Friday, 27 November 2009
Yesterday's information that a Dubai government-sponsored organisation had asked its creditors for a 6 months moratorium on a huge loan had stock market participants scurrying for the exit. The explanations offered were that a) it would hit European banks, who had sponsored some of the most ostentatious building projects on earth b) that the moratorium was a harbinger of a wave of defaults on sovereign debt c) the US markets were closed owing to the ritual feast that sees upward of 26m turkeys slaughtered or d) "I don't know what is going on, so I'd better sell".
Sure, it is bad enough if a government sponsored entity in a wealthy Gulf country goes belly up. But the amounts involved, apparently some $50bn, are small change compared to what we have gotten used to during the past 15 months, so surely the banking sector could absorb that loss – which anyway appears in fact only to be a demand for a bridge financing. But it is hardly an indication that we are on the cusp of a major melt-down in government debt.
Such fears appear to be built on a misunderstanding of government debt. Most government debt is issued in the country's own currency and can be repaid simply by printing more money – probably increasing the inflation in the passing. Creating inflation would in itself reduce the real value of the outstanding debt, which is probably why most debt defaults are also preceded by a period of domestic inflation.
It is a very different game if a country has issued a lot of debt in other currencies. In that case, the country needs a current account surplus to pay back the debt, and in a situation where the currency is in free fall, this could be very tricky and the debt default theme could become real. Currently there is a lot of talk about sovereign defaults, and Japan is often mentioned because of a skyrocketing government debt. But Japan's debt is denominated in JPY and nearly 95% of it is held by domestic savers. So a government default there would surely be spectacular, but would mainly imply a major redistribution of wealth between the generations.
So we probably should not fear a default on Dubai debt too much.
Something else can be learned from the market reaction over the last couple of days. We have (again) seen a classical "lemming" scenario where suddenly market participants appear to be heading for the exit at the same time. It is precisely such a situation that risk management systems cannot handle. Yesterday we saw the strongest spike in market volatility we have seen for months. The reason was of course that the normal correlation between market segments was cancelled and all segments move in unison. This change in behaviour simply cannot be captured in mathematical models, if those models have to be able to react quickly to changes in market conditions. A day like yesterday was exactly one of those days where all the risk systems in the world aimed at "controlling" risk again had to throw the towel in the ring. The reason is that those models are all based on "normal" situations and cannot quickly enough capture when the dynamics of the market suddenly changes. So for days like yesterday, such models were absolutely useless. Today brought calm back to the markets and the episode is likely to be quickly forgotten. But what if today had seen a similar market fall, and the same on Monday? Then the market could have lost 10 per cent and the risk control systems would still not have had time to react.
I think that it is cause for more than just discomfort that we have built nearly all risk systems in the world on assumptions that over and over again are proven wrong. And that nobody has had the smarts to create risk control on the basis of the fact that market increases, it is mostly accompanied by a falling volatility, but market falls are always coinciding with a strong spike in volatility. Some new thinking is necessary.
Friday, 20 November 2009
In a surprising display of arrogance, banks who owe their very survival to healthy doses of taxpayer money have been quick to return to mega-bonuses for their management and staff. When asked how this was possible, the answer has been that "we are paying back the money we got, so we are free to do what we want".
Bank stocks have rebounded strongly since the dark days of last March, when a wholesale collapse of the finance sector was widely feared. And now they are top of the heap again. One could rightly ask how, since the economy has not exactly been vibrant anywhere in the world with the exception of China.
The answer is of course that some of the measures put in place between October 2008 and February 2009 are still strongly positive for the banks' bottom lines. The direct assistance in the form of loans to the banks or capital injections is obviously politically sensitive and something politicians want to get off the table as quickly as possible.
One massive subsidy that is not offensive to the tabloid press is, however, the yield curve. Currently, banks can borrow at 0 percent at the short end of the curve and place at 3.5% or thereabouts in 10 year government bonds. This interest rate differential is a major subsidy and it is ongoing. It is not classified in any public accounts as "subsidy to banks" and is in this way totally under the radar screen.
Currently the yield curves across the world are at their steepest seen in a decade. A step yield curve at the end of a recession is normal, as the markets are pricing in higher short term interest rates going forward´. It also means that the hidden subsidy to the banks presumably is at its highest right now. The bottom line effect for the banks of this is probably at its maximum right now.
Most banks have trading operations. Even if the banks in their advice to clients have missed out spectacularly on the turnaround in the stock markets, their trading operations certainly haven't. The turnover in stocks which slowed markedly last year, did take off in the second and third quarter this year. While we are likely to see a nice turnover in the months going forward, it is unlikely to show the same growth rates, and this implies that the bottom line contribution from trading will have a hard time to continue it growth.
