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

Friday, 29 June 2012

Hopium Hit


This hopium shot took a long time coming. Feels so good for now.

The Summit statement (emphasis mine):
When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly.”

The statement: ‘When pigs fly, pork could possibly be handed out’ is not equivalent to any of the following: ‘Pork will be handed out’; ‘Pork is going to be handed out’; ‘Here is some pork’.

The next hopium high from the statement:
“We reaffirm that the financial assistance will be provided by the EFSF until the ESM becomes available, and that it will then be transferred to the ESM, without gaining seniority status.” 

We've been down this road exactly one year before when ESM seniority was scrapped for Portugal, Ireland and Greece. (Funny how that hopium shot faded). After that momentous decision which resolved the crisis came Greek PSI with...subordination! 
This current statement just smacks of ‘No subordination for our time’. 

In any case, FT Alphaville (quoting Citi) has already pointed out that I13 in the EFSF FAQs states (emphasis mine): “ESM loans will enjoy preferred creditor status in a similar fashion to those of the IMF, whilst accepting preferred creditor status of the IMF over the ESM (except for countries under a European financial assistance programme at the signing of the ESM treaty).”

The hopium has worn off too quickly. Please sir, may I have some more?

Further reading:
  1. http://ftalphaville.ft.com/blog/2012/06/29/1064761/a-ulysees-pact-on-eurozone-seniority/
  2. http://www.zerohedge.com/news/full-eu-summit-statement-all-its-conditional-wishy-washy-glory

Thursday, 28 June 2012

European Summit Imitates Jane Austen


“Really, you puzzle me exceedingly. If what I have hitherto said can appear to you in the form of encouragement, I know not how to express my refusal in such a way as may convince you of its being one.”

This incidentally was not spoken by Mrs Merkel on the subject of Eurobonds. The original speaker was Miss Elizabeth Bennet in Jane Austen’s Pride and Prejudice. She had refused a proposal of marriage from the obsequious Mr Collins. He couldn’t believe that he had been rejected and kept pressing on leading to her exasperated remark above.

Mrs Merkel was more direct: A joint and several liability in Europe would not be “solange ich lebe” (as long as I live). But the emotion and intent is still lost on the present day Mr Collins’. Barroso, Van Rompuy, Rajoy, Monti, Hollande and every other leader of a broke European country along with the punditry just cannot believe that Germany can refuse Eurobonds. Like Mr Collins, they keep going on and on, “When I do myself the honour of speaking to you next on the subject, I shall hope to receive a more favourable answer than you have now given me…You must give me leave to flatter myself…that your refusal of my addresses is merely words of course.”

The sheer disbelief at Germany’s refusal for debt mutualisation is unbelievable. All politics is local and decisions are made in view of the electorate. The Italians, Spanish or French are not going to elect Mrs Merkel. Her policy aims to be in tune with the voters in Germany. According to the latest poll 67% of Germans trust the government to take the right decisions about the future of the EU. Further, 44% of Germans are in support of the current policy of imposing strict conditionality. And finally 37% feel that Germany has already done enough. In light of this and the fact that German elections are next year, it is unlikely that Mrs Merkel is going to change her mind. (The regional elections that her party keeps losing are not fought on European issues. Again, all politics is local).

As Elizabeth finally cried out in frustration, “I thank you again and again for the honour you have done me in your proposals, but to accept them is absolutely impossible.”

P.S. Rather than watch the boring summit, see the BBC adaptation: http://www.youtube.com/watch?v=tWx7AF8B0R8

Monday, 25 June 2012

London House Prices: A Permanently High Plateau?

Another item has been added to life’s certainties of death and taxes. It is London house price inflation. The sentence ‘It will never go down’ has been uttered in every single recent conversation on the subject. It is usually followed by ‘I should have bought earlier, now it’s unaffordable’. The oxymoron of perpetually rising prices and increasing unaffordability amongst the top income decile seems to escape notice.

The reason for an almost unshakeable faith that London house prices will never go down is predicated on their observed behaviour. For the last 17 years, barring the credit-crisis induced meltdown, house prices have only gone up (Graph 1). Moreover, believers’ faith was further strengthened by the swift recovery from the crisis.

Graph 1: London house prices have been going up for what seems to be a lifetime
Source: Land Registry (www.landregistry.gov.uk)

There are two main rationalisations for the belief in perpetually increasing house prices. The first is the argument of limited supply. The second is the argument of unlimited demand. Limited supply is an argument made in support of house prices for almost every city. It is especially valid for the capital of an island nation beset by stringent planning laws. However, prices are determined by both supply and demand. Even if the supply curve is completely inelastic, a fall in demand will lead to a fall in prices as Graph 2 simplistically shows.

