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

Wednesday, 29 August 2012

Why more QE isn't going to help

Apart from the obvious answer that accelerating and sustaining the nascent economic recovery requires a combination of fiscal policy and structural reform, the reason to avoid another round of QE is simply that the last two rounds haven’t achieved much. Similar to a boy with a hammer who considers everything a nail; central bankers steeped in monetary dogma consider every policy solution to be monetary. Despite the limitations of monetary policy becoming apparent and the dangers of continuing with the present course of action, Bernanke and company seem undeterred.

The Federal Reserve helpfully explains its policy to dummies on its website: “Low interest rates help households and businesses finance new spending and help support the prices of many other assets, such as stocks and houses.”

Let us begin with looking at the Fed’s generosity in trying to enable new spending. Bernanke and Co. are following the Greenspanian policy of attempting (this qualification is necessary as we shall see later) to artificially lower the cost of capital to engineer a recovery through privatised fiscal stimulus. This is both ironic and amusing. Put plainly, rather than the government spending money to hire people to dig ditches and fill them, the Fed wants private enterprise to borrow money to hire people to dig ditches and fill them. It is fairly obvious why the previous two rounds of QE, followed by Operation Twist (buying long dated bonds and selling short dated ones to lower long-term interest rates) and record low Federal Funds rate have not achieved the much desired outcome of privately funded ditch digging.

Entrepreneurs are not enthused because to two reasons. The first is the economic uncertainty which dampens risk appetite, i.e. animal spirits are missing. The second, related to the first, is the broken transmission between Fed policy rate and the actual interest rates faced by a majority of the borrowers.

If the entrepreneur is uncertain of recouping his investment and making a profit, he is unlikely to invest even if he is able to borrow on very easy terms. This is why some experts advocate a fiscal stimulus. The government is the only economic actor which can invest without regard to profit or loss[1]. For a consumer, borrowing to finance spending is folly in the extreme when his future income stream is uncertain due to job insecurity in a shaky economy. Entrepreneur pessimism and subdued demand feed off each other and form a vicious circle which cheap money cannot break.

Further making monetary policy impotent is the broken transmission between policy interest rates and actual interest rates for borrowers. In an economy with high uncertainty and dominance of risk aversion, banks are unlikely to provide cheap loans to all and sundry. The most creditworthy borrowers will benefit while the least will be locked out of the market, in effect facing infinitely high interest rates. This translates into a small number of large firms and rich individuals benefiting disproportionately while the actual motor of economic growth, the small firm[2], is starved of fuel. The July Fed survey of bank lending practices proves this to be the case. Even though lending standards to businesses eased and loan demand increased, it was mostly due to large and middle-market firms (annual sales of $50m or more). Standards and loan demand by small firms were little changed. In addition, lending standards for prime mortgages (high credit quality) were unchanged but tightened for non-traditional mortgages. Despite easing in lending standards seen in the latest survey, overall lending standards were still tighter than the average since 2005. Therefore, in most cases, the Fed’s attempt to artificially lower the cost of capital has failed.  

The Fed’s failure to promote new spending is benign compared to the more malign effect of distorting the market price of capital. The good doctors of the Federal Reserve, rather than recognising the potentially dangerous side-effects[3] of their medicine, hail them as signs of a cure. Therefore they boldly state their intention to support the prices of “many other assets, such as stocks and houses”.

The economic theory underlying this prescription is the so-called wealth effect. It posits that high asset prices encourage asset owners to spend more by making them feel wealthy. Like most laws of economics, it is not generally applicable but only true within a certain range. In a normal economy where the future seems predictable, higher asset prices do engender consumer confidence. However, confidence and spending are unlikely to be boosted in an era of high uncertainty and where people feel that asset prices are being artificially kept higher. Disconnect between stock prices (blue) and consumer confidence (pink) is plainly evident in the graph below.

Graph 1: Higher stock prices failing to cheer Joe Consumer
Source: FRED, Reuters, Yahoo Finance, Author’s calculations

A rise in asset prices is not a sign of confidence but a sign of currency debasement. As Adam Smith observed, an increase in gold or silver without any increase in the productive capacity of the economy only leads to a decline in the relative price of those metals. US stocks are higher not because investors perceive a rosy future and hence value them more; they are higher because they perceive the dollar as less valuable.