And finally, the mark-to-market valuation of assets was scrapped. It leaves the banks with a considerable freedom to price assets they hold or have a lien on. In practical terms, it means that they are given the possibility to postpone (or maybe even avoid) loss provisions.
It is my perception that banks right in this moment is moving out of a "sweet spot" that has lasted for months. The hidden subsidy from the yield curve will be reduced once the yield curve flattens, the turnover from trading operations will grow less slowly and the loan provisions will slowly grow. The various initiatives towards new, tighter regulation will most likely leave the banks in a situation where they are forced to deleverage further, making it much more difficult to earn the same money as before the recession started.
All of this is unlikely to create problems for the banks' survival going forward. But I do believe that the party for financial stocks may well be over for this time.
Monday, 16 November 2009
Friday saw a widening of the US trade deficit, which apparently surprised the markets. Proving how short a memory the market has, nobody appeared to remember last month's rather disturbing observations that the US consumers again are again bringing their savings rate down. Paired with increased public spending, there should be no surprise that the trade deficit widens. The only thing that should could about an improvement in the trade balance would be a significant upsurge in US exports.
Which takes me to my other point, namely the Chinese exchange rate. Some days ago I wrote that as long as the Chinese decide to have a fixed exchange rate against the USD, there is no need to worry about the financing of the US deficit: China is simply forced to buy USD denominated assets matching the accumulated surplus. If not, the CNY will appreciate.
There are two reasons why the Chinese may in fact be interested in letting the CNY appreciate. One is the US pressure for this to happen, another is the follow-on effects on the Chinese economy.
The US pressure is probably not causing the Chinese leadership too many sleepless nights. Over the past 20 years, Western corporations have been busy de-industrialising, actively moving production to China. There are many reasons for this, and none of them can be remedied by a slightly stronger Yuan. Structurally, the Western world has been busy moving production to China, enticed by very low salaries, the lure of the productivity of freshly minted production capacities, the productivity of the Chinese workers, an attractive model for reinvesting profits and so on. This trend has certainly also been helped by a growing feeling that here in the West, we don't do dirty hands any more. Producing stuff is simply not cool any more. Banking and other service activities are cool.
I am afraid that the Yuan would have to appreciate very strongly in order to compensate for these factors. The fact that China and other Asian countries have become the primary global manufacturing motor will not change even if the Yuan appreciates by half. In this respect, the Chinese leadership has little to fear from the pressures from President Obama.
The other side of the coin is apparently more worrisome. If country runs a strong current account surplus with a fixed exchange rate towards the deficit country, this surplus will manifest itself in a strong increase in the money stock of the surplus currency. Unless the monetary authorities do something, the increased money circulation will drive up prices and in some cases lead to speculative increases in asset prices.
Usually, the central bank of a surplus country will try to offset this by selling government paper in the market, aiming to "soak up" the excess liquidity by so-called sterilising operations. And here is the rub. China does not have a well-developed market for this kind of instruments. Which means that controlling the domestic effects of the huge accumulated surplus becomes more and more difficult. By letting the Yuan appreciate, the Chinese authorities could at least partially offset this effect.
Recently, senior Chinese politicians have joined forces in warning that the low US interest rates are laying the foundation for a new speculative bubble. They are right. Nowhere is that more correct than for countries with their currency pegged to the USD and an inadequate system to control the domestic liquidity. If the Chinese decide to let the Yuan appreciate, this is the reason. US pressure will have little to do with it.
Thursday, 12 November 2009
While the financial markets continue to worry about the impending monetary tightening, the world's central banks are busy tightening. This is possible because the various policy initiatives consisted of myriads of activities which each contributed to the overall result. An extended credit line here, a swap line there, a reduced collateral requirement somewhere. And then of course the icing on the cake, the low mainline interest rates. Across the world, central banks are now sending clear signals that they are just about to pare back various elements as it increasingly becomes clear that they are not necessary any longer. Of course, central bankers say that they will not tighten monetary policy until the recovery has taken hold. They are tightening already, they just do not want to unsettle neither markets nor businesses. Obviously, the speed of the tightening will depend on the underlying economic reality.
Which brings me to the next observation. In a past life I was busy marketing products investing in Asian companies, and one of the sales pitches was that the region was moving towards an increased economic integration and hence would become more dependent on domestic demand rather than Western demand as a driver of their economic growth.
It might have been premature 10 years ago, but statements from central bankers over the past week or so are telling a revealing story about the changing roles in the world economy. What we are experiencing is a role reversal on a grand scale. In the past two decades the gospel has been that the US has been the world's growth leader and the rest of us have been pulled along in the slipstream of this technological juggernaut. When looking into the details a lot of this actually proves not to be entirely true – the sub-story of the superior US productivity growth is a case in point. But the storytelling has been clear: USA with its clear capitalistic system has again and again proven superior to any other society in the world.
