From the Financial Times this morning:
Turkey rate cut surprises markets
By Delphine Strauss in Ankara
Published: February 19 2009 23:37 | Last updated: February 19 2009 23:37
Turkey’s central bank cut its main borrowing rate by 150 basis points on Thursday evening, a much bigger step than markets had expected at a time when eastern European neighbours are considering raising rates to shore up their currencies.
Policymakers have now slashed Turkey’s benchmark borrowing rate by 525 basis points since November. The latest move takes it to a record low of 11.5 per cent. They also cut the lending rate on Thursday from 15.5 per cent to 14 per cent.
Analysts described the decision as “bold”, given the pressure on emerging currencies and Turkey’s delay in reaching an agreement with the International Monetary Fund that would boost investors’ confidence.
“This is a risky move, especially if one takes into consideration the risk of a contagion from the weakness of [central European] currencies. In this environment, the need for an IMF programme is even higher,” said Yarkin Cebeci, economist at JPMorgan.
The lira slid around 25 per cent against the dollar in 2008, mostly in the final months of the year, but has been relatively stable since the start of 2009, reflecting investors’ perception that Turkey is holding out relatively well in a troubled neighbourhood.
The central bank did not rule out further rate cuts, saying it thought inflation likely to “significantly undershoot target” at the end of the year. It said it would also take new measures to boost foreign exchange liquidity.
Policymakers were responding to growing signs of distress in Turkey’s economy, which most analysts expect will contract or at best stall in the year ahead. Recent figures show employment has hit a four-year high of 12.3 per cent , while industrial production has plunged with car manufacturers’ exports down as much as 60 per cent.
“We think that the policy rate should be lowered as much as possible this year,” said Tevfik Aksoy, economist at Morgan Stanley, arguing it would be the best chance to bring interest rates that have lingered in double digits to manageable levels in the longer term. But Turkey would also need to finalise an IMF deal and tighten fiscal policy immediately after local elections in March, he added.
Analysts at Unicredit said Turkey was among countries “in distinctly better positions” than many others in the region, adding that because domestic consumption was a big driver of growth, any scope for policy stimulus would be “especially precious”.
Thursday, February 19, 2009
US Debt On The Rise
From the Financial Times
Summit to tackle ballooning US deficit
By Edward Luce in Washington
Published: February 19 2009 19:56 | Last updated: February 19 2009 19:56
The Congressional Budget Office shocked global markets a month ago, when it estimated that America’s budget deficit would hit almost $1,200bn this year – a number that would shatter all postwar records. Four weeks later, the CBO’s projections look positively rosy.
Capitol Hill has since passed a $787bn (€620bn, £550bn) two-year fiscal stimulus. Barack Obama, US president, has announced $75bn in new spending to provide relief to struggling mortgage holders and an additional $200bn in contingent liabilities for the housing market via Fannie Mae and Freddie Mac, the state-owned mortgage providers.
Finally, Chrysler and GM have asked for another $21.6bn in state aid – barely a drop in the sea of red ink now enveloping Washington. This is without anticipating Treasury’s request for hundreds of billions to recapitalise the financial sector.
Mr Obama will host a bipartisan summit on fiscal discipline next Monday that will aim to address America’s long-term struggle to control entitlement costs in healthcare and social security. For most economists, it cannot come a moment too soon. “We are now looking at fiscal deficits of over a trillion [a million million] dollars every year for the next decade,” says William Gale of the Brookings Institution. “And that is without adding all the trillions of dollars in contingent liabilities of the Federal Reserve and the Treasury, which show up nowhere in the budget or national debt numbers.”
Under the CBO’s projections, America’s budget deficit will start to decline in 2010 and gradually reduce to 1.1 per cent of gross domestic product by 2019 – down from almost 9 per cent in 2009. But the CBO’s assumptions, which it is required by law to follow, are widely dismissed as fantasy.
For example, the CBO assumes that all of George W. Bush’s tax cuts will expire in 2010, even though Mr Obama has promised to retain them for all but the wealthiest Americans. It also assumes that the notorious Alternative Minimum Tax, which is postponed annually by Congress, will take effect. And it assumes no increases in discretionary spending.
Most economists, citing Milton Friedman’s dictum that there is “nothing so permanent as a temporary government programme”, assume that many items in the fiscal stimulus will be retained after two years have elapsed. Mr Obama has also said he will deliver on his promise for an expansion of healthcare coverage that could add up to $1,600bn in spending over the next decade, according to the Tax Policy Center think-tank.