This decline in the US dollar’s value has so far not shown up in consumer price indices because of two reasons. The first is the lack of a viable currency to replace the dollar which prevents foreigners from fleeing it and causing a surge in import prices. The second is due to the way monetary policy works. As noted above, access to cheap money is available to only a few wealthy individuals and large corporations. They only spend a fraction of their income and given the economic uncertainty are loath to make new investments. Therefore by sitting on a large and increasing pile of cash they largely neutralise any attempt by the Fed to increase in the money supply. Rather than make new investments, they buy assets. Graph 2 shows quite plainly that the Fed’s money pumping has not resulted in a proportional increase in broader money supply (M2). The ratio of broad money (M2) to narrow money (M1) is at multi-year lows despite the Fed pumping in more than a trillion dollars. All it has done is cause a dash out of the dollar and into assets such as equity and commodities. Thus ultra loose monetary policy has led to asset inflation rather than the normal kind which people initially predicted.

Graph 2: Pushing on a string
Source: Federal Reserve, Author’s calculations

Such artificial asset price inflation not only has doubtful benefits for the real economy, it also distorts the capital allocation process. A central bank ‘put’ makes speculation in financial assets more attractive compared to new investment. It promotes the rent-seeking financial sector at the expense of the productive sector of the economy. This was one of the factors for the rapid growth of finance in the celebrated ‘Greenspan put’ era. Moreover, if artificially low rates succeed in financing new spending, a large part is likely to be of dubious quality. Projects unviable without central bank largesse will be taken on as low interest rates incorrectly signal their viability. As soon as rates revert to normal, distress is sure to follow. A prolonged period of artificially low rates and easy money can store up problems for later. In some cases it may exacerbate the very problems that policy was meant to solve by causing large scale mal-investment which inhibits long-term growth.

Given the evidence, undertaking another round of QE fits Einstein's definition of insanity. No nation has been able to print its way to prosperity. Indeed, history shows the opposite is true. Declining empires usually accelerate currency debasement and consequently their own decline. In the extreme, the economy collapses due to a loss of confidence in institutions, assets and currency. However, the US is far away from such a scenario. The natural resilience of the US economy means that, however protracted, full recovery will occur. Fortunately, policymakers’ dogmatic behaviour and impatience can only retard progress towards recovery it cannot arrest it. Adam Smith captured it perfectly when he said “the uniform, constant, and uninterrupted effort of every man to better his condition…is frequently powerful enough to maintain the natural progress of things towards improvement, in spite both of the extravagance of government, and of the greatest errors of administration…it frequently restores health and vigour to the constitution, in spite not only of the disease, but the absurd prescriptions of the doctor.” He only missed out one important thing. Despite a natural recovery, credit is always taken by the good doctor and his absurd prescriptions.

[1] This of course has degenerated into the politics of pork, the discussion of which is outside the scope of this article.
[2] Corporatists favouring behemoths should look at the facts: According to the US census (http://www.census.gov/econ/smallbus.html), small firms (revenues less than $50m and less than 500 employees) employed approximately half of private sector employees and comprised 99.7% of all firms.

Thursday, 23 August 2012

The rise (and fall) of the speculator

Belying the recent risk asset exuberance, folks in the market are quite gloomy. Everyone seems to be saying the same thing; ‘It’s a tough market’. High on Draghi one day, despondent the other. In an environment where one man’s soundbite is another man’s profit (or loss), participants are naturally choosing to excuse themselves from the market rather than risk their capital. Trading volume across asset classes is subdued. But is that necessarily a bad thing?

Conventional thinking holds that higher transaction volumes imply greater liquidity1 and depth2. And these are fundamental to a well functioning capital market which efficiently allocates capital in the economy. However, this is missing the wood for the trees. Liquidity and depth are a consequence of well functioning markets not a cause. A large number of transactions do not imply that capital is being efficiently allocated. A reductio ad absurdum argument where the market only consists of Ponzi schemes (the European sovereign debt market for the cynical) shows this assertion to be true. Such a market can show a high volume of transactions as investors flit from one scheme to another in an attempt to gather high returns and exit before the inevitable bankruptcy. But it will be completely inefficient in allocating capital to productive uses.

Although liquidity and depth are beneficial in broadening the set of investors and increasing the capital available to enterprises in the economy, they should not be viewed as goals in themselves. This present undue emphasis on them is because of the rise of the short-term speculator.

Developments over the last three decades have favoured the short-term speculator over the long-term investor. Financial deregulation, improved technology, financial innovation and the exponential rise of specious quantitative financial models have all played a role. To understand how this has happened one needs to distinguish between a speculator and investor and consider their different motives.