Graph 2: Fall in demand shifts the demand curve to the left and reduces prices
Believers dismiss such an eventuality by invoking the myth of unlimited demand. To them the demand curve, rather than shifting to the left (i.e. reduction in demand) is expected to shift to the right (i.e. increase in demand). Events seem to have borne them out as London property’s ‘safe haven’ status has led wealthy individuals from across the globe to park a part of their wealth there. Once again the bias to extrapolate from recent history is apparent. However the ‘unlimited demand’ argument cannot be dismissed this easily. It requires further deconstruction.

Demand for London property can be bifurcated into internal and external demand. The former is due to people employed and primarily resident in UK. It may be as a primary residence to live or as a buy-to-let investment. The latter is due to external residents buying property for investment, capital preservation or as holiday homes. Internal demand largely depends on demographics and performance of the economy. As long as jobs are plentiful, wages rising and population increasing, the internal demand for housing will rise. This has been the case since the mid-nineties.

London has been a major beneficiary of the developed world’s move towards FIRE (Finance, Insurance, Real-Estate) economies. It contributed almost half of UK’s gross value added (GVA) from finance and insurance sectors in 2009 and almost a fifth of GVA from real estate. The high and more rapidly increasing income from these sectors underpinned the high and rapidly increasing house prices (Graph 3).

Graph 3: Paying with FIRE
Source: ONS
Moreover these sectors generated a lot of jobs until the credit crisis (Graph 4) and also created ancillary employment in other sectors (Graph 5). A combination of job creation and a liberal immigration policy attracted immigrants enhancing the demand for housing for both purchase and rent.

Graph 4: Employment powered by FIRE
Source: ONS

Graph 5: London unemployment dropped faster but is now rising faster than UK average
Source: Labour Market Statistics, ONS

This natural demand was supercharged through access to easy credit apart from an influx of wealth from abroad. It led to house prices increasing at a faster pace than increasing employment and income would warrant (Graph 6).

Graph 6: Relative changes in income, jobs and house prices
Total Income = Average FIRE Pay x Total Jobs
Source: ONS, Author's calculations

After the FIRE economy consumed itself in the conflagration of 2007-08 the dynamics of internal demand have changed. Cinders have fallen on all sectors as can be seen from the quickly rising unemployment which has increased more than the UK average (Graph 5). In FIRE sector employment is below the peak and as Graph 4 shows, jobs were again being destroyed in finance and insurance in the first quarter of 2012. Anecdotally the second quarter is going to affirm this trend. Real-estate’s bucking the trend may be due to temporary factors such as the Olympics. Moreover in finance and insurance stricter regulation and increased market volatility have reduced revenue and return for institutions. This has resulted in employee pay trending down (Graph 3). If this was not enough, politicians have decided to cater to populist xenophobia by cracking down on immigration. Employers and skilled migrants, already deterred by poor economic conditions, are further put off by the official hostility against immigration.

All the conditions responsible for a rising internal demand for housing are now acting in reverse. In addition, the rocket fuel of easy credit has burnt out with banks tightening lending criteria (Graph 7). Despite demand from households, credit availability remains moribund, application approvals are decreasing and mortgage interest costs are rising. Although data for London is not exclusively available, given the arguments above, it is unlikely that banks are acting differently for Londoners. Especially in light of the fact that despite high average incomes in London, price to income ratios are highest there (Graph 8). This implies banks either need to offer higher loan-to-income mortgages to Londoners or ask for higher deposits. And as graph 6 shows, loan-to-income ratios are being reduced across the UK.

Graph 7: Conditions for secured lending by households across UK
Source: Bank of England

Graph 8: London house prices are the most overvalued compared to earnings
Source: ONS, Land Registry

Even as internal demand started collapsing after the advent of the credit crisis, external demand underpinned the market and reflated house prices. This was despite external demand being much lower. The reason why a decrease in demand did not lead to lower prices was because of diminished supply (explained simplistically in Graph 9). Bank of England’s rate cuts reduced the pressure on homeowners to sell by lowering their repayments dramatically. The massive reduction in the number of transactions (Graph 10) along with anecdotal evidence supports this conclusion.

Graph 9: Supply reduces even as demand reduces preventing price fall

Graph 10: Completed transactions in London are at the lows
Source: Land Registry

The additional external demand keeping the market alive has been due to London’s status as a ‘safe haven’. London’s location, cosmopolitan character and British rule of law and property rights have traditionally attracted wealthy investors. Recently, investors fleeing from the European debt crisis have caused another burst of demand.

However as the history of sovereign debt crises shows, external demand for a country’s assets is fickle and can turn in an instant. Houses may not be as easy to sell as debt and equity but investor sentiment is the same. In fact, due to the illiquid nature of the asset, prices can fall more dramatically. As long as London property can preserve capital and provide returns it will sustain foreign money inflows. But in the absence of internal demand these flows become Ponzi like. The pool of foreign investors needs to be constantly replenished to enable existing investors to cash out at a profit. This causes prices to become dependent on perceptions of the UK economy and performance of the Pound Sterling.