Nor do the markets appear to believe the CBO’s forecasts. With an eye perhaps on the dramatic expansion of the Fed’s balance sheet, which has taken on more than $1,000bn dollars in new guarantees and loans in the past year, the bond markets are starting to price in an unthinkable possibility of US government default.
The implied risk of US government default in the market for credit default swaps has risen from 1 per cent to 6 per cent last September. Alan Greenspan, former chairman of the Federal Reserve, on Tuesday picked up on the recent steepening of the US Treasury yield curve to warn that it might lead to inflation.
“There is obviously a limit to the expansion of federal debt,” he said in a speech in New York. “The recent rise of long-term interest rates may be signalling market concerns about inflationary pressures.” On the outlook for spending cuts, Mr Greenspan added: “It would be foolish to disregard how American politics will shape the fiscal and monetary resolution of our current crisis.”
Maya MacGuineas, who heads the committee for a responsible federal budget, says Monday’s White House summit needs to set a credible agenda to begin a bipartisan effort to tackle America’s debt. Between October last year and October 2010, it is expected to have risen 43 per cent – or $2,500bn. That is without including any of the new commitments from the Fed and Treasury. Nor does it include the $1,500bn in debt held by Fannie and Freddie.
“We can safely say that our current system of public accounting is way out of date and that it seriously understates both the budgetary and debt implications of all these liabilities,’ says Ms MacGuineas. “It is 40 years old. We live in very different times now.”
Summit to tackle ballooning US deficit
By Edward Luce in Washington
Published: February 19 2009 19:56 | Last updated: February 19 2009 19:56
The Congressional Budget Office shocked global markets a month ago, when it estimated that America’s budget deficit would hit almost $1,200bn this year – a number that would shatter all postwar records. Four weeks later, the CBO’s projections look positively rosy.
Capitol Hill has since passed a $787bn (€620bn, £550bn) two-year fiscal stimulus. Barack Obama, US president, has announced $75bn in new spending to provide relief to struggling mortgage holders and an additional $200bn in contingent liabilities for the housing market via Fannie Mae and Freddie Mac, the state-owned mortgage providers.
Finally, Chrysler and GM have asked for another $21.6bn in state aid – barely a drop in the sea of red ink now enveloping Washington. This is without anticipating Treasury’s request for hundreds of billions to recapitalise the financial sector.
Mr Obama will host a bipartisan summit on fiscal discipline next Monday that will aim to address America’s long-term struggle to control entitlement costs in healthcare and social security. For most economists, it cannot come a moment too soon. “We are now looking at fiscal deficits of over a trillion [a million million] dollars every year for the next decade,” says William Gale of the Brookings Institution. “And that is without adding all the trillions of dollars in contingent liabilities of the Federal Reserve and the Treasury, which show up nowhere in the budget or national debt numbers.”
Under the CBO’s projections, America’s budget deficit will start to decline in 2010 and gradually reduce to 1.1 per cent of gross domestic product by 2019 – down from almost 9 per cent in 2009. But the CBO’s assumptions, which it is required by law to follow, are widely dismissed as fantasy.
For example, the CBO assumes that all of George W. Bush’s tax cuts will expire in 2010, even though Mr Obama has promised to retain them for all but the wealthiest Americans. It also assumes that the notorious Alternative Minimum Tax, which is postponed annually by Congress, will take effect. And it assumes no increases in discretionary spending.
Most economists, citing Milton Friedman’s dictum that there is “nothing so permanent as a temporary government programme”, assume that many items in the fiscal stimulus will be retained after two years have elapsed. Mr Obama has also said he will deliver on his promise for an expansion of healthcare coverage that could add up to $1,600bn in spending over the next decade, according to the Tax Policy Center think-tank.
Nor do the markets appear to believe the CBO’s forecasts. With an eye perhaps on the dramatic expansion of the Fed’s balance sheet, which has taken on more than $1,000bn dollars in new guarantees and loans in the past year, the bond markets are starting to price in an unthinkable possibility of US government default.
The implied risk of US government default in the market for credit default swaps has risen from 1 per cent to 6 per cent last September. Alan Greenspan, former chairman of the Federal Reserve, on Tuesday picked up on the recent steepening of the US Treasury yield curve to warn that it might lead to inflation.