Short-term speculators are interested in making a relatively small gain by selling assets at a price which is higher than where they purchased them. The ‘buy low-sell high’ cliché originated from them. Unlike the long-term investor they are only peripherally interested in the long-term value of the asset. Their main aim is to gauge the demand and supply of the asset and accordingly make a trading decision. Therefore they need a liquid and deep market to absorb their continual buying and selling of assets. They can also easily obtain information on demand and supply in such a market. This information is the ‘edge’ which speculators seek. It is expressed through their desire to ‘see the flow’, i.e. know who is buying and selling which assets. The growth in importance of ‘flow trading’ at banks has coincided with the rise of the speculator. No less a person than Fischer Black (of Black-Scholes fame) advocated devoting more resources to flow trading as opposed to proprietary trading while at Goldman Sachs. He viewed the former as having a more sustainable advantage and profit potential.

While speculators cannot survive without the oxygen of liquidity and depth, these characteristics are only marginally useful to the long-term investor. These investors are interested in the enterprise underlying the financial asset. Rather than analyse the number and motives of other market participants they evaluate the productive enterprise to determine their expected return. In contrast to the speculator, they are not looking for liquidity and depth per se; they only wish to be able to enter into positions and sometimes exit them when the value proposition deteriorates or capital is required elsewhere. Warren Buffett with his preference for an infinite holding period typifies such investors.

With these different motives in mind it is easy to see how deregulation and technology have favoured the speculator. As deregulation allowed more institutions and individuals to transact, technology enabled them to do so more frequently and with ease. A click replaced shouting men with flailing arms and real-time risk engines replaced paper and pencil tallying. It also allowed enormous quantities of noise to be delivered straight to trading terminals where speculators, men or machine, could instantaneously react by buying or selling something. Thus deregulation and improvements in technology have delivered the twin benefits of reduced transaction costs with increased number of market participants. For a speculator looking to flip a stock for 5% gain in a month, a 1% transaction cost eats up 20% of the return. In contrast, transaction costs are peripheral for an investor looking for a 5% gain per annum for the next 10 years. A 1% cost will reduce return by less than 2%.

An increase in market participants not only enhances liquidity and depth but it also leads to an increased pool of “greater fools”, at whose expense the speculator can benefit. It is for this reason that Keynes quipped that “It is generally agreed that casinos should, in the public interest, be inaccessible and expensive. And perhaps the same is true of Stock Exchanges.”

However, the biggest benefit of deregulation and technology to the speculator was to cause the rise of quantitative finance. With stock and bond trading becoming accessible and cheap, interest naturally increased even in academia. And the increase in computing power enabled clever models based on unrealistic assumptions to transcend the barrier from academic discourse to practical use. Consequently financial innovation shifted into higher gear and trading models started being employed to exactly quantify risk, discover pricing discrepancies and predict asset prices. Almost all these models were speculative tools in that they sought to analyse asset prices rather than the underlying enterprise which affected the price. Most were successful until the market exposed their shortcomings. However this early success and faith in clever men and mathematics enabled them to gain widespread acceptance. As a result speculators employing such models found people clamouring to fund them and banks eager to provide them leverage.

All these developments not only swelled the ranks of speculators but also created an industry which was focused on the short-term and detrimental to the survival of the long-term investor. It established and encouraged constant benchmarking, portfolio churning and short-term trading. As prices remained disconnected from fundamentals for long periods of time, long-term investors either lost hope or lost financial backing. The shift towards speculation was also reinforced by the human tendency which gives rise to speculation in the first place – preference for short-term rewards over more distant ones. An indicator of this shift is the massive reduction in stock holding periods across US and UK stocks over time (Graph 1 and 2). The decline is especially marked after the advent of deregulation and the rise of quantitative finance which started about 35 years ago.

Graph 1: NYSE average holding period in years
Source: Haldane, Author calculations

Graph 2: FTSE average holding period in years
Source: Haldane, Author's calculations

The decline in holding period has gone hand-in-hand with an increase in traded volume (Graph 3). But the positive impact on liquidity and depth due to speculators has made very little difference on efficiency of capital allocation. In fact, if anything, it has reduced efficiency of capital allocation. The current financial crises starting from the credit crisis in 2007 demonstrate a gigantic misallocation of capital.  

Graph 3: Average annual NYSE volume

Currently short-termism has become so acute that supposedly ‘long-term’ fund managers have an investment horizon of 2-3 months. For an average fund a few months of “poor” performance leads to an exodus of investors. The fear of underperformance has resulted in herding where a majority of speculators follow the same strategy leading to enhanced volatility and meagre returns. And compounding the problem is the market’s brutal exposé of flawed assumptions underlying immaculate mathematics. Add re-regulation of financial markets and the result is a trading environment equivalent to the environment dinosaurs faced after the meteorite impact. Some speculators have been annihilated, others are left dazed, confused and wary of trading. This has led to a drop in liquidity and depth creating a negative spiral as more speculators either exit or pull back from trading. It is too early to write a requiem for speculators but the signs definitely point to the long-term investor staging a comeback.


