finance

Pension funds and liquidity spirals

Bruno Bonizzi and Jennifer Churchill

Falling prices in UK government bond (aka gilts) markets yesterday forced the Bank of England to intervene: “a material risk to financial stability” led the Bank to “carry out temporary purchases of long-dated UK government bonds” and to postpone the beginning of Quantitative Tapering, i.e. the sale of bond holdings accumulated over the past decade.

Falls in gilt prices are caused by both global factors – the strong dollar and rising global interest rates – and the large unfunded tax cuts announced in Kwasi Kwarteng’s budget. The most immediate worry is the risk of pension funds “falling over”. How do increasing bond yields pose a problem for pension funds?

Pension funds are widely assumed to function as large passive “containers” of long-term assets which engage in little short-term activity. This is incorrect: pension funds, especially large and mature ones, are sophisticated investors that use leverage and derivatives to achieve their financial objectives.

One such objective, for Defined Benefits (DB) pension funds (that still hold most UK pension fund assets), is best captured by the rise of the Liability Driven Investment (LDI) paradigm. According to LDI, the ultimate goal of pension funds is not the maximisation of returns per se, but performance against the commitments originating from pension liabilities. The key objective of LDI is the minimisation and stabilisation of the so-called “funding deficit”, the difference between the market value of assets and the discounted value of the future pensions to be paid (liabilities).

To achieve the stabilisation of the “funding deficit”, pension funds use a dedicated protection or liability-matching portfolio. This involves strategies that makes the value of assets move in the same direction as the valuation of liabilities. The most important influence on the funding deficit is movements in interest rates: if rates fall, the value of liabilities rises because bond yields are used as discount rates. But if pension funds invest in bonds with similar duration (i.e. sensitivity to interest rate changes) to their liabilities, their assets will also increase by a similar amount, leaving the funding deficit unchanged.

As well as bonds, these strategies also use interest rate swaps, which act in a similar way: pension funds pay a variable rate (e.g. the LIBOR or its recent replacement SONIA) in exchange for a fixed interest payment (the swap rate). By so doing they hedge against interest rate changes. Another LDI strategy is to use repos: pension funds can use their gilts to borrow in the repo market, and then buy more gilts, effectively doubling their exposure to gilts, and thus the degree of interest rate hedging.

The advantage of using repos and derivatives is that it frees up space to invest in other assets. Rather than fully investing their portfolio in bonds, pension funds typically hold a growth portfolio which is invested in all sorts of higher-risk assets, with the objective of increasing returns. This too can make use of derivatives, especially to hedge foreign currency risk. Data from the the ONS Financial Survey of Pension Schemes shows that interest rate swaps and foreign exchange forwards account for almost the totality of derivatives held by pension funds, and these sum (in gross terms) to over 10% of the value of their assets. And while LDI is only relevant to DB pension funds with debt-like liabilitiesall pension funds hedge their overseas assets.

These strategies all require collateral, often short-term bonds. A decline in the market value of collateral or the value of the derivative contracts can lead to margin calls on repo or on interest rate swaps, as explained by Toby Nangle. Similarly, if the value of the sterling falls, pension funds might face margin calls on their foreign exchange derivative positions.

This means that pressure in the short-term bond market can spill over into the market for long-term bonds. To meet margin calls, pension funds can be forced at the extreme to sell growth assets (such as equity, or long-term bonds) to raise the required liquidity to meet margin calls. This is what was seen in the wake of the budget, with pension fund managers reportedly “throwing the kitchen sink to meet margin calls”. If margin calls are not met then collateral could be seized and liquidated, further adding to the downward pressure on asset prices.

This is how we find ourselves in liquidity spiral territory – a situation of severe financial instability, as markets become one-sided, depressing asset prices and potentially provoking more margin calls. The risk of such instability lay behind the decision by the BoE to intervene.

More trouble could be on the horizon: similar liquidity spirals could originate in other derivative markets, such as foreign exchange derivatives as the Pound keeps depreciating against the dollar, or other financial institutions. The possibility of a broader “dash for cash”, requiring more BoE intervention, is still very much on the cards.