“There is obviously a limit to the expansion of federal debt,” he said in a speech in New York. “The recent rise of long-term interest rates may be signalling market concerns about inflationary pressures.” On the outlook for spending cuts, Mr Greenspan added: “It would be foolish to disregard how American politics will shape the fiscal and monetary resolution of our current crisis.”
Maya MacGuineas, who heads the committee for a responsible federal budget, says Monday’s White House summit needs to set a credible agenda to begin a bipartisan effort to tackle America’s debt. Between October last year and October 2010, it is expected to have risen 43 per cent – or $2,500bn. That is without including any of the new commitments from the Fed and Treasury. Nor does it include the $1,500bn in debt held by Fannie and Freddie.
“We can safely say that our current system of public accounting is way out of date and that it seriously understates both the budgetary and debt implications of all these liabilities,’ says Ms MacGuineas. “It is 40 years old. We live in very different times now.”
Wednesday, February 18, 2009
Let The East Into The Eurozone Now!
“It’s 20 years after Europe was united in 1989 – what a tragedy if you allow Europe to split again.”
Robert Zoellick, World Bank president, in an interview with the Financial Times
World Bank president, Robert Zoellick, made a call this week - in an interview with the Financial Times - for a European Union-led and co-ordinated global support programme for the economies of Central and Eastern Europe. I agree wholeheartedly, and even if I have, reluctantly, to accept the point made yesterday by our Economy & Finance Commissioner Joaquin Almunia that our pockets, though deep, are certainly not bottomless (and it may thus beyond our means right now to rescue the non EU Eastern states), I still feel we should make good on our responsibilities to those CEE states who are EU members and open the doors of the Eurozone to those member states who want to join. There would have to be a new set of criteria, of course, but ones which offer the certainty of entry as being guaranteed forthwith, for those who chose to accept. Rules were made to be broken, and nothing should be so inflexible - not even the Maastricht eurozone membership criteria - that it cannot be ammended as circumstances dictate. And at this point even the undertaking that this - like the long awaited US Stimulus programme - was on the table, would be sufficient to provide immediate, and much needed relief. Flirting with doing nothing here is, in my opinion, flirting with disaster, both in the East and in the West.
Existing Maastricht Criteria
Convergence criteria (also known as the Maastricht criteria) are the criteria for European Union member states to enter the third stage of European Economic and Monetary Union (EMU) and adopt the euro. The four main criteria are based on Article 121(1) of the European Community Treaty. Those member countries who are to adopt the euro need to meet certain criteria.
1. Inflation rate: No more than 1.5 percentage points higher than the three lowest inflation member states of the EU.
2. Government finance:
Annual government deficit: The ratio of the annual government deficit to gross domestic product (GDP) must not exceed 3% at the end of the preceding fiscal year. If not, it is at least required to reach a level close to 3%. Only exceptional and temporary excesses would be granted for exceptional cases.
Government debt: The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year. Even if the target cannot be achieved due to the specific conditions, the ratio must have sufficiently diminished and must be approaching the reference value at a satisfactory pace.
3. Exchange rate: Applicant countries should have joined the exchange-rate mechanism (ERM II) under the European Monetary System (EMS) for 2 consecutive years and should not have devaluated its currency during the period.
4. Long-term interest rates: The nominal long-term interest rate must not be more than two percentage points higher than in the three lowest inflation member states.
The Dimensions Of The Problem
European governments, the European Union and international financial organizations need to act fast on risks stemming form banks’ exposure in the eastern part of the continent to avert an escalation of the credit crisis, Nomura Holdings Inc. said. East European countries are struggling to refinance foreign- currency loans taken out by borrowers during years of prosperity through 2007, when economic growth averaged at more than 5 percent. The International Monetary Fund, which has bailed out Latvia, Hungary, Serbia, Ukraine and Belarus, warned on Jan. 28 that bank losses may widen as “shocks are transmitted between mature and emerging market banking systems.” “Swift action is needed to restore confidence and prevent trouble” to financial and economic stability in the euro region and emerging Europe, said Peter Attard Montalto, an emerging markets economist at Nomura International in London. “Any move should be quick. The situation has begun to decline more rapidly since the end of last year and there is risk that any action may come too late.”
