to do some R&R, and after a very difficult time for many investors in 2006 (although it certainly didn't feel that way for many private equity firms and hedge funds, Amaranth not withstanding), it is probably time to forget about the markets for the next two weeks, clear your head, and get ready for 2007!
In preparation for our trip back to Houston, I have also not been able to answer emails – I promise I will get to them over the next week or so. At the same time, I also anticipate writing a commentary articulating my “macro views” for the global economy and what asset classes will outperform in 2007. Stay tuned.
Before I go on, I would like briefly mention our MarketThoughts discussion forum. Over the last 12 months, the place has evolved from a one-man operation (basically, the posts were mostly mine) to a more lively place where intellectual discussion and exchanges reign. Two sections where we would love some fresh ideas and contributions from our smart subscribers are the “Books and Periodicals” and the “Research Papers…” sections. There is no monopoly on knowledge, so to speak, and this author can certainly learn a lot from our smart subscribers who are active readers and who certainly have much more expertise than I do in many sectors of both the U.S. and the global economy.
For subscribers who are relatively knowledgeable about the U.S. current account deficit and international finance, there is no doubt that you may have heard the term “financial dark matter” brandied around in the Financial Times or the Wall Street Journal in recent years. For subscribers who have not heard of the term – or for subscribers who just want to refresh their memories – let us now explore where this term came from. In order to do this, I would like to use an article in the Bank of England's 2006 3rd Quarter Bulletin as a basis, entitled: “The UK International Investment Position” by Simon Whitaker of the Bank of England's Structural Economic Analysis Division.
Before we go on to discuss the term “financial dark matter,” it is important to put the UK's international investment position into context. Just like the United States, the UK has been persistently running current account deficits (this did not prevent the Pound Sterling from outperforming the Euro by 2.6% since the beginning of 2006!), however just like the US, the UK has continued to earn a net income from the rest of the world, and this net income has consistently increased at the same time the current account deficit has consistently increased. Since the Bank of England can articulate this better than I do, I will quote straight from the publication:
Official data suggest that the United Kingdom's financial liabilities exceed the value of its financial assets — net foreign liabilities were equal to around 14% of GDP at the end of 2005. Yet the data also suggest the United Kingdom has been earning net income on those net liabilities. In other words, the income generated by UK-owned assets abroad is greater than the payments made on the larger stock of UK liabilities owed to foreigners. Moreover, net investment income has improved at the same time that the United Kingdom has become more indebted.
This apparent contradiction is illustrated by the following chart. Note that the UK's international investment position peaked in the mid 1980s (which curiously came at a time when the UK did not earn that much net income from the rest of the world) and it has deteriorated consistently since that time:
From a “classical economics” point of view, an ever-deterioration in the international investment position (IIP) is clearly not sustainable. Just like an individual who borrows an ever-increasing amount of debt on his several credit cards (or pawns or sells his car) in order to satisfy his consumption in excess of his income – the UK will eventually go bankrupt at some point or another if her citizens consume more than they produce. However, the existence (and the continuing rise) of her net investment income suggests that other forces may be at work, and here we now ask the following questions:
- What if the above individual – instead of borrowing on his credit card – can borrow at ultra-low interest rates? Okay, this will certainly decrease the chances he will become bankrupt, but it will not change the inevitable.
- Sooner or later, it will be time to pay up, but let us now also consider this: What if, besides using the borrowed money to buy an iPod, a Porsche, and a Sony PS3 on eBay, the individual also uses some of this monies to invest in global equities or to invest or set up a private business?
- And finally, what if the private business (such as Google before it brought out its IPO in August 2004) that this individual has invested in (whether through his money, time, or effort) is not valued by his auditors correctly? What if all his businesses that he has invested in were valued at book value instead of at valuations of a similar publicly-traded company?
Indeed, these questions are essentially the questions that this Bank of England's article is asking – but only in the aggregate and as it is applied to the UK. Again, quoting the article:
Two factors are behind the United Kingdom's ability to obtain net investment income despite increasing net indebtedness. First, the yield that the United Kingdom pays on the bonds and equities issued to overseas investors — termed portfolio debt and equity — appears to have declined relative to the yield that the United Kingdom earns on the bonds and equities issued by the rest of the world that it owns. Second, there has been a shift in the composition of UK external assets towards foreign direct investment (FDI). FDI assets generate a higher yield than the United Kingdom's predominantly debt-like liabilities.