Dreams are hard to kill, including the American one. But the current situation shows that the US is now lagging woefully behind in recovering from the recession. The growth leaders are the emerging economies, with China as the pace-setter. In between, we find Europe, who was worse hit than I expected, but is also quicker to recover than feared. Yesterday's statements from a raft of US federal bankers and from the German member of ECB's board told a clear story. The US Federal Reserve fears that the recovery will be weak and hesitant, while the German economy is likely to surprise on the upside in the coming quarters. Fresh statistics out of China indicates a GDP growth around 8 per cent.
There are a lot of conclusions to be made from this development. One is that the laggards appear to be the economies where the household sector carries large debts relative to their incomes. Another is that the allegedly bloated public sectors in Europe indeed function as stabilisers. A third lesson is that even command economies are able to react swiftly and decisively in the face of major economic trouble. The most important lesson to be learned is however that the emerging economies are finally delivering on their promise of becoming self-sufficient in terms of growth.
Investors should embrace this new reality. It is unlikely to go away anytime soon. The US may be the world's technology leader. Europe may lead in terms of being clever regarding organisational design and efficient infrastructure. But we are getting increasingly dependent on the ability of the emerging countries to produce the clever devices we surround ourselves with. Who talked about a "post-industrial society"?
Monday, 9 November 2009
Yet, there seems to be no drama in the bond market and that the dollar weakening (against the EUR) progresses orderly and not in a collapse.
The factor that most commentators appear to overlook entirely is that half of the world (or at least half of the world's GDP) has been running on a spontaneous dollar peg for quite a while. With such a mechanism in place, there is no particular reason why there should be no funding of dollar deficits.
10 years ago, in the period between the Asian currency crisis in 1997 and the introduction of the Euro, tons of ink were spilled in arguing the pros and cons of the European currency union. All the right buzzwords were used, and the debate was utterly inconsequential. In that very same period, a number of the Asian countries (and quite a number of Latin American ones as well) quietly established a peg towards the USD. At that period it was a logical choice, as USD was the unrivalled trading and reserve currency as well as the currency of the world's largest single market, the USA.
Typically, a peg to the dollar was a unilateral decision taken by the country pegging its currency to the USD. It is the country itself that assumes all responsibility for maintaining the peg. Given the traditional US attitude: "our currency, your problem", nobody would expect the US monetary authorities to lend a hand to, say, Argentina if her currency were about to weaken or strengthen.
Using the most fundamental of theories about exchange rates, a country that happens to run a current account surplus with the USA can chose two actions. A) to accept that the USD falls against the currency of the country in question or B) to purchase assets denominated USD in order to prevent the exchange rate from moving.
According to US government data through august 2009, the three countries with the largest trading surplus against the US are China, Japan, and Mexico. Canada comes in on 6th place, while Venezuela is 7th.
All of these countries have to a varying degree pegged their currencies towards the US. Japan and Canada have no official peg but are known to manage the float of JPY/CAD, whereas the other countries have rather strong pegging mechanisms.
For the USA it has the huge advantage that the largest surplus countries are forced to re-invest their surplus in USD denominated assets. For the surplus countries, maintaining the peg means that they have only a small currency risk towards their largest export market, and they have only a small risk of seeing their dollar assets devalue.
Against this background it seems almost foolhardy when US lawmakers rattle their sabres and call for a Chinese revaluation or a free float of the currency. It appears that those using such arguments only see the exchange rate as a measure of competitiveness. They fail to see the other side, the dependence of the US on a continued funding from abroad, and that this funding is secured as long as the main surplus countries peg their currencies.
Meanwhile, in a parallel universe, the big losers are the Europeans, who at every turn see their currency appreciate against the dollar bloc. European politicians may enjoy the warm glow of having the manliest of currencies. But in a slightly longer perspective, the fact that the EUR has been the only currency to systematically appreciate is a serious danger for the nascent economic recovery in Europe.
Tuesday, 3 November 2009
I have on earlier occasions been ranting about the way the US Administration missed an opportunity to reset the clock on the balance between government and the financial sector. No doubt, I am a great fan of the consequential and straightforward way the Swedish authorities handled the financial crisis in that country in the early '90s. To date, I have still not seen anything that would convince me that the same model could not have been applied in the US.
All of that is now history, and we should look forward to see how the issue of "too big to fail" (TBTF) is being handled. It is widely accepted that large institutions had scant regards for risk, simply because the gambled on being sufficiently big that the US Government would bail them out in case of trouble. Many observers believe this "Moral Hazard" to be the ultimate reason for the banking crisis.