Bloomberg
Zoellick is far from being a lone voice in the wilderness here, and indeed precisely those EU banks who have been most active in emerging Europe are now busily trying to convince EU regulators, the European Central Bank and Brussels itself to coordinate measures to counter the impact of the financial crisis which confronts the region. The problem in the East now adds a new dimesion to our problems, since West European governments are now being simultaneously hit on a number of fronts, and the situation is complicating by the day.
In the first place most West European economies are now either in or near recession, and the domestic banking systems are, to either a greater or lesser extent, struggling. They are thus, by and large, already feeling stress on their own sovereign borrowing capacities. But, with greater or lesser effectiveness the countries are still able to increase their debt, even if sometimes the surge in borrowing is very dramatic, as in the case of Ireland, which will see debt/GDP shooting up from 24.8% in 2007 to a projected 68.2% in 2010 (EU January 2009 Forecast).
The situation in Eastern Europe is very different, and their economies evidently can't support such dramatic increases in their debt levels. Thus, in the case of those countries with a significant home banking presence, like Latvia's Parex, or Hungary's OTP, the support of external organisations (the IMF, the World Bank, the EU) becomes necessary when the bank starts to have liquidity problems. But as a result of the consequent bailout the debt to GDP ratio starts to rise in a way which then places even subsequent eurozone membership in jeopardy. Latvia's Debt/GDP is, for example set to rise from around 12% of GDP in 2007 to over 55% in 2010.
But the other half of this particular coin turns up in the case of the West European banks who have subsidiaries in CEE countries, and who find themsleves faced not with bailouts, but with rising default rates. This difficulty then inevitably works its way back to the parent bank, and the home state national debt, as the bank almost inevitably needs to seek support from a West European government. Austria is a good case in point here, and Finance Minister Josef Proell recently indicated that the country had some 230 billion euros outstanding in Eastern Europe. equivalent to around 70 percent of Austria's GDP. The Austrian daily "Der Standard" recently reported an analyst view that a failure rate of 10 percent in Eastern Europe's debt repayments could lead to serious difficulties for the country's financial sector. The European Bank for Reconstruction and Development (EBRD) has estimated Eastern Europe's bad debts could go over 10 percent and could even reach 20 percent in the course of the current crisis. Underlining the mounting concern in Austria, Proell tried last week to convince EU finance ministers to provide 150 billion euros is support to CEE economies in an attempt to contain the growing wave of defaults.
Austria is a good case in point, and Finance Minister Josef Proell recently estimated that Austrian exposure to Eastern Europe was in the order of 230 billion euros or some 70 percent of Austria's GDP. The Austrian daily "Der Standard" cited an estimate that a 10 percent default rate in Eastern Europe's debt repayments would present very serious problems for the country's financial sector, while the European Bank for Reconstruction and Development (EBRD) has estimated that bad debts in Eastern Europe will very probably rise above the 10 percent level during the current crisis, and might even reach 20 percent. Underlining the mounting concern in Austria, Proell tried last week unsuccessfully to convince EU finance ministers to provide 150 billion euros in support to the CEE countries in an attempt to halt the growing wave of defaults.
The total quantity of debt outstanding is hard to put a precise number on, but the Bank for International Settlements estmated that, as of last September, more than $1.25 trillion had been leant by eurozone banks, and if you add in U.K., Swedish and Swiss banks’ liabilities the number rises to $1.45 trillion.
Western Europeean banks have a very important market share in the East, ranging from a low of 65 percent in Poland to almost 100 percent in the Czech Republic. This basically means two things, that the region's businesses and consumers are extraordinarily dependent on uninterrupted capital inflows from the West, and that some West European banking systems are extremely sensitive to rising default rates in the East. Of course the problem goes beyond the EU's borders, and while EU bank market shares in the Community of Independent States is rather less significant than in the EU12, due to the still substantial domestic ownership, exposure to defaults is not unimportant, especially in Ukraine, Kazakhstan and, of course, in Russia itself. Further, there is South East Europe to think about, and countries like Serbia and Croatia.
Large Banks Take The Initiative
Getting near to desperation, some of the largest banks involved - Italy's UniCredit and Banca Intesa, Austria's Raiffeisen International and Erste Group Bank, France's Societe Generale and Belgium's KBC - have launched a common initiative to try to lobby for an EU wide solution to the problem.
UniCredit is the largest lender in Poland and Bulgaria, while Erste is number one in Romania, Slovakia and the Czech Republic, with KBC occupying the position in Hungary, Intesa in Serbia, and Raiffeisen in Russia and Ukraine. Hungary's OTP Bank, emerging Europe's number 5 lender and the largest one in its home country, does not formally belong to the group. On the other hand OTP is actively looking for support.