[1] Liquidity is defined as the ability to buy/sell an asset without affecting the price and where the difference between buying and selling price, at any instant, is minimal. It can be measured by the average amount which can be transacted at the bid and offer price and the absolute difference between the bid and offer price.
[2] Depth is defined as the amount of a particular asset which can be sold without affecting the price too much. It can be measured by the amount of an asset bought/sold which moves the price by not more than a certain, say 1, percent from the price prevailing before the transaction.

Tuesday, 14 August 2012

Standard Chartered Folds

After all that fighting talk, Peter Sands folded. He could have saved all the trouble by looking at how Bob Diamond’s tactics panned out.

The statement from the DFS regarding the settlement underscores how meekly Standard Chartered surrendered after all that bluster about “we strongly reject both the position and the facts”.

First, it agreed that the conduct at issue involved transactions of at least $250bn. So much for the “over 99.9% were valid U-turn transactions” and only $14m were non-compliant.

Second, the DFS statement mentions that Standard Chartered will pay a “civil penalty”. This indicates that it may not be the standard case where banks conveniently neither admit nor deny wrongdoing. The installation of a monitoring team for two years and agreement to create a team to oversee and audit money laundering due-diligence suggests that the 'no admittance, no denial' clause will be absent from the final statement of the settlement. (On a side note, Tea Partiers and Republicans should note the job creation by government regulator Lawsky)

Third, this is a settlement with the DFS only. Federal agencies are free to pursue the matter and reach separate settlements. In fact the FT mentions that the US Treasury, the Department of Justice, the Federal Reserve and the FBI are probing transactions with Iran. Now the big question is whether $340m anchors their settlement expectations upwards (Standard Chartered had offered a paltry $5m to DFS to settle the matter initially). In addition, DFS and Lawsky have emerged as clear winners willing to take on “evil” banks. Does that force the Feds to up the settlement amount in order to not be seen as weak and conciliatory towards banks?

The promise of fireworks may have fizzled out but the case still holds interest.   

Related Posts:

Game over for traders in the new normal world?

An interesting message popped into the In Box. Nothing quite implies that the game is over like recruitment consultants throwing in the towel.

"The Placing Traders web site has been running now for over 4 years and is an established brand which provides an invaluable resource to the industry. However, as the years roll by, the time has come for the owners and directors to retire and they are therefore putting the site up for sale.

PS: Yes, hypothesis cannot be constructed on a single datum and other caveats about incorrect inference, rise of technology, etc. But I find it interesting in light of the jobs bloodbath, recruitment freezes and impending regulatory assault on the industry.  

Thursday, 9 August 2012

Standard Chartered Doth Protest Too Much

Livening up the summer and continuing with the Bob Diamond approach, Standard Chartered has threatened to unleash hell on the “*******Americans”. Or one of their small, overzealous non-captured regulators to be precise.

In an interview to the FT, Peter Sands, CEO said that “…we were very surprised by the announcement…and we strongly reject both the position and the facts, the portrayal of the facts by the DFS. We differ on a range of matters of substance, fact and argument.” The surprise is fairly evident. However one eagerly awaits the rejection of facts and their portrayal. Specifically, the rebuttal of the following points from the DFS order which would showcase the Olympian legal and public relations skill possessed by the bank.

Paragraph 20 of the order: 
As early as 1995, soon after President Clinton issued two Executive Orders announcing U.S. economic sanctions against Iran, SCB’s General Counsel embraced a framework for regulatory evasion. He strategized with SCB’s regulatory compliance staff by advising that “if  SCB London were to ignore OFACs regulations AND SCB NY were not involved in any way & (2) had no knowledge of SCB Londons [sic] activities & (3) could not be said to be in a position to control SCB London, then IF OFAC discovered SCBLondons [sic] breach, there is nothing they could do against SCB London, or more importantly against SCBNY.”  He also instructed that a memorandum containing this plan was “highly confidential & MUST NOT be sent to the US.”

This is apparently a direct quote from an email which goes on to say:
“when dealing with OFAC countries that are not on the UK’s list SCB London should use another US Dollar clearer in NY. It should not in any event use SCB NY.” 
“SCB should use eg [National Westminister Bank] who in processing the transactions would breach OFAC regulations & would expose themselves to a penalty.”

