Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Monday, 30 April 2012

The Crisis Reading List

Successful trading/investing in the present environment requires a clear understanding of the situation. Knowledge of history and a long term view are essential to rise above the profit killing noise of headlines. In this, the five books listed below have helped me stand apart from the momentum chasers and carry traders ever since the crisis began. They provide invaluable perspective on the current sovereign debt crisis and help in gauging what the future holds. In no particular order:

1. The Chastening: Inside the Crisis That Rocked the Global Financial System and Humbled the IMF
Author: Paul Blustein
This is very relevant to the current crisis as it lays bare the politics and infighting which make crisis resolution extremely difficult. It shows the inability of the IMF and officialdom to resolve the Asian financial contagion. A point of interest is the German opposition to bailouts and how they were bullied into submission even as the bailout itself proved inadequate to stop capital flight. Sound familiar?

2. And the Money Kept Rolling in (and Out): Wall Street, the IMF and the Bankrupting of Argentina
Author: Paul Blustein
Another Blustein book and the sequel to the first one. Excellent analysis of the Argentinian default which shows that the IMF has learnt very little if anything from its past debacles. There are many parallels with the current peripheral situation and it is an indicator of how things are going to turn out in Europe. Argentina defaulted six months after its debt swap (Debt-Swap on 3rd June, Corralito on 1st December, official default announcement on 23rd December). Greece is almost at the finishing line and the others are running in the same direction.

3. The Economics of Inflation: A Study of Currency Depreciation in Post-War Germany, 1914-1923 (Monetary Economics)
Author: Constantino Bresciani-Turroni
An unrivalled study and analysis of Weimar hyperinflation by an economist who was there at the time it took place. Provides the background for the Bundesbank distaste for easy money policies. It also shows one of the end games of the QE experiment now being conducted.

4. This Time Is Different: Eight Centuries of Financial Folly
Authors: Carmen M Reinhart, Kenneth Rogoff
Essential backgrounder for the current sovereign debt crisis. A masterpiece of data analysis which blows away incredible arguments being made today such as '120% debt-GDP ratio is sustainable'. It not only shows how the endgame pans out for debt-burdened states but also the shape of subsequent recovery from busts (whether sovereign, housing or banking). The latter is important for those decrying the USA's "anaemic" recovery.

5. Lords of Finance: 1929, The Great Depression, and the Bankers who Broke the World
Author: Liaquat Ahamed
The most entertaining and easy to read book of the lot, it chronicles the pre World War-I and inter-war period. Ahamed's financial analysis is a bit weak but the presentation of historical facts and storytelling make up for it. The gold standard and central bank policy mistakes of the era have an uncanny resemblance to the current period. The former is reflected in the Euro, the current de-facto gold standard for the Eurozone, and the latter is echoed in the misguided policy of austerity.

Friday, 27 April 2012

State of Spain and Spanish Banks

This is dedicated to Senor Alfredo Saenz who must be one of the world’s most gullible bankers for declaring that “Mortgages get paid in good times and in bad”. It would come as a surprise to him that the correlation between unemployment and mortgage arrears in Spain is 0.78.

The collection of “stupid” graphs below shows the problem that Spain and Spanish banks face.

Graph 1: Doubtful loans to households for purchase and renovation
Source: Banco de Espana

Graph 2: Unemployment and doubtful loans (Dec-88 = 100%) (Correlation = 0.78)
Source: Banco de Espana

A possible reason why mortgage defaults have held in (on a relative basis) is because of low interest rates (Graph 3). However as unemployment rises, low interest rates will not keep mortgage defaults low. Moreover, as lenders shy away from Spanish banks, rates charged to borrowers are moving up.

Graph 3: Mortgage interest rates for mortgages have fallen consistently
Source: Banco de Espana

Despite this, NPLs have soared (Graph 4) and Coverage ratios have fallen (Graph 5).

Graph 4: NPL Ratio for lending to resident sectors
Source: Banco de Espana

Graph 5: Coverage Ratios falling in the face of rising NPLs
Source: Banco de Espana

A fall in coverage ratios implies that banks expect the bottom to be near. The theory being that as the economy and the housing market swing back into growth, NPLs will decline and coverage ratios will rise automatically. Unfortunately this is based on a large injection of Hopium as the last two graphs show.