OTP Bank Nyrt., Hungary’s biggest bank, said it’s in talks over a “role” for the European Bank for Reconstruction and Development, as it announced a 97 percent drop in fourth-quarter profit and “substantial” job cuts. As well as a possible EBRD involvement, OTP may also seek funds from Hungary’s emergency loan package from the International Monetary Fund, the European Union and the World Bank to “better serve the economy,” Chairman and Chief Executive Officer Sandor Csanyi said at a press conference in Budapest today. “There’s a chance the EBRD will assume a role in OTP, but I must stress that we plan no issue of new shares,” he said. OTP “doesn’t need to be saved,” Csanyi added.Chancellor Angela Merkel, while expressing support for the bank initiative, has stopped short of offering concrete assistance or suggesting measures beyond those which are already in place.
The president of the European Bank for Reconstruction and Development, Thomas
Mirow, wrote in the Financial Times this week the bank proposals "deserve
full support as a worsening crisis in emerging Europe will threaten Europe as a
whole".
Austria, whose banks have 230 billion euros in outstanding loans in the region, has already announced it is trying to raise support for a general European Union initiative to rescue the region’s banking system. The country has set aside 100 billion euros ($132 billion) in cash and guarantees to stabilise its banking sector. Next in line in terms of exposure are Italy ($232 billion), Germany ($230 billion) and France ($175 billion).
Unicredit is publicly rather dismissive of the problem (as can be seen from the slide below from a presentation they gave earlier this week, please click on image to see better), but Italian investors are far from convinced by their arguments, as witnessed by the fact that their stock has plunged 41 percent this year, and that they were forced to sell 2.98 billion euros in 50 year bonds this week to shore up their Tier I capital after investors only bought about 4.6 million shares, or 0.48 percent, from their most recent rights offer. UniCredit, which said last month it is considering asking for government assistance, has also been disposing of assets to raise money and it plans to pay shareholders their dividends in yet more shares. Nationalisation of banks to supply credit lines to the private sector is one hypothesis currently being studied by Silvio Berlusconi, according to a Financial Times report this morning.
The Austrian government, as can be imagined, have also not been exactly idle, and have been strongly pushing their own proposal, which includes funds from the European Investment Bank, the European Central Bank and the EU Cohesion Fund. The Austrian government has offered money of its own and has been urging Germany, France, Italy and Belgium as well as the EU itself to contribute. One feature, however, stands out in all of the proposals which have so far been advanced: they are loan based-support. What Soros calls the "tricky question" of fiscal allocation from Europe's richer member states has not so far been raised, but it will be, since it will have to be.
And of course, Austria's concern is far from being altruistic, as Austria's economy and sovereign debt stability depend on finding a solution. It is hardly surprising to learn that credit-default swaps linked to Austrian government debt soared this week - by 39 basis points to a record 225 - on concern the country will need to bail out the domestic banks itself as they report losses and writedowns linked to eastern European investments. Erste, which said last week that full-year profit probably slumped by almost 26 percent, is in talks with the government to get 2.7 billion euros ($3.4 billion) in state aid. RZB has asked for 1.75 billion euros.
The European Central Bank on the other hand, seems reluctant to extend emergency financial help to crisis-hit countries beyond the 16-country eurozone. The ECB did not have “a mandate to be a regional United Nations agency”, Yves Mersch, governor of Luxembourg’s central bank, recently told the Financial Times. Such comments reveal the level of resistance which exists within the ECB’s 22-strong governing council to the idea of offering financial support to countries outside the zone.
The ECB has so far offered loans to Hungary and Poland, but has attached what some consider to be excessively strong conditions on facilities allowing them to borrow up to 5billion and 10billion euros respectively. Mr Mersch, whose views are thought to be widely shared in the ECB, suggested the central bank was worried about setting precedents if it relaxed its stance on helping individual countries. While some euromembers might favour assisting nearby nations, “we must not forget that other people might be sensitive to different countries”.
Who Bails Out The West European Banks In The East?