The facts are pretty well established. Maybe the fault is with their portrayal. DFS might have omitted the last line which stated “Just joking of course. This is what some evil bank would do but not us because we believe it is not just about what we do, but how we do it. (Great line, we should make it official).”

Paragraph 24 of the order: 
In March 2001, SCB’s Group Legal Advisor counseled several of SCB’s officers that, “our payment instructions [for Iranian Clients] should not identify the client or the purpose of the payment.”

Again the facts seem irrefutable. Maybe the portrayal is again unfair and Standard Chartered is a victim of being selectively quoted. Maybe the Group Legal Advisor went on to state that “However we need to ascertain that the payment instructions are authorised and compliant with both the spirit and letter of the law because as you know we believe it is not just about what we do, but how we do it”.

Paragraph 45 of the order: 
Having improperly gleaned insights into the regulators’ concerns and strategies for investigating U-Turn-related misconduct, SCB asked D&T to delete from its draft “independent” report any reference to certain types of payments that could ultimately reveal SCB’s Iranian U-Turn practices. In an email discussing D&T’s draft, a D&T partner admitted that “we agreed” to SCB’s request because “this is too much and too politically sensitive for both SCB and Deloitte.  That is why I drafted the watered-down version.”

Memo from the ‘powers that be’ to all staff: Henceforth, email communication is banned. All messages will be sent on self-destructing papyrus. This message will self-destruct in 5 seconds.
Maybe DFS has the facts but is selectively displaying them. Maybe the “watering down” was in the national interest in conformance with the Patriot Act and others. The non-watered down version would have been damaging to the USA not to Standard Chartered as DFS seems to be unjustly implying.

Paragraph 48 of the order: 
In September 2006, New York regulators requested from SCB statistics on Iranian U-Turns, including the number and dollar volume of such transactions for a 12 month period. In response, SCB searched its records for 2005 and 2006, and uncovered 2,626 transactions totaling over $16 billion. SCB’s Head of Compliance at the New York branch provided the data to SCB’s CEO for the Americas, who in turn, sent it to the SCB Group Executive Director in LondonIn his memorandum to the Executive Director, the CEO expressed concern that this data would be the “wildcard entrant” in the ongoing review of U-Turns by regulators and could lead to “catastrophic reputational damage to the [bank].” Based on direction from “the powers that be,” SCB’s Head of Compliance in New York provided only four days of U-Turn data to regulators.

This seems to be based on employee interviews by the authorities. Standard procedure of refuting the facts and discrediting the employee can be followed. The memorandum is trickier to deny. Maybe the portrayal is unjust. The response to the memorandum which has not been revealed could have been “You are right. We must correct all failings at once and inform the regulators immediately because as you know we believe it is not just about what we do, but how we do it.

Even though Standard Chartered have responded by swinging their fists wildly and loudly proclaiming their innocence, their defence seems to rest on legal technicalities than proof of appropriate behaviour. Moreover with their own staff warning about reputational damage if their actions regarding Iranian counterparties came to light countersuing when the actions have actually come to light requires some chutzpah. And a disregard for shareholder’s money. 

This required a strategy of ‘Ok, you scored your political points now can we talk settlement away from the spotlight’ rather than the currently employed ‘FU. We’re Standard Chartered. How dare you?’ strategy.

But the spectators are not complaining. As the Olympics are about to come to a close, it promises to provide a much needed distraction from the predictably boring Eurocrisis.

Tuesday, 7 August 2012

Stunned Chartered Employs Bob Diamond's Tactics

The sands seem to have run out for Peter as New York Department of Financial Services (DFS) brings an end to the schadenfreude reflected in the half-yearly results. The statements of Sir John Peace, the Chairman and Peter Sands, the CEO of Standard Chartered were distinctly smug when released 6 days ago.

Sir John Peace: “In recent weeks, issues have surfaced around governance and behaviour in banking. At Standard Chartered, we believe it is not just about what we do, but how we do it. Our culture and values continue to be a source of strength and a competitive advantage. Strong corporate governance and an obsession with the basics of banking remain key areas of focus for our Board.”

Peter Sands: “Amidst all the turbulence in the global economy and the apparently never-ending turmoil in the world of banking, we remain consistent in delivering strong performance…These results are not a bounce-back, nor flattered by big one-off items. They are just our tenth consecutive first half of record profits.”