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How pension funds shape financialisation in emerging economies in Colombia and Peru

Guest post: Bruno Bonizzi, Jennifer Churchill and Diego Guevara

In early spring 2020 emerging economies (EEs) were hit by the largest ever episode of portfolio outflows. Stock and bonds were sold as investors fled to safer investments in Europe and the United States, showing once again the fragile nature of EEs’ financial integration. To overcome this problem, one suggested solution is to allow for a larger base of domestic institutional investors, such as pension funds, which can stabilise financial markets. While having a large institutional investor base can be a source of demand for domestic financial securities, it is important to review the evidence from the experience of those EEs where pension funds have existed for more than two decades.

As we show in our forthcoming article, the experience of Colombia and Peru can be instructive. Their pension system, while maintaining a significant parallel public Pay-As-You-Go structure, has a sizeable funded private component with assets that have grown to over 20% of GDP. These were established as part of the Washington Consensus reforms in the 1990s, following the prior example of Chile.

However, more than two decades since the creation of private pension funds, capital markets in the two countries, as in the rest of Latin America, remain small and underdeveloped. It is perhaps for this reason that the experience of pension funds in Latin America remains under-researched by financialisation scholarship. However, recent literature has put forward the idea that financialisation patterns, while having common tendencies, can present “variegated” forms. Pension funds play a role in this process by exerting an important role in shaping the demand for financial assets, even if this does not occur, as in typical “Liberal Market Economies” by fuelling domestic capital markets.

Some key characteristics of Colombia and Peru’s political economy have acted as the distinct determinants of pension fund demand for assets, shaping a specific form of financialisation. Firstly, pension funds in these countries reflect the characteristics of Hierarchical Market Economies, the Latin American variety of capitalism. Workers and unions have very limited control over how pension fund assets are invested, as pension funds are provided by private companies as pure individual retirement accounts. Investment policy is therefore heavily shaped by the interest of the financial industry, which was also key in promoting their establishment and in shaping their regulation since.

But next to these considerations, pension fund asset demand in Colombia and Peru has been structurally constrained by the limited by limited effective space in domestic capital markets. These two countries have a highly “extraverted” growth regime, where commodity exports play a key role in determining aggregate demand. As a result of the 2000-2014 commodity price boom, companies had substantial financing coming from export proceeds and foreign direct investment, therefore limiting their issuance of securities in domestic capital markets. Governments too limited their net borrowing during this period, thanks to booming revenues and limited increases in public spending. Additionally, the countries have attracted considerable interest by foreign financial investors, whose weight in domestic bond and stock markets increased. These characteristics reflect the status of Colombia and Peru of as subordinate emerging economies in global financial markets.

Pension funds in Colombia and Peru have looked for other investments. Supported once again by the domestic and international financial industry, these have been found in “alternative assets”, most typically private equity, infrastructure and real-estate funds, as well as in foreign investment, which now account for more than a third and more than 40% of total assets in Colombia and Peru respectively. The latter have been important in stimulating a derivative market to hedge foreign currency positions, mostly vis-á-vis US dollars.

Therefore, pension funds have been important in shaping the financialisation trajectory in these two countries, despite the limited development of domestic capital markets. This can serve as an important lesson to calls for the promotion of private pensions to stabilise capital markets. In emerging economies subject to subordinate forms of economic and financial integration, and where the interests represented are those of a highly concentrated financial industry, pension funds may fail to act as catalysts for deep, liquid and stable domestic capital markets. They may instead contribute to finance privatised forms of infrastructure and real estate and reinforce the hierarchies of global finance.

Developing and emerging countries need capital controls to prevent financial catastrophe

A shorter version of this letter was published in the Financial Times on 25 March 2020.

All countries currently face the unprecedented threat of a simultaneous and global health crisis, economic recession and financial meltdown. But unlike rich nations, emerging and developing countries  (DECs) lack the policy autonomy needed to confront these crises. The global currency hierarchy places DECs in the periphery of global financial markets, exposing them to sudden stops caused by triggers such as the COVID-19 crisis. The US Federal Reserve announced it would lend up to USD 60bn to the central banks of Mexico, Brazil, South Korea and Singapore. But this is not enough. Immediate capital controls, coordinated by the IMF, are needed to prevent financial disaster.