Graph 6: Housing Affordability still high and above historical norm
Source: Banco de Espana

Graph 7: House Price Index is highly correlated to housing affordability
Source: Banco de Espana

And the pain in housing is going to be felt severely by the banks which have lent €1.05trn (~100% of Spain’s GDP) to the construction and real estate sectors. It comprises almost 60% of their total lending.

Graph 8: Bank exposure to construction and real estate sectors
Source: Banco de Espana

Wednesday, 25 April 2012

Eurozone: The Argument For

On occasion I like to construct scenarios at variance with my investment base case. It dispels confirmatory bias by forcing me to examine all evidence and arguments on the issue. The latest bout has been sparked off by discussions with people who are decidedly more sanguine on the Eurozone than I am. So I thought that I’d construct a scenario where the Eurozone emerges victorious from this battle for its survival. (The battle has the makings of a great movie: Paulson and the evil speculators vs Knights Templeton, El-Erian and the Real Money Gang) 

Here goes:

Rejection of Germanic austerity is gaining ground in Europe as erstwhile secure citadels like Netherlands fall. Along with the withdrawal of support in Holland, the support for Hollande raises the probability that descent into a debt-deflationary spiral may be avoided. Italy and Spain have already unilaterally raised deficit targets and other peripherals are unlikely to hit theirs. From a growth perspective, this is good news. But it is not enough. Even now, austerity remains the dominant theme and talk of fiscal expansion is timid at best. At a time when the private sector is de-leveraging, unwilling or unable to expand, the government has to step in to prevent a debt-deflationary collapse. Rejecting Keynes based on selective reading makes for poor policy alternatives.

Unfortunately it is almost impossible to undertake bold fiscal expansion given current levels of indebtedness and shaky investor confidence. The market allows European nations to have any fiscal policy they like as long as it’s austere. Despite this, there is cause for optimism. It comes from the unlikely direction of the ECB. Like the Fed and BoE, it has sounded more hawkish than it has acted. At every point in the crisis, it has gone against Bundesbank principles to buy more time through SMP, LTROs and collateral widening. Greece shows that an insolvent government can still finance itself through a pliant central bank. In the case of Greece it was not allowed to be taken to its logical end because Greece is an exception (one hopes that no other member manipulated data to quite the same extent in order to join and stay in the monetary union). The Greek trick involves issuing T-bills which investors finance through central bank borrowing. Government borrowing is easy as long as domestic banks are willing to indulge in this ECB financed carry trade. Therefore if the Europeans decide on fiscal expansion and the foreigners take fright, all they need to do is engage in monetary financing through T-bill issuance. At some point even the foreigners will want a cut of the free money (Russian default demonstrated that where free money is concerned, investor nationality is no bar)

Of course, structural reform will still be required to eventually break free from the short-term monetary financing cycle. The good news is that indirect monetary financing provides a long enough timeframe for structural reforms to take effect. The better news, for those who believe that CDS is the instrument of the devil, is that it would destroy CDS buyers. Loyal bondholders may suffer through currency depreciation but that is the price for keeping the union intact.

The two problems with monetary financing are that first, German resistance is sure to be encountered. And second, indebted governments are very likely to relapse and abandon any reform. There are grounds for optimism on the first as TARGET2 imbalances increase and ECB balance sheet carries more and more credit risk. The Germans will realise that the choice is between compromising their cherished ideals or participating in mutually assured financial destruction.

There is less hope of resolving the second problem. Italian backtracking on labour reforms shows that corrective action is not guaranteed even with market pressure and an unelected technocratic prime minister. If promises of reform are not credible, and they are not at the moment, Germany will be unwilling to compromise. However, it is only a matter of creating the right incentive structure. Quotas for monetary financing can be agreed in advance with the promise that those who successfully undertake structural reforms join a fiscal union. Those who fail will be left on their own to be eviscerated by the market. Since the impact of most structural reforms is felt within one/two election cycles, the threat will concentrate the minds of even the most populist politicians.