Unfortunately the UK economy is not doing too well. The outlook is not too bright either given the policy mix. Not only is fiscal austerity combined with monetary debauchery going to fail but it is also exactly opposite to investors’ interests. The former will snuff growth and hence internal demand while the latter will cause a fall in the currency. Once attention shifts from the beleaguered European Union, investors will notice an island nation with a debt-burden[1] next only to peripheral Europe (Graph 11). Since defaulting will be politically unpalatable and the strain of repayment socially and economically impossible, fall in the value of Sterling is virtually certain over the long term. Moreover the UK will suffer enormously from an implosion of its largest trading partner, the Eurozone. In such an event, it is a safe haven only in a relative sense – maybe the loss will be only 70% compared to 90% in Europe.

Graph 11: High debt-burden without the benefit of a reserve currency
Source: Eurostat, IMF, Author's calculations

In conclusion, the analysis above lays bare the myth of permanently increasing London house prices. A broader look at history shows that even if supply is limited, periods of seemingly insatiable demand and rising house prices do not persist forever. Data of house prices from another former colonial and European power makes this clear (Graph 12). The only sure things still remain death and taxes.

Graph 12: Real house prices on the Herengracht Canal, Amsterdam (1628-1973)

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[1] On Interest/Revenue and Debt/Revenue metrics. To see why these are more relevant than debt/GDP:

Wednesday, 20 June 2012

Another Cunning RescEU Plan


Exasperating is the word that most diplomatically describes Eurozone officials and politicians.

Revealing a worrying lack of fresh ideas to solve the crisis, the Eurozone has gone back to the bond buying scheme. In the hope that doing the same thing again and again will somehow yield a different result, Mario Monti has proposed peripheral debt buying by EFSF on the open market. The three minor problems with this are:
  1. ECB has bought €210bn of debt including €50 worth of Greek bonds with little to show for it. Indeed, it couldn’t save Greece even after buying bonds worth about 25% of Greek GDP or 15% of outstanding debt. Using the same metric, EFSF will have to buy more than €120bn - €250bn of Spanish debt (depending on whether one uses purchase/GDP or purchase/outstanding debt as the lower bound) to make an impact. For Italy, it is €400bn - €480bn. Now I may have forgotten my stochastic calculus but elementary algebra is still within my grasp.
    1. Available EFSF funds are €250bn[1] (very charitably allowing Spain and Italy to contribute and guarantee their own bailout).
    2. 250bn < 600bn (using purchase/outstanding debt as lower bound) < 650bn (using purchase/GDP as lower bound)
    3. Now taking out Spanish and Italian contributions, EFSF funds drop by about a third (Spanish contribution is 12.75% and Italian 19.18%) to €170bn. This still assumes that Italy and Spain will be willing and able to guarantee the bailouts of Ireland, Greece and Portugal.
    4. Non-ratified ESM is €500bn. Take out Italian (17.91%) and Spanish (11.904%) contributions and ESM drops to €350bn.
    5. Therefore total funds actually available subject to ESM coming into force: 170 + 350 = €520bn < €600bn < €650bn. It just doesn’t add up.
  2. To be able to buy every member state has to agree. Browbeating only Germany isn’t enough.
  3. EFSF needs to raise money to buy debt by issuing debt. Given that the nature of EFSF guarantees is not joint and several and bondholders are subject to domestic law for guarantee enforcement, who is going to buy EFSF debt? Yields are already trending higher.
But as a wise leader said: “It’s not acceptable that Spain, which just got a promise for support, has interest rates around 7 per cent”. Exasperating.


[1] All numbers rounded to the nearest 10bn

Monday, 18 June 2012

Will Ben Bernanke Gamble?


The market expects Bernanke and his band to perform the Twist. Even as US economic data has deteriorated, Pavlovian buyers have lifted stocks and treasuries in anticipation of central bank largesse. However is the Fed going to play the tune that the market wants to hear?

Growth requires fiscal policy to be stimulatory. When private and household sector is deleveraging and unwilling to invest, government must take up the slack. The basic macroeconomic identity: Y = C + I + G + X implies that when consumption (C), investment (I) are decreasing in an economy with a trade deficit (negative X) then government spending (G) must increase to keep national income (Y) from falling. Monetary policy can help if it is able to impact investment spending through lower rates. However, investment spending depends on a whole host of factors apart from interest rates. Sometimes these factors overwhelm the effect of lower rates making monetary policy impotent to restart growth. Unfortunately prevailing economic dogma scarcely recognises such liquidity traps.

It is in such a liquidity trap that US, UK and Europe[1] have resorted to thoroughly dogmatic “unconventional” policy response. Beyond protecting the interests of the elite, monetary policy has only demonstrated its ineffectiveness. This has become even more apparent with time and increasingly led to the dogma being questioned.