Governments and EU officials are struggling to formulate a coherent response to the economic and financial turmoil that has started to engulf the eastern part of the old continent. EurActiv presents a round-up of national situations with contributions from its network. Leaders of EU countries from central and eastern Europe will meet on 1 March ahead of an extraordinary summit on the same day with the bloc's other members, it emerged on Thursday (19 January). Polish Prime Minister Donald Tusk has invited his counterparts from the Czech Republic, Slovakia, Slovenia, Romania, Bulgaria, Lithuania, Latvia and Estonia for the talks to ensure the 27-nation meeting on the financial crisis is not dominated by the interests of Western member states. See
full Euractiv article on background.
The EU has so far provided emergency balance-of-payments assistance to two of the East European member states in difficulty - Hungary and Latvia, and EU ministers did agree in December to more than double the funding available for such emergency lending to 25 billion euros ( so far Hungary has been allocated 6.5 billion and Latvia 3.1 billion). It is also quite probable that such lending will now have to be extended to the two newest southeast European members, Romania and Bulgaria, since their ballooning current account deficits and dramatic credit crunches mean that they are steadily getting into more and more difficulty.
The core of the problem is that the East European economies enjoyed strong credit driven booms, which fuelled higher than desireable inflation and lead to strong foreign exchange loan borrowing which simply bloated current account deficits. Now capital flows into emerging Europe have dried up as the global financial crisis has raised investors' risk aversion and prompted them to dump emerging market assets, leaving foreign-owned banks as the only source of loans for companies and consumers.
Italy's UniCredit, the biggest lender in emerging Europe, warned at the end of January that there was a clear risk of the global credit crunch gripping the region. UniCredit board member Erich Hampel stated at a Euromoney conference in Vienna earlier this month that the bank was committed to fund its subsidiaries in the CEE countries and would continue to lend, but at the same time made absolutely clear that in order to do this hiw bank would need government support, whether from Austria, or Poland, or Italy itself.
Hampel said Bank Austria would decide during the first quarter whether to tap
the Austrian government's banking stability package for fresh equity. " he said.
"Our budget is under discussion now and clearly assumes growth in lending and in
funding to the East. "
And according to a report from the Austrian central bank the fact that a relatively small number of Western European groups - including three Austrian ones - own most of the banks in the region there is the risk of a "domino effect" that could let a crisis spread quickly from one country to another. "How capital flows into (emerging Europe) will develop depends on the financial strength of the parent groups and of the sister banks, and on whether the parents are willing and able to fund their subsidiaries," the bank's half-yearly Financial Stability Report said. "The risks to refinancing are increased by the danger of a domino effect, because a large part of the foreign capital in many countries comes from a relatively small number of Western European banks," .
"What we see is that the emerging European economies have lost all sources of funding but banking," said Deborah Revoltella, chief economist for central and eastern Europe of UniCredit, the region's biggest lender. The task to carry whole economies through a downturn comes at a time when parent banks already face a double challenge: a likely sharp rise in loan defaults at their eastern subsidiaries and more difficult and expensive refinancing for themselves. "The international banks cannot solve this situation," Revoltella said. "They can do their part, and it's fundamental that they do their part but we have to take care of the other sources of funding which are missing now."And it isn't only Austria who is worried, since Greek central bank governor George Provopoulos warned Greek banks only last Tuesday against transferring funds from the country's bank package to the Balkans, where they are heavily invested.
Regional Risks
The problem is that this is not only a banking crisis, it is strong credit crunch which is now having a severe impact on the real economies in the region. Most of the economies are already in recession, and those that are not soon will be (I have intersperced a number of relevant graphs throughout this post which should give some general impression of what is happening). Thus these countries are all taking multiple hits at one and the same time.
1/ In the first place they have an economic contraction on their hands, in some cases becuase they are struggling with a steep decline of export demand from western Europe, in others becuase their externally financed credit boom is now over.
2/. Most countries have some form of foreign currency exposure. In some countries -notably Hungary, Romania, Bulgaria and the Baltics this is because most mortgages were taken out in euros or Swiss Francs, and the default risk is now rising as their economies either deflate (internal devaluation) or their currencies fall as part of the regional sell-off.
They are also suffering significant asset writedowns, as those assets bought at very high prices during the boom - some at up to six times their book value - now have to be written down, further weighing on earnings and weakening balance sheets.
Finally there is significant contagion risk. The comparatively small number of foreign lenders involved has lead IMF economists and the credit ratings agencies to repeatedly warn of how the risk that a seemingly isolated incident in one country may rapidly spread right across the region.