The LTROs have provided enough time for the Eurozone to come up with the correct medicine to save itself. Structural reforms, however hesitant, are taking place even as events are forcing it to abandon misguided austerity. Therefore reports of its demise are grossly exaggerated.

If one believes that the above scenario will come to pass then the trading calls are:
1. Sell CDS/Buy bonds on Spain and Italy
2. Buy curve steepeners on Spain and Italy
3. Buy Spain/Italy/Ireland/France/Belgium/Netherlands/Austria vs Germany
4. Bank-sovereign spread convergence (for TBTF and nationally important banks)
5. Sell EUR vs USD and vs GBP
6. Buy short-end T-bills for peripherals

Saturday, 21 April 2012

Looking at the IMF resource "boost"

First the politics:
1. Canada wants non Eurozone countries to have a veto over further aid to the Eurozone according to the FT.
2. BRICS (and other EM) nations have delayed giving specific commitments until June and their contributions are contingent on reform of IMF governance, i.e. they want more voting power.)
3. Japan wants more clout on the IMF in exchange for its contribution.

Second, how the $430bn stacks up:

USA, Canada:                                                    $0bn (Yes, Zero. Not a typing error)
Japan:                                                               $60bn
UK, South Korea, Saudi Arabia ($15bn each):  $45bn
EM (including BRICS):                                      $72bn
Europe:                                                           $200bn (Bit circular isn't it?)
Remainder:                                                        $53bn

The inescapable conclusion is that the "boost" is going to be of little use in resolving the Eurozone crisis. 

Thursday, 19 April 2012

Political Will Won't Save Eurozone

Martin Wolf in the FT warns us not to underestimate the political will of the European elite. I don’t know if someone gave a similar warning on the will of the Bourbons but this argument is a red herring. This is equivalent of a ‘Hail Mary’ argument since it is almost impossible to construct an economic defence of the stated policy of no default, no exit, no monetisation, no fiscal union and austerity led growth through massive internal adjustment. As Greek default, sorry voluntary PSI, showed these objectives are impossible to achieve together. One or more conditions will have to be relaxed. And the longer the delusion of political will triumphing economic reality continues, the worse the situation will become and the bigger the eventual catastrophe.

The two main political arguments touted in the FT article are the fear of break-up and the sunk costs associated with the commitment to the ideal of Europe. The first is a weak force. Fear is transitory and self-interest triumphs over it eventually. At the moment, fear of exit and being alone in the wilderness is propelling minimal reforms and short-term austerity measures from peripheral nations. But fear does not mean that there is widespread acquiescence for austerity and reform. There is support for the Euro and European integration because people recognise that it benefits them. However, they want someone else to pay for it. Again Greece makes it very clear that although the people desire the Euro they are not willing to jump into the German sacrificial altar for it. This conflict will be resolved one way or another as unstoppable economic force washes away the immovable elite.

The defence of sunk costs is a stronger force. Throughout history the establishment, allied with reactionaries and vested interests, has stoutly defended the status quo. But history is also littered with the corpses of elites too slow to change and recognise the danger facing them. The entire handling of crisis so far shows that the European elite is making the same mistake. They have been consistently behind the curve and reacted to events through ill thought short-term policy fixes. Tremendous political will does not guarantee continuation of the union by itself. The elites have to express their will through intelligent policy to be able to mount a credible defence against the economic forces arrayed against them. Until now they have only proved JK Galbraith’s statement that between grave ultimate disaster and the conserving reforms that might avoid it, the former is frequently much preferred.

There is still time to save the Eurozone. It requires an end to self-delusion by pulling the plug on insolvent sovereigns and banks. The pain will have to be alleviated through monetisation and fiscal transfer enroute to a full fiscal union. Austerity will have to be abandoned. This is not a compromise between Germanic ideas and messy European reality but a surrender of Germanic ideas to messy European reality. 