In aggregate over the past decade, the estimated yield that the United Kingdom received on its overseas assets has increased relative to the estimated yield that it pays on its liabilities (Chart 4). The estimated yield differentials on portfolio equity and debt have moved from being substantially negative to slightly positive. The improvement in the debt yield differential is broadly consistent with the decline in UK interest rates relative to world interest rates since the early 1990s. In addition to the changes in relative yields, there has been a big shift in the composition of assets and liabilities: over the past decade the United Kingdom has shifted sharply towards having a substantial net asset position in FDI (Chart 5). The difference between the yields on the United Kingdom's FDI assets and liabilities has typically been positive, so this shift has increased net investment income. At the same time, the United Kingdom has been accumulating mainly low risk, and hence low yield, net banking liabilities; Chart 5 shows all interest-paying assets and liabilities (including bonds and bank deposits) in one broad category, called net interest-sensitive assets. While the UK net liability position in this category is larger than its net positive FDI position, the net payments that the United Kingdom makes on interest-sensitive liabilities are smaller than the net income it receives from FDI assets (Chart 6). So the United Kingdom could broadly be characterised as being like a bank or venture capitalist that earns net income by borrowing to invest in projects that earn a higher return than the cost of funding.
As mentioned in the above paragraph, the following chart (Chart 4) shows the difference between yields of UK assets and liabilities. In general, the yield differential between UK assets and liabilities has consistently improved over the last 20 years:
Moreover, as shown by the following chart (Chart 5), there has been a noticeable shift in the UK's net investment position into foreign direct investment (FDI), and given that FDI (as practiced by the British) has historically given high investment returns, this has contributed significantly to improving the net investment income of the UK:
Moreover, while the above chart shows that the UK's net liability in “net interest sensitive” assets (bonds and bank deposits) is larger than its position in FDI, it is to be noted that “the net payments that the United Kingdom makes on interest-sensitive liabilities are smaller than the net income it receives from FDI assets” This fact is illustrated by the following chart (Chart 6):
As I have alluded to before, and as stated by this Bank of England's article, the UK is not unlike a bank, hedge fund, or venture capitalist who earns income by borrowing at relatively low rates and investing the monies in higher-yielding assets.
The fact that both the UK and the US are actually earning net income (and at an increasing pace despite the fact that their current account deficits have continued to deteriorate!) suggests that the assets held by both the UK and the US may be undervalued. After all, if a bank's book of assets is earning 6% while it is paying out 4% in its customers' savings accounts, shouldn't the bank's book of assets be valued more highly than its liabilities (its customers' deposits)? The same argument could be made to hedge funds, venture capital firms, and leveraged buyout firms. In fact – by definition – assets have to be valued higher than liabilities, as banks and other financial institutions and investment funds will totally lose confidence should it booking a negative stockholders' equity amount year-in and year-out (this is essentially what the UK and the US are currently doing). This apparent gap between the amount assets are valued on the books of the both the UK and the US and what they may or should be valued if higher yields are taken into account is termed “dark matter.” Again, quoting the Bank of England's article:
There are big measurement problems with both stocks and flows of assets and liabilities. Lane and Milesi-Ferretti (2006), for example, suggest that official estimates of world liabilities exceed official estimates of world assets by around 5% of world GDP. Hausmann and Sturzenegger (2006) have argued that the income generated by the United States' financial position is a good measure of the true value of its assets. They suggest that if US assets generate more income than US liabilities then they must be worth more. In other words because the United States earns net investment income it must be a net creditor, rather than a substantial net debtor as measured by official statistics. The authors term the apparently missing assets ‘dark matter'.