Now of course they stand accused of being a “rogue institution”. Forget the possibility that the DFS is trying to gain some political mileage and some credibility having started official functions only towards the end of last year (3rd October 2011). What is interesting is the Standard Chartered response. Instead of HSBC’s mea culpa strategy, they’ve gone for the Bob Diamond approach. For a bank which “see[s] some virtue in being boring” and having maintained a low profile so far, this is uncharacteristically bold. And exciting.

In October 2006, the CEO for Americas sent a message to the Group Executive Director stating the Iranian business needed urgent reviewing at the Group level. The boring banker replied with humility ''Who are you to tell us, the rest of the world, that we're not going to deal with Iranians."

Let’s review Strategy 101:
Currency of international trade and investment: US Dollar (mainly).
Your main business: Financing international trade and investment.
Nation in control of the US Dollar and thereby your business: USA.
Therefore what you should not do: P*ss off Uncle Sam.
What you actually do: P*ss off Uncle Sam.
Job well done Group Executive Director.

The allegations combined with the incendiary language of the DFS statement seem shocking and on the sensational side. But in cases such as these and especially in times such as these where every bank is guilty even when proven innocent, one does not adopt the Bob ‘all guns blazing’ Diamond approach. However, it seems that inside every boring banker is a repressed cage fighter waiting to get out. Standard Chartered have counterattacked.

Unfortunately their tactics are as strong as the tactics employed by Napoleon in 1815. Their first mistake was stating that transgressions were “small clerical errors”. “Clerical errors” might have been sufficient and would have enabled them to put the matter to rest by finding some scapegoats and sacrificing them. Qualifying it with “small” is needless and dangerous. If it turns out that the sum involved runs into billions ($250bn is alleged by DFS, $14m claimed by Standard Chartered) then the “small” is going to come and haunt them.

Their second and big mistake is to lobby the City to fight a hitherto obscure US department and make it into Britain vs US fight. It risks drawing the main US regulatory forces into battle. According to the FT article, a ‘City figure’ said “This is an attack…If we don’t stand up to it, it could be catastrophic for London’s financial standing…Political intervention may be needed over this.” In case this ‘City figure’ has just come back from a mission to the Antarctic, banks are not very popular at the moment. And consequently politicians do not want to intervene on their behalf. It would be a “courageous decision” in the words of Sir Humphery Appleby. Raising the stakes in this manner achieves nothing and is likely to backfire. The City cannot win a battle with the US. Simple game theory shows that any threat is not credible. Revoking Standard Chartered’s (and even HSBC’s) banking license makes little difference to the US economy. In contrast, retaliation by London through banning JP Morgan or Bank of America would be suicide. Therefore the prudent course would have been to make ‘City figures’ laud the bank’s “boring” culture and trust its innocence and use diplomatic channels to defuse the situation.

Their third mistake is to make intemperate remarks to the press. According to the FT an executive described the DFS report as “a John Grisham novel”. This is not only intemperate but poorly thought strategy. It achieves nothing but antagonises the opponent making it that much harder to settle.

Looking at these shambolic tactics, two questions arise. The first question is why if the facts are so much in Standard Chartered’s favour (as it argues) does it need to escalate it to the level of the City and the government? After all, whatever the popular opinion in the US and whatever the incentives of regulators, the rule of law still applies. If they can prove their innocence, the DFS can do nothing.

This leads to the second question of whether they are being disingenuous or are they so poorly advised and led?

Maybe this response is a rush of blood. The boring banker finally making a stand and showing the world. Much like Lloyds’ purchase of HBOS.

Saturday, 4 August 2012

ECB Declares Silly Season Open

The silly season is clearly upon us. It is the best explanation for Friday’s rally. Just like medieval priests interpreting holy texts to accord with their own worldview, the market has found a more appealing and convenient interpretation on re-reading Draghi’s remarks. Therefore equivocation is yet again greeted by jubilation. The plot is becoming tired having been repeated since the beginning of 2010: 
1. Panic as inevitable collapse looms; 
2. A few off-the-cuff remarks to instill hope; 
3. Panic abates, hope rises; 
4. Some summit/meeting/press-conference occurs; 
5. An equivocal and ambiguous statement of “solidarity”, “policy makers realise concerns”, “new and improved bazooka”; 
6. Sharp rally as fools rush in.

There is not much on offer looking at Draghi’s statement. Ignoring the “Euro is irreversible” rhetoric which is meant to calm the masses (“Peace for our time” anyone?) the critical two paragraphs which the high priests of optimism have interpreted to hail Draghi as the saviour are as below: [emphasis mine]

“The adherence of governments to their commitments and the fulfillment by the EFSF/ESM of their role are necessary conditions - not sufficient, necessary conditions. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective.

In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.”