It is only UK which has nailed itself to the mast of defunct economics. In indebted Europe, calls for fiscal stimulus have grown louder as the experiment in austerity fails[2]. In the US, Bernanke put emphasis on fiscal policy for continued recovery. To quote from his Congressional testimony (emphasis mine):
Another factor likely to weigh on the U.S. recovery is the drag being exerted by fiscal policy...real spending by state and local governments has continued to decline. Real federal government spending has also declined, on net, since the third quarter of last year…The economy's performance over the medium and longer term also will depend importantly on the course of fiscal policy…Even as fiscal policymakers address the urgent issue of fiscal sustainability, a second objective should be to avoid unnecessarily impeding the current economic recovery. Indeed, a severe tightening of fiscal policy at the beginning of next year that is built into current law--the so-called fiscal cliff--would, if allowed to occur, pose a significant threat to the recovery.If the “fiscal cliff” is allowed to occur then the US would follow UK into a recessionary abyss. Bernanke clearly does not want this to happen. The FOMC meeting on June 19-20 gives him the opportunity to try and avert this disaster.

It requires the Orwellian feedback loop between economic data, market response and policy to be broken. As shown below, this loop has meant that bad is good and good is bad.
Orwellian feedback loop

This means that stable and rising markets lead to policy stasis. Lack of a crisis encourages policymakers to indulge in partisan ideological fights. A prime example is the failure to pass TARP the first time. The ensuing market meltdown quickly concentrated minds and led to its eventual passage.   

Currently market expectations are running high for Bernanke to deliver especially in light of the turmoil in Europe. If Bernanke disappoints, he’ll cause a sell-off putting some pressure on Congress and Senate[3]. The timing is politically charged but the presidential election is not going to be decided on whether the S&P500 is at 1100 or 1400. The level of unemployment is a much bigger factor and it is unlikely to change dramatically, especially by November, through a display of monetary policy fireworks.

This is probably the last chance to avert fiscal suicide. The upside for Bernanke to cater to the market’s wishes is small and transient but the downside is huge. In contrast the upside of doing de minimis is potentially large while the downside can always be mitigated through action later if required. Therefore a gambling man would do nothing. Is Bernanke a gambling man? We'll know by Wednesday.


[1] Europe has the dubious distinction of overlaying the liquidity trap with several other tragedies largely of its own making.
[2] It is another matter that the calls to end austerity are loudest from self-serving politicians with a tenuous grasp of both reality and economics. See http://www.shashankkhare.com/2012/05/nonsensical-austerity.html
[3] This is not a novel approach. ECB's reticence is partly due to the need to put pressure on policymakers. More recently the Reserve Bank of India has turned on the heat on fiscal policymakers by keeping rates on hold to the market's surprise. See http://ftalphaville.ft.com/blog/2012/06/18/1048151/reserve-bank-of-india-were-holding-rates-you-sort-it-out/

Saturday, 16 June 2012

Hope turkeys vote for Christmas in Greek elections


Imagine you’re one of the 22.6% Greeks without a job. Or their family member. Maybe you’re one of the 52.7% of the under-25s without a job. Or their parent. You voted against the “No jobs, no money, more pain” aka the pro-bailout parties in the last election. Then the democrats of Europe “advised” you to change your mind otherwise ejection from the Eurozone and catastrophe loomed. But they have a history of backing down under pressure. They have also destroyed all remaining credibility of their threat by advertising a “no-conditions attached” bailout of Spain. Moreover you have little to lose as your benefits, if not expired, have been reduced at the insistence of the wise men of Europe and IMF. Your savings have also run down. The economy is slowly shutting down as a brutal credit crunch tightens, multinationals prepare to flee (if they haven't already done so) and money leaves for safer havens.

So do you change your support in the hope that maybe this time the same set of policies will produce a different outcome? Answer carefully because a lot of people have bet that you will. 

Funds, Greeks, market-makers, lend me your ears;
I come to bury Syriza, not to praise them.
The orthodoxy that parties follow lives after them;
The sensible policy is oft interred with their defeat;
So let it be with Syriza. The noble Eurocrats
Hath told you Syriza was ambitious:
If it were so, it was a grievous fault,
And grievously hath Syriza answer'd it.
Here, under leave of Eurocrats and the rest -
For Eurocrats are sensible men;
So are they all, all sensible men -
Come I to speak in anticipation of Syriza’s defeat.
It appeared sensible, faithful and just to Greeks:
But Eurocrats says they were ambitious;
And Eurocrats are honourable men.
It rejected many tyrannical bailout conditions on Athens
Those bailouts did Franco-German bank coffers fill:
Did this in Syriza seem ambitious?
When that the poor have cried, Syriza hath wept:
Ambition should be made of sterner stuff:
Yet Eurocrats say it was ambitious;
And Eurocrats are honourable men.
You all did see that in the last election
Greeks presented Syriza with a kingly crown,
For which they refused to compromise principles: was this ambition?
Yet Eurocrats say Syriza is ambitious;
And, sure, they are honourable men.
I speak not to disprove what Eurocrats spoke,
But here I am to speak what I do know.
Greeks all did vote for them once, not without cause:
What cause withholds Greeks then, to not vote for them again?
O judgment! thou art fled to brutish beasts,
And markets have lost their reason. Bear with me;
My heart is in the ballot there with Syriza,
And I must pause till it come back to me.