The article then goes on to discuss some ball park numbers for financial “dark matter” in both the US and the UK:
Based on US net investment income of around $30 billion, and the assumption of a 5% rate of return, Hausmann and Sturzenegger (2006) calculate an implied net asset position of $600 billion. That compares with the official net debt position of $2.5 trillion. There are obvious parallels with the United Kingdom. Applying their same simple arithmetic, UK net investment income of approximately £27 billion in 2005 implied net assets of £540 billion. That compared with the official measured net liability position of £169 billion.
The Bank of England article then qualified the above numbers – stating that the above study is merely a starting point given that it rests on the assumption that both assets and liabilities are yielding the same return. Quoting the article again:
This is obviously a very simple story. In particular, it rests crucially on the assumption that yields on assets are identical to those on liabilities. But there are good reasons why the overall yields on UK or US assets may exceed those on their liabilities. The composition of assets and liabilities is different, with risky investments like foreign direct investment accounting for a larger share of assets than liabilities. And yields are only one aspect of total returns: capital gains matter as well. For example, overseas investors may have been investing in UK or US companies paying no or low dividends (e.g. information communication and technology firms) but whose share prices are expected to rise quickly and generate large capital gains, increasing the value of the United Kingdom's stock of liabilities.
However, there is no doubt that yields on FDI assets for both the US and the UK have been consistently higher than those on FDI liabilities over the last ten years. So where is the disconnect? This brings us back to our third bullet point above – that direct investment positions in foreign companies tend to be very illiquid, private, and thus are valued at book value instead of being valued at similar companies that are publicly traded. If the latter valuation methodology is used, the UK turns into a net creditor instead of a net debtor! Quoting the Bank of England article:
However, it is puzzling that for both the United States and the United Kingdom, the yields on overseas FDI assets appear to have been consistently higher than those on FDI liabilities in recent years. This is particularly notable for the United States (see Higgins et al (2005)). That could reflect problems with measuring the FDI stock positions. International statistical guidelines recommend that FDI assets and liabilities are measured at current market prices. But direct investment positions often involve illiquid ownership interests in companies that are not listed on stock markets and may possess unique attributes that are hard to value. So, in practice, book values are often used — this practice is followed in the United Kingdom (see Elliott and Wong Min (2004)). Previous work by Westwood and Young (2002) has suggested that the United Kingdom's net stock of FDI is much higher than currently measured. Recent updates by Nickell (2006) suggest that when FDI is approximately revalued according to relative movements in stock markets, the United Kingdom has actually remained an overall net creditor, despite persistent current account deficits in recent years: the capital gains from equity revaluations have more than offset the run of trade deficits.
The current account deficit statistic – as it is being measured and used today – is not unsimilar to the official “savings rate” statistic of the United States. That is, it fails to take into account capital appreciation and the value of all private businesses in the US currently run by entrepreneurs – a group of businesspeople whose productivity (by logic) outshines those of wage earners. This again brings us back to the Google example. Assume, for example, that one of the co-founders of Google, Sergey Brin, bought a roomful of Chinese-made furniture in 1999 and put the charge on his credit card (this was five years before Google went public). Mr. Brin would thus be adding to the current account deficit of the US – and in the meantime, be greatly indebted to his credit card company. Under the current valuation methodology, Mr. Brin would have a negative net worth in 1999 – but this ignores the fact that he is investing much of his waking hours in his soon-to-be dominant internet search company, Google. Today, Mr. Brin is worth $15 billion and is the 26th richest person in the world according to Forbes, but nowhere in the “savings rate” or the “current account” statistics is this “income earned” by Mr. Brin being taken into account.
Finally, it is to be noted that as the value of the US dollar goes down, FDI income will generally increase – simply because of the lower exchange rate between the dollar and most other currencies. In other words, the FDI income of the US will continue to increase should the value of the US dollar goes down – thus cushioning the fall. This is especially notable given that the evidence (however little there is) suggests that most UK (and most probably most US) assets are denominated in foreign currencies – suggesting that any fall in their respective currencies will serve to increase overall net income – cetris paribus. And should the US domestic stock market outperform the European and Japanese stock market next year (which is what this author is currently looking for), then the inevitable repatriation of foreign assets held by US individuals will serve to put upward pressure on the US dollar going into the end of this year and through 2007.
Henry To, CFA