In a global financial crisis, there is a rush to hold liquid assets denominated in safe currencies, especially US dollars. This enables rich countries to respond to crises with the necessary fiscal and monetary tools. The opposite is true for DECs. Since the outbreak of the COVID-19 crisis, international investors have withdrawn large sums from DEC assets, leading to dramatic currency depreciation, especially for those exposed to falling commodity prices.

Over the past decade, ample global liquidity driven by rich country central banks, alongside sustained demand for liquid assets, has led to enormous flows of credit and equity investment into DECs, where bond and stock markets grew from about 15 trillion to 33 trillion US dollars between 2008 and 2019. ‘Frontier economies’ and DECs corporations have issued substantial volumes of foreign currency debt. With G20 encouragement, DECs opened their domestic currency bond markets to international investors. In what has been termed the second phase of global liquidity, new financial instruments and institutions, such as international funds and exchange-traded funds (ETFs), have enabled easy global trading of DECs assets, cementing the illusion of liquidity.

DECs are now confronted with a sudden stop as global liquidity conditions tighten and investors flee from risk: exposure to DECs remains a high-risk/high-return strategy, to be liquidated in times of crisis. In consequence, DECs face severe macroeconomic adjustment at precisely the moment when all available tools should be used to counter the public health crisis presented by COVID-19: some countries may be forced to tighten monetary policy in an attempt to retain access to the US dollar, while fiscal action may be constrained by fear of losing access to global markets. Foreign exchange reserves are unlikely to provide a sufficient buffer in all countries. This would have profound consequences for the global economy: DECs, both in the G20 and beyond, are now far more important for global growth and markets than even a decade ago. The failure of a large sovereign or quasi-sovereign borrower could trigger significant contagion.

There is an urgent need for action to prevent this crisis reaching catastrophic proportions in DECs. Despite long-standing calls for action, there is still no international lender of last resort. The only instruments currently available are IMF lending and foreign exchange (FX) swap lines between central banks. IMF loans typically impose fiscal tightening, which would be disastrous under current conditions. The US Federal Reserve stands ready to provide US dollars to a handful of major central banks: among DECs, only Mexico can access Fed and US Treasury swap lines under NAFTA provisions, and South Korea and Brazil have just had their arrangements re-opened. But these ad-hoc arrangements exclude a large proportion of DECs’ need for dollar liquidity.

We call for decisive action to constrain the financial flows currently transmitting the crisis to EMs. Capital controls should be introduced to curtail the surge in outflows, to reduce illiquidity driven by sell-offs in DECs’ markets, and to arrest declines in currency and asset prices. Implementation should be coordinated by the IMF to avoid stigma and prevent contagion. FX swap lines should be extended to include more DECs, in order to ensure access to US dollars. Finally, we concur with recent calls for greater provision of liquidity by the IMF using special drawing rights (SDRs) – but this must take place without the imposition of pro-cyclical fiscal adjustment.

The unfolding crisis is one of the most serious in economic history. We must ensure that governments can do everything possible to protect their citizens. In our globally integrated economy, coordinated action is needed to minimise the externally-imposed constraints on developing and emerging countries as they face the triple threat of pandemic, recession and financial crisis.