"I don't think it's an exaggeration to say that the whole banking sector and
financial system (in the region) rests on the response of parent banks," said
Neil Shearing, economist at Capital Economics. "If they withdraw funding
it's not very difficult to see how there would be a very severe financial
crisis sweeping across the region, and the whole region en masse would have to
go to the IMF," he said.
Governments in the region have already taken what measures they can. Most increased deposit guarantees from 20,000 to 50,000 euros foloowing the EU October Paris meetin. Lithuania went further and upped the limit to 100,000 euros, while Slovakia, Slovenia and Hungary all now offer unlimited protection.
But the problem has now become a very delicate one, since the banks want to maintain there presence even while almost every factor imaginable is working against them. The latest of these is the threat of credit downgrades for their core business in Western Europe, and Moody’s Investors Service warned only this week that some of Europe’s largest banks may be downgraded because of loans to eastern Europe, a warning which sent Italy's UniCredit to its lowest level in the Milan stock market in 12 years.
Moody’s argues there will be “continuous downward rating pressure” in the region as a result of worsening asset quality and western banks’ reliance on short-term funding. UniCredit’s Bank Austria subsidiary earned almost half its pretax profit from eastern Europe in 2007, Raiffeisen International Bank-Holding almost 80 percent and Austria’s Erste Group Bank more than 60 percent, according to Moody’s.
“The most risky parts of the western European banks’ businesses are in eastern Europe and when you decide to cut risks, you cut back on the most risky assets first,” Lars Christensen, an analyst at Danske Bank A/S in Copenhagen, said by telephone today. “This could add further risk in the region as the economies there may face large current account deficits if funding from western European banks is withdrawn.”
As a result Tuesday saw a surge in the cost of protecting bank bonds from default, lead by Raiffeisen International Bank-Holding and UniCredit. Credit-default swaps on Vienna-based Raiffeisen climbed 26 basis points to a record 369 and those for UniCredit soared 23 basis points to an all-time high of 213, according to data from CMA Datavision in London. Credit-default swaps on Erste increased 24.5 to 307, Paris- based Societe Generale rose 6 to 116 and KBC in Brussels was unchanged at 240, according to CMA prices.
The rising cost of insuring against default by a “peripheral” European
government is likely to weigh on the euro, according to Merrill Lynch & Co.
“This remains an important background negative for the euro,” Steven Pearson, a
strategist in London at Merrill Lynch, wrote in a note today. “European
banking-sector exposure to Eastern Europe, often via foreign currency lending,
is an additional euro negative story that is gaining air-time.” Emerging market
central banks may move away from holding European government bonds in their
reserves as widening yield spreads between debt of different euro-zone economies
makes bonds more difficult to trade, Pearson said.
So Why Would The Euro Help?
Well, in the first place, four of the Eastern economies - Bulgaria, Latvia, Lithuania and Estonia, are effectively stuck, since their currencies are pegged to the Euro. They are in the unenviable position of being stuck between the proverbial rock and the hard place. They are now faced with US depression type economic slumps, and massive internal wage and price deflation all at the same time. Would Euro membership help? Well lets look at what the IMF said in their most recent report on the stand-by loan arrangement for Latvia.
Accelerated adoption of the euro at a depreciated exchange rate would deliver most of the benefits of widening the bands, but with fewer drawbacks. Unlike all other options for changing the exchange rate, the new (euro-entry) parity would not be subject to speculation.
By providing a stable nominal anchor and removing currency risk, euroization would boost confidence and be associated with less of an output decline than other options.Euroization with EU and ECB concurrence would also help address liquidity strains in the banking system. If Latvian banks could access ECB facilities, then those that are both solvent and hold adequate collateral could access sufficient liquidity. The increase in confidence should dampen concerns of resident depositors and also help stem non resident deposit outflows.
However, this policy option would not address solvency concerns and has been ruled out by the European authorities. If combined with a large upfront devaluation, there would be an immediate deterioration in private-sector solvency, which could slow recovery. Privatesector debt restructuring would likely be necessary. Finally, the European Union strongly objects to accelerated euro adoption, as this would be inconsistent with treaty obligations of member governments, so this option is infeasible.
Basically, devaluating the Lat and entering the euro directly was the IMF's preferred option for Latvia, "euroization with EU and ECB concurrence" was the second option, and keeping the peg and implementing massive internal deflation only the third. The problem was that the EU, in its wisdom felt euro adoption "would be inconsistent with treaty obligations of member governments" - as would I suppose bailing out Austria and Ireland be "inconsistent with treaty obligations of member governments under the Maastricht Treaty. Go tell it to the marines, is what I say!