For this reason it is interesting to see how the two governments deepest influenced by the financial crisis, the US and UK governments are handling the situation. There have been no shortage of observers pointing out that even if the financial institutions were TBTF but certainly not "too big to be carved up". The idea is that by splitting up the banks, one would reduce the risk of a systemic breakdown.
Over the weekend, news came out from the UK that the government would use its status as large shareholder to force a carving up of some of the largest banking groups in the UK, namely RBS and Lloyds TSB. It appears that carve-outs from these two banks together with the branches of Northern Rock, will be turned into three new retail banks. Several other business activities will also be sold off.
All in all, the government intends to recover some of the billions poured into the banks by divesting business activities. They will increase competition by bringing in new investors to the UK market (read: decrease the power of large banks in the UK). Further, the intention is to let RBS and Lloyds TSB "pay" for the participation in various elements of guarantee or insurance schemes. This latter element is a smokescreen as the "fees" will come out of dividends that would otherwise have gone to the biggest shareholder – namely the government. General elections are obviously coming up....
The US will likely choose a different way. For one, the Administration is favouring a shake-up of the regulatory bodies and it may end up creating a Financial Stability Council to monitor systemic risk in the economy and identify specific problem areas for attention.
Secondly, the approach to reducing the systemic risk of having a large number of TBTF institutions is aimed at using the market logic. So far it appears that the Administration will have discretionary powers to define institutions of systemic importance. These institutions will have to work with higher reserve requirements. An institution thus defined to be of systemic importance will have serious problems delivering the return on equity obtained by other institutions not defined to be of systemic importance.
Shareholders and management of central financial institutions would then have strong economic incentives to avoid being classified as "important". Trying to regulate by managing the market forces appears attractive to an American culture of leaving the markets to work their magic, but as always the details are important. And that is what remains to be seen. Will this seemingly clever idea make it through Congress intact under the predictable onslaught from industry lobbyists? Or will the financial institutions use every conceivable means of avoid being classified as systemically important?
In any case, regulators will eventually take on the banks and their wayward behaviour. Once all the dust has settled, only one thing is certain: Banking profitability will end up being reduced structurally. Probably we should not mourn this development too much.
Monday, 2 November 2009
Interestingly, hardly had I pushed the "publish" button for my post on Friday before the markets went into a tailspin. The story was the same as I have touched upon a couple of times in recent weeks, namely the role of consumer spending in the recovery.
On Friday, both Germany and the US reported that consumer expenditure had surprisingly fallen in September. The concrete numbers are probably likely to be changed in due time, but the damage was done and serves as a timely reminder about the uncertainty still haunting the markets.
My point of view remains unchanged. The consumer did not lead us into this downturn, and it is unlikely that the consumer will lead us out of the downturn, either. The downturn gained strong momentum because business managers across the world hit the stop button under the carpet bombing from news media covering the US banking crisis.
It is obvious that without the return of the consumer confidence and spending, this recovery will remain rather anaemic. Alone the weight of consumer spending in the composition of GDP is a guarantee that there will no return to robust economic growth if the consumers remain focused on saving money instead of spending.
This does not change my basic point, namely that the economy is in fact able to pull out on the recession by growth generated in two other subcomponents of the GDP, Business Investments and Government Expenditure.
As for the latter, we know that economic stimulus programs are beginning to work their magic from Beijing over Moscow to Berlin, Paris, and Washington. Depending on the relative size of the public sector in the economy this will have some positive effects in the coming quarters.
Which leads us back to the business investments. Traditionally the smallest part of the GDP, it is also the most volatile part (well, together with the residual known as inventory investments, that is). The beginning of this downturn was no different from any other downturn. Business investments reacted quickly as business leaders hit the stop button. What was, however, different is the depth of the contraction of investment.
Business investment fell sharper than seen anytime else since the war. 1/3 or more of the business investment disappeared in a matter of a few months, leading to suspicion that business leaders did not really hit the stop button. They hit the panic button instead. The same was true for the reduction of inventories.
My point is that the most important dynamic of the recovery comes from exactly the business investments. Inventory rebuilding has already started, while still investment is beginning to focus on yet another round of productivity gains. This goes hand in hand with further job cuts, leading to a continued increase in the unemployment.
So my point about the business investment component of the GDP being the most important in creating recovery dynamics should be seen in the light of increasing unemployment. Consumers are likely to remain uneasy until they see that unemployment is beginning to fall. Whenever that will happen, probably late next year or even later.
But such fine points were lost on the stock markets last week. They were looking for economic news to feed the nervousness that had been building in the previous weeks, and they found it. In the slightly longer term, such arguments are not relevant as the consumers will eventually return to the shopping malls. In the mean time, the stock markets may end up somewhat less bullish than seen in the past months.