Once again the market assumes that the statement “We may do something” is equivalent to the statement “We will do something”. It further assumes that “concerns about seniority will be addressed” means “We will consider ourselves pari-passu with other private holders”. The latter is a reasonable assumption considering that not even the ECB is that stupid to declare itself a senior creditor. However, someone (read governments) will have to underwrite all that credit risk unless ECB feels brave enough to operate on negative capital. Now the governments which have the ability to underwrite the credit risk are also the ones unwilling to underwrite it. Of course, Italy and Spain can once again guarantee SMP purchases like they have guaranteed EFSF and ESM but only a lobotomised optimist would find it credible.

And yet again the promise of future action, “over the coming weeks…” seems to have lulled the optimists into somnambulistic buying. What has been ignored is Draghi's emphasis on official request for aid and the conditionalities that go along with it before any action by the ECB (which may or may not happen). The relevant paragraphs are below [emphasis mine]:

“In order to create the fundamental conditions for such risk premia to disappear, policy-makers in the euro area need to push ahead with fiscal consolidation, structural reform and European institution-building with great determination.

As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist - with strict and effective conditionality in line with the established guidelines.”

This is a nice back-heel pass to the Eurozone governments. FT reports that Spain wants aid but in typical fashion without many (any?) conditions. The chances of that are slim unless Rajoy again manages to ambush Merkel at the next summit (which by the way is going to decisively solve all problems).

The importance of ECB awaiting government measures is being ignored. The high-priests of optimism have interpreted “must stand ready to activate EFSF/ESM in the bond market” as “will activate EFSF/ESM in the bond market”.

Leave aside the fact that EFSF/ESM do not have sufficient firepower to stop a Spanish/Italian meltdown unless ECB monetises copiously. The bigger immediate problem is that Draghi has clearly isolated the Bundesbank with his “The voting was…basically unanimous with one – with one reservation” (Orwell would have loved this – ‘unanimous with one reservation’). In the question and answer session he dismissed Weidmann’s concerns “…the endorsement to do whatever it takes to preserve the euro as a stable currency has been unanimous. But it’s clear and it’s known that Mr. Weidmann and the Bundesbank…we should never forget that they have their reservations about programs that you see buying bonds”.

He seems to suggest that the Bundesbank is going to be voted down and its sound money policies are going to be replaced by policies undertaken by the French and Italian central banks in the 70s and 80s. If this is the case then the Germans are going to be even harsher in setting aid terms. That is assuming they countenance the impertinence of relegating their beloved BuBa to the fringes of monetary policymaking. In the words of Weidmann “We are the largest and most important central bank in the Eurosystem and we have a greater say than many other central banks in the Eurosystem.” 

Riding roughshod over Weidmann's objectives may not only have repercussions on German policy on Eurozone bailouts but may also lead to his resignation. To have lost two German representatives from the Board may be carelessness but to lose three will be a calamity. The credibility of the Euro and its current strength derive from the assumption that the Bundesbank is firmly in charge. But if this is not the case then the Euro should make the transition from trading like, an albeit weakened, Deutsche Mark to the Italian Lira. The market is practicing doublethink when it pushes the Euro up on news of potential monetisation. 

Thursday, 2 August 2012

Super Mario - What's he going to do?

The plumbing is broken.
Were his words only a token?

But the market has eaten the mushroom
And cast aside fears of doom

Elevated itself on cloud nine
Gathering coins since it's all fine

A leap into the unknown
May answer the Mediterranean's moan

But will he raise the flag?

Or will his intentions perish under attack?

Stay tuned for the answer and keep playing (or is it praying).

Post Script:

In the Olympic spirit, it matters not if one wins or loses
Because in the end, its the Bundesbank which choses

Wednesday, 1 August 2012

Red Flags Over China

Since doubts surround Chinese economic data, one way to infer the health of the Asian dragon is to look at the impact on its neighbours. This does not provide a very comforting picture of the Chinese economy. Growth across the region is spluttering even as hopes of a gigantic Chinese stimulus remain undimmed.

Naturally part of the slowdown is due to a lacklustre US recovery and the slow-motion implosion of the EU. However, China plays an exceedingly large and important commercial role in the region. It has supplanted USA as the primary export destination for Japan, South Korea and Taiwan, three of the four largest economies in East Asia. A very simplistic model of the global goods supply chain is illustrated below.

As developed world demand fails to regain the growth rates prevailing before the 2007 credit crisis, it impacts demand all through the chain. Moreover, even as demand remains anaemic, continued investment in productive capacity has taken place, especially in China. This necessitates robust consumer demand to achieve profitability. 