(With apologies to Shakespeare.)

Sunday, 10 June 2012

Spanish Bailout: No Rejoicing


Investors were provided the usual large helping of Eurofudge to drink along with Kool-EuroAid this weekend. Eurozone leaders promised a bailout of great size with no one to know where the funds would come from. Ostensibly there are so many sources of funds that the actual source of funds is immaterial. Before swallowing this Eurofudge and washing it down with Kool-EuroAid, one must see how it all stacks up.

First glass of Kool-EuroAid: No added conditionality is German surrender and sets precedent for covert unconditional bailout of everyone
Reality: The Germans have not caved in; they are sticking to the plan.

The big deal that Mr Rajoy is making about no additional conditionality for the €100bn is slightly disingenuous. In the 21 July 2011 meeting (which, if one remembers correctly, had “solved” the crisis) EFSF was given the mandate to lend for bank recapitalisations. And aid for the banking system was considered to be different from general macro-economic aid programme. According to the EFSF “The request for and control of this instrument [bank recapitalisations] needs to be ‘lighter’ than in the case of a regular macro-economic adjustment programme in order to increase the speed of funding as well as to reflect the sectorial nature of the loan.

Therefore even though the details have not been divulged, it is likely that EFSF gets tapped.

Second glass of Kool-EuroAid: Quick bailout agreement is positive for Spanish assets
Reality: The prospect for Spanish assets hasn’t improved; in fact sovereign debt is riskier

If the EFSF funds the €100bn then according to the conditionality attached to bank recapitalisations, shareholders have to bear the first brunt. EFSF guidelines state “The following pecking-order in the financing of the recapitalisation should be respected. First, before considering a public intervention, the primacy of private sector contributions should be reasserted. Recapitalisation of a financial institution should be first and foremost financed by its shareholders, as the owners and those ultimately responsible for past business decisions.” Buying Spanish bank stock last week isn’t looking so hot now is it?

ESM funding the total or a part of €100bn requires ratification of the fiscal compact by Spain. This will doom Spain into an austerity-led deflationary depression much like Greece. Another reason why conditionality was not imposed; no further conditionality is required. The prospect of deflationary collapse means that Spanish assets are in no way cheap.

Sovereign debt has also become riskier. ESM’s status as a senior creditor subordinates existing debtholders. In addition, ESM can call for the private sector to share the burden before aid disbursal (aka PSI).

Moreover, €100bn is approximately 10% of Spanish GDP. The debt-government revenue ratio[1] will be next only to Italy and Portugal in the Eurozone. And this is excluding its off-balance sheet obligations (such as guarantees to EFSF). The rapid rise in indebtedness is on the lines of what was seen in Ireland as it decided on a policy to save the banks and crucify its citizens.

Third, a helping of Euro-fudge: €100bn is more than IMF estimated and well within Eurozone’s means
Reality: IMF always underestimates the quantum of rescue required and this bailout further depletes “firewall” funds

Spain contributes 12.75% of EFSF and 11.904% of ESM. If it is no longer able to fund itself in the market to rescue its banks, it is for all intent and purposes unable to contribute to either bailout fund. This is similar to Ireland, Greece and Portugal not contributing to EFSF. Based on this, the recalculated capacities are:
  • Spain’s EFSF contribution = €92.544bn (out of €726bn)
    • €192bn committed for Portugal, Ireland, Greece.
    • If Spain is taken out total drops to €633.456bn.
    • This implies €383.9bn of actual total lending capacity.
    • Therefore, remaining lending capacity drops to €191.8bn.
    • If one makes the heroic assumption that, if called upon, Spain can pay its commitments to the EFSF, the reduction in remaining capacity is smaller. It reduces to €216.38bn.
    • If Spain obtains funds from EFSF then remaining EFSF capacity is €91.8bn (€116.38bn if one is optimistic)
  • Spain’s ESM contribution is 11.904% of capital
    • If Spain cannot contribute to capital then ESM firepower of €500bn reduces to €440.48bn.
    • Since total EFSF and ESM lending capacity was capped at €500bn once ESM comes into being, Spain’s exclusion reduces the total lending capacity to €440.48bn unless other European partners are feeling rich, generous and full of solidarity.
Given IMF and EU’s optimism about funds required as demonstrated throughout this crisis (and IMF's optimism in other crises), €100bn is likely to be only bailout part uno. Moreover, the depleted firewall cannot protect Rome from the barbarians.