Tuesday, 17 April 2012

Dumb and Dumber - MHRD Policy

Inured by the barrage of thoughtless short-term decisions of our great politicians we overlook the rare momentous decision which decides the long-term future of a country. The man behind one such momentous decision is the honourable Kapil Sibal, Union Minister for Human Resource Development. Such is the genius of the man and his idea to remake the JEE, that he will have insured India has no long-term future. The consequence of tinkering with a system which has worked spectacularly for the last 50 years will be the eventual bankrupting of scientific and engineering capital of the country. One cannot help but appreciate this masterstroke. By destroying India’s future, he creates a playing field heavily biased towards his cabinet colleagues who seem to specialise in populist, ill-thought short-term decisions.

After having massively diluted the IIT brand by opening one in every marginal constituency, now the MHRD wants to dilute entrance requirements. At this stage, one must emphasise that there is nothing wrong with trying to create educational centres of excellence and enabling greater number of students to access them. However, creation of institutes of excellence is more than a naming exercise. A point which is probably lost on the party which believes every road and avenue in India must be called Nehru, Gandhi, Indira or Rajiv. And believes such renaming is national progress and generates national pride. An institute attains excellence not because of its name but because of the quality of its faculty, students and facilities. And these cannot be manufactured by merely affixing a signature to a file.

Entry to educational institutes of excellence usually requires students to meet tough qualifying criteria. Thus selection is biased towards those from more privileged backgrounds (whether it is race, caste, class or wealth) who are able to build a strong educational foundation through access to good primary and secondary schooling. They are usually also the ones who are able to afford private coaching for the entrance exams. Therefore, one way to enable greater access to institutes of excellence is to improve the standard of primary and secondary schooling and make it affordable for all. Unfortunately, this is a long, hard slog. Much easier to make education a fundamental right and assume away the problem. The other way to enable greater access is to dilute the entrance requirements and introduce randomness in the selection criteria to enable the mediocre to get in. This is the favoured choice since this can be done with the stroke of a pen and the consequences will only become apparent when the great policy maker has long departed for his reserved place in heaven.

The flawed assumption behind such policies is that every child is intellectually equal. Therefore, diluting rigourous qualifying criteria provides a level playing field immediately. In addition one does not need to bother with constructing a policy which provides quality primary and secondary education to the talented but unprivileged. It is also a vote winner since dreams of accessing institutions of excellence and subsequent high paying jobs can be sold to the masses. Unfortunately, as any child can tell Mr. Sibal, there are some really smart kids along with some really dumb ones in a classroom. The above line of reasoning ignores that intellect and talent continue to be normally distributed across the world despite the best efforts of leftist educators and teachers unions. Lowering educational standards to make every student feel smart and conform to an artificial average is a colossal waste of talent. If Gauss was born in India today he would have received a slap across his face for coming up with a formula to find the sum of the first hundred integers and told to go back and do it the long way like everyone else*.

The focus of an education policy should be to ensure that irrespective of his/her background, every student gets the highest quality of education to enable him/her to rise to his/her potential. The general level of education has to be moved up rather than moving down the level of institutes of excellence. It is understandable why the reverse is being attempted by MHRD. The test of a policymaker and a policy is not how it logically and rationally aims to achieve some national objective. Instead it is how much loyalty it demonstrates for “the” great leader and family. Lowering intellectual and educational standards passes the test with flying colours since most of the great leaders (not to mention “the” great leader in waiting) in this government inhabit the left tail of the intellectual (and seemingly the moral) normal distribution.