Unfortunately, this demand is unlikely to come any time soon from China or the rest of the developing world. They simply do not have the purchasing power that the developed world imagined it had during the credit boom. Hopes pinned on Chinese domestic demand are likely to be disappointed. All such talk about Chinese rebalancing and promotion of domestic consumption is mere rhetoric. In China, a tiny minority has captured a giant’s share of the wealth generated over the past decade. This is evident from the refusal of Chinese authorities to release the Gini Coefficient (a measure of economic inequality) for the last 11 years. Such lopsided distribution of rewards from growth ensures that domestic consumption cannot supplant export demand any time soon. 

Thus as export demand cools, the Chinese economy must either embark on a fresh investment stimulus and create an even more imbalanced economy or reduce imports used in manufacturing export goods. The former has not been forthcoming in any appreciable magnitude so far despite hopium-based belief. The latter implies a lower rate of growth not just for China but its suppliers. It also implies lower commodity prices and deterioration of the manufacturing sector. Recent data from economies of Asian neighbours, heavily dependent on the continued march of the Chinese juggernaut, does provide evidence of this slowdown. Table 1 below, shows the recent economic deterioration in the context of the nation’s dependence on China as an export market.

Table 1: Economic deterioration in economies linked to China
Chinese dependence
· Manufacturing PMIs signalling contraction and “Firms signalled that demand from US, European and Chinese markets weakened.” [Emphasis mine]
Exports to China: 27% of total exports; 41% including HK; approx. 30% of GDP
South Korea
·   Q2 GDP grew 2.4% annualised (a two-year low)
· Manufacturing PMIs signalling contraction and “New orders declined at the fastest pace since December 2011. Moreover, new export business decreased for the second successive month amid reports of a downturn in the international economic climate.” [Emphasis mine]
Exports to China: 28% of total exports (Biggest export partner)
· Manufacturing PMIs signalling contraction and “Japanese manufacturing production declined for a second successive month in July, and at an accelerated rate. The overall reduction in factory output reflected lower levels of incoming new business, according to survey respondents. The pace of reduction in new work was solid, and the steepest since April 2011. New export orders also decreased in July, for the fourth month running, with the rate of reduction the fastest in 15 months. Companies mentioned demand weakness in China, Europe and the United States.” [Emphasis mine]
Exports to China: 19% of total exports (Biggest export partner)
·   Q2 GDP fell 1.1% annualised

The PMI charts are given below.

Graph 1: Taiwan
Source: HSBC, Markit

Graph 2: South Korea
Source: HSBC, Markit

Graph 3: Japan
Source: Cabinet Office, Markit, JMMA

Looking at commodity prices, these also seem to indicate that the great Chinese resource grab is coming to an end. Both copper and oil show a declining trend (Graphs 4 & 5) while coal and iron-ore have plunged to 2½ year lows. 

Graph 4: Brent crude
Source: FT

Graph 5: Copper
Source: FT

Whether a Chinese slowdown turns into a meltdown is open to question. However, it is likely to persist before any recovery occurs. The sharp turnaround in 2009 was because of the combined bank bailout and monetary easing in the US and Europe along with Chinese stimulus. At this juncture if China acts (a big if) then it is likely to be alone and thus the impact will consequently be more muted. This implies further falls in commodities notably copper of which the Chinese have built a gargantuan inventory and which has not fallen in line with the bleak demand picture. 

It also implies a shock to the Australian commodity boom. China is the largest export partner for Australia accounting for 25% of total exports. As an example of Australia’s commodity dependence, 41% of the world’s iron-ore exports are from Australia and it is also home to 57% of the new production coming online. Interestingly new investment has been made assuming a worst-case price of $110 per tonne which is in danger of being breached. A shock to the Aussie economy and consequent RBA cuts are likely to lead to a fall in the Aussie Dollar (AUD). At the moment it is riding high due to the twin advantages of higher yield and perceived safety from the debt detonation of the Eurozone and currency debasement of Ben Bernanke. As yield differentials vanish and safety proves illusory, flows could reverse leading to a sharp drop.

On a micro level, mining and commodity stocks (Rio, BHP) might take a further hit. In addition banks exposed to Asia (HSBC, StanC) might see the souring economy feeding into their balance sheets as the stellar performance of Asian units reverts to mean.  

As the Eurozone differs and dithers into oblivion, China is likely to be the unwitting recipient of the power to dictate global markets and policymakers. Ironic.

Disclaimer: All ideas elucidated above should not be taken as investment recommendations. The reader should perform his/her own analysis before making any investments.