Fourth, final helping of Euro-fudge: “Victory” for Spain and demonstration of will to resolve crisis
Reality: Nothing concrete has been agreed as usual

The agreement for bailout has been made in principle and nothing more. The Eurogroup statement makes it quite clear: “The Eurogroup has been informed that the Spanish authorities will present a formal request shortly and is willing to respond favourably to such a request.” The final terms are yet to be determined and may differ from what Mr. Rajoy wants people to believe. Given the rapidity at which the crisis is spreading, the final package and the terms are anyone’s guess.

Meanwhile Moody’s has already warned: “We would also consider an increased reliance on indirect support, such as external lending targeted at banks in order to relieve a distressed sovereign of the burden of support for its banking system, to be strongly indicative of increasing financial strain. Depending on the extent of intervention and the degree of financial strain it was intended to alleviate, we might consider such action to be tantamount to direct dependence on external support, also warranting downward rating action.” Moody’s is the only rating agency keeping Spain above the higher ECB haircut threshold of BBB+. A downgrade would lead to increased haircuts demanded by ECB on Spanish debt increasing the burden of those LTRO carry trades.

Even if the terms are finalised and funds disbursed quickly, it will only have reduced the near-term probability of default. As pointed out above, the bailout has increased loss given default for existing sovereign bondholders and may even have increased longer-term probability of default. As a result any bond/CDS/Euro rally should be faded.


[1] This is more relevant than debt-GDP (see what I wrote earlier)

Thursday, 7 June 2012

At what point does French CDS break through 300?


As another Hopium shot courses through the market’s veins, some exciting news from the other safe haven in the Eurozone:

  1. Hollande rolls back pension age to 60 from 62 since happy shirkers workers are more productive shirkers workers
  2. And for his next move, Hollande is planning to ban unemployment (or something along those lines)
It must be great to have a wealthy neighbour working hard to finance one’s dreams.

All economic data points indicate a worsening situation across the Eurozone (PMIs, unemployment, industrial production, confidence, etc). But the good news is that there is broad political agreement between peripheral nations and others (where politicians are concerned about their re-election prospects and approval ratings). The consensus which seems to be emerging is "Give us the money quick but don't ask for anything in return. We are proud sovereign nations capable of handling our own bailouts with your money."

All eyes on Ben Bernanke to keep the Hopium flowing until Merkel is bullied to pay for a well deserved early retirement at a Spanish beachfront property. After all it's hard work doing a job from which one can never be fired. 

P.S To hazard an answer to the question - 300 before the year is out. Maybe 400 even. Beyond that is impossible because the market will be banned and a command and control economy established.

Wednesday, 6 June 2012

Reserve Bank of India Making Greenspanian Error


“You can either die a hero, or you live long enough to see yourself become the villain.”

Harvey Dent’s statement from the Batman movie 'The Dark Knight' certainly applies to central bankers. And unfortunately they always live long enough. The crisis in the western world has laid low all the heavyweights. The ignominious fall of the Maestro is perhaps the best known example. But Greenspan is not the only fallen idol in the pantheon of catastrophic central bankers. Jean-Claude Trichet was much feted for his bold and proactive approach of being the first to provide unlimited liquidity to European banks during the credit crisis. But his inexplicable rate rises and timidity during the sovereign debt crisis destroyed his and the ECB’s aura of competence. Although Sir Mervyn King has done a heroic job of keeping his knighthood, his descent into the halls of infamy is assured. Not only was he asleep at the wheel[1] as the unsustainable credit boom unfolded but now by subscribing to the ideology of austerity he has sown the seeds of a greater future disaster.

The latest central banker whose halo is becoming tarnished is Dr. D. Subbarao of the Reserve Bank of India (RBI). He assumed office little more than a week before Lehman went bankrupt and the global credit crisis took on a more dangerous turn. Under his leadership RBI cut rates to provide both liquidity and an economic stimulus. As India and its banking system emerged relatively unscathed in 2009, he rapidly normalised rates. Paeans were written about RBI’s hands-on approach to macroprudential risk management and the ability of monetary policy to deliver sustainable growth. In August 2011, rather than let him retire the government rewarded his heroism with a two-year extension of his term as RBI Governor. Alas, the extension was long enough to see him knocked off his pedestal. Whether it is long enough to see him become a villain remains to be seen.