Organising Signatories

Nelson Barbosa, Sao Paolo School of Economics

Richard Kozul-Wright, UNCTAD

Kevin Gallagher, Boston University

Jayati Ghosh, Jawaharlal Nehru University

Stephany Griffith-Jones, Columbia University

Adam Tooze, Columbia University

Bruno Bonizzi, University of Hertfordshire

Daniela Gabor, UWE Bristol

Annina Kaltenbrunner, University of Leeds

Jo Michell, UWE Bristol

Jeff Powell, University of Greenwich

Signatories

Adam Aboobaker, University of Massachusetts Amherst

Kuat Akizhanov, University of Birmingham and University of Bath

Siobhán Airey, University College Dublin

Ilias Alami, Maastricht University

Alejandro Alvarez, UNAM, México

Donatella Alessandrini, University of Kent

Jeffrey Althouse, University of Sorbonne Paris Nord

Carolina Alves, Girton College – University of Cambridge

Paul Anand, Open University and CPNSS London School of Economics

Phil Armstrong, University of Southampton Solent and York College

Paul Auerbach, Kingston University

Basani Baloyi, South Africa 

Frauke Banse, University of Kassel, Germany

Benoît Barthelmess, Le Club Européen

Pritish Behuria, University of Manchester

Kinnari Bhatt, Erasmus University Rotterdam

Samuele Bibi, Goldsmiths University

Joerg Bibow, Skidmore College

Pablo Bortz, National University of San Martín

Alberto Botta, University of Greenwich

Benjamin Braun, Institute for Advanced Study, Princeton

Louison Cahen-Fourot, Vienna University of Economics and Business

Jimena Castillo, University of Leeds, UK

Eugenio Caverzasi, Università degli Studi dell’Insubria

Jennifer Churchill, Kingston University, London

M Kerem Coban, GLODEM, Koc University, Turkey

Andrea Coveri, University of Urbino, Italy

Moritz Cruz, UNAM, Mexico

Florence Dafe, HfP/TUM School of Governance, Munich

Yannis Dafermos, SOAS University of London

Daria Davitti, Lund University, Sweden

Adam Dixon, Maastricht University

Cédric Durand, Université Sorbonne Paris Nord

Chandni Dwarkasing, University of Siena, Italy

Gary Dymski, University of Leeds

Ilhan Dögüs, University of Rostock, Germany

Carlo D’Ippoliti, Sapienza University of Rome

Dirk Ehnts, Technical University of Chemnitz

Luis Eslava, Kent Law School, University of Kent

Trevor Evans, Berlin School of Economics and Law

Andreas Exner, University of Graz

Karina Patricio Ferreira Lima, Durham University

José Bruno Fevereiro, The Open University Business School

Andrew M. Fischer, Erasmus University Rotterdam

Giorgos Galanis, Goldsmiths, University of London

Santiago José Gahn, Università degli studi Roma Tre

Jorge Garcia-Arias, University of Leon, Spain and SOAS, University of London

Alicia Girón – UNAM-MEXICO

Thomas Goda, Universidad EAFIT, Colombia

Antoine Godin, University Sorbonne Paris Nord

Gabriel Gómez, UNAM, México

Jesse Griffiths, Overseas Development Institute

Diego Guevara, National University of Colombia

Alexander Guschanski, University of Greenwich

Sarah Hall, University of Nottingham

James Harrison, Prof, University of Warwick

Nicolas Hernan Zeolla, National University of San Martin, Argentina

Hansjörg Herr, Berlin School of Economics and Law

Elena Hofferberth, University of Leeds

Jens Holscher, Bournemouth University

Peter Howard-Jones, Bournemouth University

Bruno Höfig, SOAS, University of London

Roberto Iacono, Norwegian University of Science and Technology

Stefanos Ioannou, University of Oxford

Andrew Jackson, University of of Surrey 

Juvaria Jafri, City University of London

Frederico G. Jayme, Jr, Federal University of Minas Gerais, Brazil

Emily Jones, University of Oxford

Ewa Karwowski, University of Hertfordshire

Y.K. Kim, University of Massachusetts Boston

Stephen Kinsella, University of Limerick

Kai Koddenbrock, University of Frankfurt

George Krimpas, University of Athens

Sophia Kuehnlenz, Manchester Metropolitan University

Ingrid Harvold Kvangraven, University of York

Annamaria La Chimia, University of Nottingham

Dany Lang, Université Sorbonne Paris Nord

Jean Langlois, Le Club Européen

Christina Laskaridis, SOAS, University of London

Lyla Latif, University of Nairobi

Thibault Laurentjoye, École des Hautes Études en Sciences Sociales (EHESS), Paris