For over half-a-century, the JEE has been a fiendishly tough entrance exam to pass. As a result some of the brightest scientific talent in India gets admitted to the IITs (note the “scientific” adjective – IITians are not “the” brightest, if there can be such an unqualified category, and neither are they the only bright scientific talent). True, there are Type II errors but that is the case with every selection process and in any event they are not numerous. The new format of the entrance exam relegates the old JEE to a 60% weight to bestow a huge 40% weight to the school leaving exam. If the school leaving exam was consistent across the country and actually tested for scientific aptitude rather than acuity of memory then this may not have been a big deal. Unfortunately, neither is true. Instead of testing the ability to apply scientific laws, school leaving exams mainly test the ability to remember and correctly state them. Moreover, the marking of school leaving exams is also not consistent throughout the country. As a result students with similar performance may receive widely differing marks depending on their geographical location. There is no way for the central government to force uniformity as education is on the concurrent list and the states aren’t going to acquiesce in a reduction of their power and patronage. Even worse, as every school kid in India knows, marks in the school leaving examination are only loosely correlated to performance or intellect.
As a result, the change would dilute standards and inject randomness into the entrance process. The result would be two-fold. One, there will be a massive increase in Type II errors as mediocre students are admitted. Two, the talented will move abroad due to disenchantment with the process (They will not move to private universities as no Indian private university comes even remotely close to the IITs despite some daring to think beyond). The first will ensure that the general level of education suffers since classroom discourse will have to be brought down a level. It will also destroy the brand which has painstakingly been built over decades. It only takes a few graduating batches to dispel the halo surrounding an institute. The second adds to the brain drain experienced by the country. Easy availability of student loans has made going abroad to top universities for an undergraduate degree much easier. Those negatively affected by this policy will vote with their feet (that’s probably why Mr Sibal couldn’t care less). In any case, a large number of trained and talented doctors, engineers and scientists leave the country. This retrograde step will only reduce the average age of talent fleeing the country and make the situation worse. Unfortunately insidious policies such as these are not ones which make people come out and demonstrate on the streets. Therefore we can only look on with impotent rage and prepare to reap the whirlwind. 

* True story: I know someone who was penalised in high school for solving a maths problem more elegantly. The teacher said something to the effect that ‘This is a 5 mark problem, you are not supposed to use only 3 steps to solve it. That is why I have given you only 2/5’.

Disclaimer: As an IITian I am obviously opposed to the death and destruction of one of my favourite brands. So, as can be gauged, I have been unable to completely disassociate emotion from the arguments above.

Monday, 16 April 2012

Analysing and Trading Sovereign Debt Crises

With the Eurozone crisis making a comeback (quelle surprise) and ECB officials getting worried about US Public Finances (For the record, Bloomberg did not quote Praet saying “Move along, nothing to see here…oh look look smoke across the Atlantic”) it would be an interesting exercise to look at the general question on sovereign debt burden and its sustainability.

The aftermath of the credit crisis has left public finances in tatters in several western countries. But not every country with a large public debt has a debt problem. Therefore it is important to understand the factors and measurement metrics which can help filter the vulnerable from the resilient. An informed capital allocation can then be made.

The four main factors to consider are:
  1. Economic structure – This is a qualitative factor encompassing an economy’s legal framework, regulatory structure, labour and product market flexibility, etc. A capitalist economy is prone to periodic shocks and is equipped to deal with them (Note that this does not advocate laissez faire, governments should and must ameliorate the shocks as Keynes pointed out). However the shock absorbing capacity of the economy can be gummed up by an overextension of the welfare state and over-regulation. Structural flexibility of the US economy is one of the reasons why the US has started to recover.
  2. Debt burden – Although easy but measuring debt burden through the standard metric of debt/GDP is flawed. The numerator and denominator reference different variables. The former only measures government debt while GDP measures the entire value of goods and services produced in a country by both public and private sectors. Since the government accounts for only part of the GDP, the debt/GDP ratio understates the debt burden. A better measure used by some is Debt/Government revenue.
  3. Cost of debt service – This is measured by Interest expense/Government revenue. It is akin to the interest coverage ratio for corporates.
  4. Currency of debt – It matters a great deal if debt is mainly denominated in domestic or foreign currency. Issuance in domestic currency which is under the control of the sovereign allows greater flexibility in managing debt crisis and default (central banking independence stops where a sovereign debt crisis begins).
Let’s look at each in turn to analyse the prospects of selected EU and other developed sovereigns. First, the economic structure and political response to the recession determines how quickly growth resumes. A festering recession leads to entrenchment of vested interests as everyone wants to hold on to their share of the shrinking pie. It also erodes faith in the political structure and may lead to social upheaval. A quick and approximate way to gauge how well an economy is coping with recessionary conditions is by looking at the Misery Index (sum of inflation and unemployment in an economy). It doesn’t substitute for a detailed qualitative analysis but it does act as a warning signal. For an economy, higher the index, bigger the problem. Typically, economies which are structurally more flexible should see faster falls in the index. Graph 1 below shows the Misery Index since 1998 and Table 1 shows it since 2007 when the credit-crunch began.