RBI’s inflation fighting credibility was in serious doubt even as Subbarao’s term was extended. Inflation was stubbornly high throughout 2010 and 2011 and has refused to moderate. A slight downward blip in inflation in March (6.89% compared to 6.95% in February) was seized upon as a justification for a 50bp rate cut in April. Unfortunately no one quite believed that it was the start of a secular decline. Even more unfortunate for Subbarao was the fact that the April inflation print went back up to 7.23%. This is not a case of simply being wrongfooted by high oil prices. Although high oil and commodity prices are inflationary, the main reason for high Indian inflation is structural. Infrastructure and supply-side reforms are essential to achieve high growth without accompanying inflation. Rate cuts are meaningless in a country where foodgrain prices soar even as thousands of tonnes of grain stock rots due to poorinfrastructure and management.

The April rate cut along with more dovish talk from the RBI raise doubts on more than policy competence. The hurry to reduce rates casts suspicion on central bank independence. The current government is in a state of policy paralysis brought on by a frightening lack of leadership coupled with an ardent desire to hold power. This has made them severely dependent on populist allies and too scared to undertake reforms. With fiscal policy already in 2014 election mode the government would like monetary policy to follow suit. The hope is that the rising tide of liquidity and credit will hide the fact that the Indian economy is swimming naked. The dovishness is either a catastrophic policy error or Subbarao has bowed to diktats from the government. In both cases, the result is the same. The pressure to restart reforms has abated and the stage is set for a low growth-high inflation economy.

A more pernicious result of this monetary easing is due to the distributive effects of monetary policy. Neoclassical dogma ignores that monetary stimulus, much as fiscal stimulus, has distributive effects. However, unlike a fiscal stimulus, monetary easing is directly beneficial to asset owners. While a rural employment scheme puts money in a poor villager’s pocket (when not embezzled by corrupt officials), lower rates save money from the margin trader’s and buy-to-let landlord’s pocket. In addition, higher inflation hits the poor villager harder than the city slicker. To pursue such policy in a country where more than a third live below the poverty line and which has a rising Gini coefficient is not only wrong but criminal.

Perhaps Subbarao’s dovishness is not a policy mistake or obeisance to the government. He might have a third more noble reason – to counter capital flight. A burgeoning current account deficit and increased risk averseness on imminent European implosion has led to capital fleeing India. Foreign investors haven’t even stopped to marvel at the Bollywood tragi-comedy being enacted by Indian politicians. In this scenario, RBI was the only credible line of defence. Lowering rates to attract capital may seem counterintuitive but foreign investment in India is attracted by capital appreciation not yield. Lowering rates provides an impetus to asset appreciation thus reversing and attracting more foreign capital flows. However, there is a very high cost to pay for this short-term fix. The political landscape makes it very difficult to reverse policy quickly or even at all. And as usual, an unfolding credit fuelled asset boom will mask problems and provide positive reinforcement on policy. Subbarao and his successor will be hailed as maestros. Until Harvey Dent’s aphorism is proved again.

Trading/Investing takeaway:
RBI’s dovishness is positive for Indian assets, especially real estate, over the medium to long term. The equity market turnaround may be premature and primarily due to short-covering. Unless the European situation miraculously improves, declines in NIFTY and SENSEX are not over yet. But the best part of Europe induced sell-off will be that it would provide a great entry point.

Correction:
Prakash Kailasam has corrected my poor knowledge of Batman by pointing out that the statement was made by Harvey Dent not Bruce Wayne as I thought earlier. This has been corrected above.


[1] FT reports that “Although one of the BoE’s two core purposes was “to ensure financial stability”, it seems he [King] neither enjoyed nor fully understood the influence the BoE still had in calming financial excess by use of its powerful voice. Work in the financial stability division did not excite him and he told colleagues to “operationalise” it, by which he meant simply writing and publishing two financial stability reports every year.” A letter to the Economist notes that Sir King is now attempting to embellish his credentials and legacy.

Friday, 1 June 2012

Yen: An Unsafe Haven


Interview question: As the European crisis intensifies, US fiscal cliff approaches, Chinese growth starts slowing and risk assets take a dive, in which currency would you park your money?

The consensus answer seems to be the Japanese Yen (JPY). It has appreciated almost 8% from its low against the US dollar in mid-March. Bank of Japan’s refusal to ease further for the time being may account for some of this bounce. However, the Yen’s behaviour is consistent with the Pavlovian market response when the switch is flipped to risk-off.

Apart from renewing headaches for Japanese policymakers, JPY appreciation provides a false sense of security to investors by instantly validating their investment thesis. Investors are falling into the behavioural trap that since buying JPY in moments of crisis has worked before and seems to be working now, it will always work.