Dominik A. Leusder, London School of Economics

Noemi Levy-Orlik, UNAM, Mexico

Gilberto Libanio, Federal University of Minas Gerais, Brazil

Duncan Lindo, Vrije Universiteit Brussel

Lorena Lombardozzi, Open University

Anne Löscher, University of Siegen, Germany; University of Leeds

Birgit Mahnkopf, Prof.i.R., Berlin School of Economy and Law

Pedro Mendes Loureiro, University of Cambridge

Victor Isidro Luna, UNAM

Jonathan Marie, Université Sorbonne Paris Nord

Norberto Montani Martins, Federal University of Rio de Janeiro, Brazil

Olivia Bullio Mattos, St. Francis College, New York, USA

Andrew Mearman, University of Leeds

Monika Meireles, UNAM

Thorvald Grung Moe, Levy Economics Institute

Lumkile Mondi, University of the Witwatersrand, South Africa

Thanti Mthanti, University of the Witwatersrand, South Africa

Susan Newman, Open University

Howard Nicholas, International Institute of Social Studies, Erasmus University Rotterdam

Maria Nikolaidi, University of Greenwich

Patricia Northover, University of the West Indies, Jamaica

Cem Oyvat, University of Greenwich

Oktay Özden, Marmara University, Turkey

Vishnu Padayachee, University of the Witwatersrand 

Rafael Palazzi, PUC-Rio, Brazil

José Gabriel Palma, Cambridge University and USACH

Marco Veronese Passarella, University of Leeds

Jonathan Perraton, University of Sheffield

Nicolás M. Perrone, Universidad Andres Bello, Viña del Mar

Keston K. Perry, UWE Bristol

Mate Pesti, UWE Bristol

Karl Petrick, Western New England University

Christos Pierros, University of Athens

Leonhard Plank, TU Wien

Jose Pérez-Montiel, University of the Balearic Islands, Spain

Hao Qi, Renmin University of China

Mzukisi Qobo, Wits Business School, University of Witwarsrand

Joel Rabinovich, University of Leeds

Dubravko Radosevic, University of Zagreb

Miriam Rehm, University of Duisburg-Essen

Marco Flávio da Cunha Resende, Federal University of Minas Gerais, Brazil

Lena Rethel, University of Warwick

Sergio Rossi, C University of Fribourg, Switzerland

Maria Jose Romero, Eurodad

Roy Rotheim, Skidmore College

Josh Ryan-Collins, UCL Institute for Innovation and Public Purpose

Alfredo Saad Filho, King’s College London

Lino Sau, University of Torino, Italy

Malcolm Sawyer. Emeritus Professor of Economics, University of Leeds

Anil Shah, University of Kassel

Dawa Sherpa, Jawaharlal Nehru University 

Hee-Young Shin, Wright State University

Farwa Sial, Global Development Institute, University of Manchester

Crystal Simeoni, FEMNET, Nairobi, Kenya

Engelbert Stockhammer, King’s College London

Ndongo Samba Sylla, Dakar

Carolyn Sissoko, UWE Bristol

Celine Tan, University of Warwick

Gyekye Tanoh, Accra

Daniela Tavasci, School of Economics and Finance, Queen Mary University of London

Andrea Terzi, Franklin University Switzerland 

Daniele Tori, Open University Business School

Gamze Erdem Türkelli, University of Antwerp

Esra Ugurlu, University of Massachusetts Amherst

Ezgi Unsal, Kadir Has University

Tara Van Ho, University of Essex 

Sophie Van Huellen, SOAS University of London

Frank Van Lerven, New Economics Foundation

Elisa Van Waeyenberge, SOAS University of London

Paolo Vargiu, University of Leicester

Luigi Ventimiglia, School of Economics and Finance, Queen Mary University of London

Apostolos Vetsikas, University of Thessaly, Greece

Davide Villani, The Open University and Goldsmiths, University of London

Camila Villard Duran, University of Sao Paulo

Pablo Wahren, University of Buenos Aires

Neil Warner, London School of Economics

Mary Wrenn, UWE Bristol

Joscha Wullweber, University of Witten/Herdecke

Devrim Yilmaz, Université Sorbonne Paris Nord