Graph 1: Misery Index (1998 – 2011)
Source: Eurostat. Based on annual HICP and average annual harmonised unemployment.

Table 1: Misery Index since beginning of credit crunch (2007-2011)

United Kingdom
United States

Source: Eurostat. Based on annual HICP and average annual harmonised unemployment.

As expected, the index has climbed up for all economies since the credit crunch and the four P, I, G, S lead the team. The first interesting point of note is the high ranking of US, UK without any signs of recovery. Given their relative structural flexibility, this is indicative of the severity of the bust and the weakness of subsequent recovery. However, this is not unduly alarming given that recoveries after a housing bust are slow and protracted (average recovery is 5-6 years based on Reinhart and Rogoff’s seminal work). The second interesting point of note is the spike Iceland experienced. The decision to not bail out its banks may be responsible for the rapid turnaround.

Table 2 looks at debt burden and debt sustainability for the selected countries. 

Table 2: Debt burden and sustainability

Gross Debt /Revenue (2010)
Interest /Revenue (2010)
Difference between real interest rate and GDP growth (2010)
Greece (pre-PSI)
United Kingdom
United States

Source: Eurostat, IMF

The chart below shows it graphically for selected countries. The size of the bubble indicates the difference between real interest rates on government debt and real GDP growth rates.

Chart 2: Debt burden and sustainability

Here also the problem with the peripherals becomes clear. Moreover, as the data is only until 2010 (waiting for IMF to update WEO database) the chart provides a more upbeat picture. For example, Spanish debt/revenue will go close to 200% based on a 70% debt/GDP ratio. The real standout though is Japan which seems to be in a league of its own. The other interesting observation is the comfortable position of Germany against others. Combined with a declining Misery Index (Table 1), this partly explains Germany’s confidence and associated failure to understand the apocalyptic urgency of the situation.

The final piece of the picture is the currency of debt. Even though the economic situation in US and UK looks poor according to the metrics above, the fact that they control the currency in which their debt is issued alleviates the credit risk. But in accordance with the first law of financial dynamics (risk can neither be created nor destroyed, it can only be transformed from one form to another) credit risk appears as inflation risk. The ultra loose monetary policy coupled with QE means that if reduction in debt is required in future, it will occur due to inflation. In the case of Japan, this is almost a foregone conclusion. The adjustment will take place through currency depreciation. Therefore, the recent slide in the Yen is probably the start of a major long-term move.

For European peripherals the situation is dire. They have issued in what is effectively a foreign currency and thus the only two routes open to them are either painful internal adjustment (aka austerity) or default. The scale of internal adjustment required makes it very difficult if not impossible as a course of action (especially in light of the Misery indices). Therefore barring a last minute monetisation and fiscal union, the Eurozone is marching towards catastrophic failure.

Finally to use this analysis for trading/investment requires establishment of some correspondence between these fundamental metrics and market data. An examples is to use a naïve equally weighted ranking of all the four metrics (Misery Index, Gross debt/Revenue, Interest/Revenue, Difference between real interest rate and GDP growth) and plot it with the respective 5Y CDS spreads (Graph 3).

Graph 3: CDS spreads vs average rank
Table of data:

Average Rank
5Y CDS spread (bps)
(CoB 13/4)
United States
United Kingdom

The following trading/investing inferences can be drawn:
  1. Japanese CDS looks too high compared to US/UK given that adjustment is likely to be through currency depreciation and inflation rather than outright default (more so given the loss of face involved in default).  Though at the moment selling Yen vs Dollar seems a better trade. The CDS differential is too low and Japan CDS can spike as people mistakenly rush in to buy at the first sign of trouble.
  2. Austria seems too high compared to Netherlands. This is primarily due to overblown fears about Austrian bank exposure to Central and Eastern Europe (CEE).
  3. German spreads appear too low given it is not solely in charge of monetary policy and its intransigence to monetisation. The latter is important especially in the light of TARGET2