To determine whether buying JPY as a safe haven is sound strategy requires some analysis. This requires comparing Japan against the following three main characteristics which define a safe haven currency:
  1. Political stability and certainty
  2. Sound fiscal and monetary policy, i.e. policies which are sustainable and do not debase the currency
  3. Macroeconomic structure and outlook, i.e. resilience to shocks, ability to quickly bounce back from recession and good growth prospects
The first two are necessary to attract short-term safe haven flows. All that investors care about is preservation of capital until a crisis blows over. This desire also explains why government bond yields for countries which face significant long-term challenges have gone negative. The third factor operates over a longer-term and determines whether capital brought in during a crisis will stay and whether more capital will be forthcoming after the crisis is over.

Looking at Japan, it satisfies only the first condition of political stability and certainty. Even that is actually a weakness as stability has turned to sclerosis with an inability to break the deflationary status quo. Fiscal and monetary policies being pursued are far from what is desirable in a safe haven.

Japanese fiscal policy and its debt burden make peripheral European nations look like models of prudence. As the graph below shows (reposted from my earlier blog postJapan’s debt burden and cost of servicing debt is worse than any European sovereign bar pre-default (pre-PSI) Greece. And this is when interest rates on Japanese bonds have been at record lows.


Graph 1: Debt by a thousand deficits
Key: Size of the circle indicates the difference between real interest rates on government debt and real GDP growth. Higher the difference, bigger the circle and more onerous the interest service.



The argument made to defend this gigantic debt burden as sustainable is the fact that it is held largely by the Japanese and is denominated in JPY. Therefore evil speculators and foreigners cannot manipulate a sell-off causing a self-fulfilling debt crisis like the one in Europe. A large stable base of debt holders may be a necessary condition for debt sustainability but it certainly is not a sufficient one. Ultimately debt has to be repaid and this requires growth. Growth is the one thing that Japan has desired without much success for the past two decades. At the current level of debt, it is highly likely that bond holders suffer real losses even if they get back their nominal investment.

Along with fiscal policy, the soundness of monetary policy is also under question. The Bank of Japan was the first to venture into quantitative easing (QE) in 2001. In April this year, it increased its asset purchase program by 10 trillion Yen to 40 trillion. While Japanese conservatism makes this a relatively small amount as compared to the ammunition deployed by Ben Bernanke, the more popular debaucher of currencies, Japan’s money stock in relation to its GDP is huge. Japanese M2 money stock (currency in circulation and deposits) currently stands at 175% of GDP. In contrast, Fed’s QE has only managed to boost M2 to 68% of GDP. It is also much higher than other developed countries as Graph 2 shows. Moreover BoJ’s asset purchases unlike the Fed’s are not confined to government bonds and MBS. The asset purchase program can also buy corporate bonds and equity enhancing the risk taken by the central bank. Purely from a monetary perspective, Japan’s situation is closer to the UK, whose currency is certainly not a safe haven.

Ironically, Japan cannot reverse its easy money policy without causing a debt crisis. Individuals, institutions and banks are holding an enormous amount of fixed-income securities which will fall in value if BoJ tightens monetary policy. In addition, debt servicing costs for the government will also rise more than in proportion since capital losses on existing debt will force the government to pay a higher premium to sell new debt to investors. 


Graph 2: Money, money, money, it’s a printing bank’s world
Japan also lacks the third characteristic of a safe haven. Its two lost decades of meagre growth and continuing deflation amidst policy failures cloud future growth prospects. The contribution of exports as a continuing source of strength for the Yen and the economy is exaggerated. The current account surplus is decreasing and stood at a paltry 2% in 2011 according to the IMF. Moreover, Japanese exports are heavily geared towards business investment which will be adversely affected by the global crisis and Chinese slowdown. Graph 3 and 4 show the composition of exports and imports.


Graph 3: Has Chinese investment demand created its Japanese supply?


Graph 4: Decidedly less elastic to global growth
The demographic picture adds to the sense of gloom. The dependency ratio (number of non-working age to working age people) rose from 46.9% in 2000 to 57.1% in 2010. This is set to deteriorate further as the low growth rate means that the number of children entering working age is less than the number retiring. The percentage of children in the total population declined from 14.6% in 2000 to 13.1% in 2010. The lack of growth opportunities at home is shown by the net outflow of capital through direct investment (Graph 5).


Graph 5: Follow the money


In conclusion, JPY does not satisfy the metrics for being a safe haven. The precarious state of its public finances combined with loose monetary policy which cannot be tightened means that the adjustment has to come through currency depreciation. In addition the state of the economy and aging population is unlikely to attract investment. A Chinese slowdown and decline in global demand will worsen the terms of trade putting further pressure on the Yen. Investors rushing blindly into JPY as a safe haven may find out too late that they have instead put their money into a Ponzi scheme.


Post-script for short-term traders:
Even if short-term trading horizons justify buying JPY against USD or other currencies (except EUR) to play momentum, a contrarian position is likely to be much more profitable at this juncture. This is in light of the fact that the downside to being short JPY (especially against USD) is substantially lowered by expected intervention. And the probability of intervention increases with JPY strength.