And this is not just Latvia, but four entire countries (little ones, but still countries) that are effectively being thrown to the wolves here.
Nor is the position of those with floating currencies - Poland, Hungary, the Czech Republic and Romania - much better, since their currencies are now coming under substantial pressure, and as a result defaults are growing, defaults which will only work their way back upstream to the Western Countries whose banks will have to stand the losses.
Obviously there is now a sense of urgency here, and the warning signs are everywhere, for those who know how to read them. According to Zbigniew Chlebowski, the chairman for the Polish ruling party’s parliamentary group speaking in an interview earlier this week, the Polish government has been in official talks with the European Central Bank over joining the pre-euro exchange-rate mechanism “for several days.” So consultations are getting to be fast and furious.
And Hungarian, Polish and Czech government debt, which has been among the highest rated in emerging markets, is now being downgraded by bondholders. Investors are currently demanding 20 basis points more yield to own Hungary’s bonds than similar-maturity Brazilian debt, which is rated four levels lower by Moody’s Investors Service, according JPMorgan bond indexes. The risk of Poland defaulting is currently running at about the same as Serbia, ranked six levels lower by Standard & Poor’s, based on credit-default swap prices, while Czech 10-year bonds yield the most compared with German bunds since 2001.
“Everybody is running for the door,” said Lars Christensen, head of emerging-market strategy at Danske Bank A/S in Copenhagen. “The markets have decided the central and eastern European region is the subprime area of Europe.”
The currencies of these currenciies are tumbling on investor concern the region’s economies are among the most vulnerable to the global credit crisis. Poland’s zloty has fallen 35 percent against the euro since August, the forint - which has fallen around 13% since the start of the year, and about 25% since last August -weakened to a record low of 309.71 this week. At the same time the Koruna hit the lowest level since 2005.
The zloty has rose - against the previous trend - by 3.2 percent this week, following a decision by the Finance Ministry to enter the market (on Wednesday) and started selling euros from European Union funds for zlotys. Prime Minister Donald Tusk said yesterday the currency must be defended “at any cost.” The Czech central bank stated it regards the buying and selling currencies to manage the koruna as an “exceptional” tool that it’s resisted using since 2002, with the implication that it may not be able to resist much longer, although interest rate hikes (as practised in Hungary) seem to be the more likely approach in the Czech Republic. Such gains as have been obtained for the zloty are likely to be short lived (intervention is a tool of desperation, not of strength, and rarely has any lasting effect) and they can hardly exhaust EU funding they badly need to spend on stimulus type projects in the face of the downturn defending the indefensible, as Russia has been learning to its cost in another context.
“It [currency intervention ]is for us an exceptional tool at our disposal,” Tomas Holub, head of its monetary policy department, said in a telephone interview today. “Of course it’s one of the potential tools, but so far no decision has been taken in this direction.”
After intervention the only real tool left is interest rate policy, and fear of further currency falls is now acting as a serious brake on monetary policy as the pace of economic contraction gathers speed in one country after another. “A lowering of interest rates at the current levels of the exchange rate is completely out of the debate,” Deputy Governor Miroslav Singer told E15 newspaper earlier this week. “The question is whether to raise, and by how much.”
Really the suggestion that all these countries simply trapse of to the IMF in search of help is shameful. There is simply no other word for it, shameful. Let them in, and let them in now, before the whole house of cards collapses on top of each and every one of us.
BoJ To Buy More Corporate Bonds
From the Financial Times:
The Bank of Japan stepped up measures to help embattled companies weather the credit crisis, unveiling plans to buy up to Y1,000bn in corporate bonds and extend its purchases of other assets in an acknowledgement that Japan’s economic downturn would last longer than it had initially expected.
The BoJ said it would buy corporate bonds rated A and higher from financial institutions as well as extend its programme to buy commercial paper and provide unlimited collateral-backed loans to financial institutions, but kept its key policy rate unchanged at 0.1 per cent.
“Economic conditions have deteriorated significantly and are likely to continue deteriorating for the time being,” the BoJ said in a statement, adding that Japan was likely to see prices falling by the spring.
Although the central bank continues to predict that the Japanese economy will start recovering from the latter half of fiscal 2009, “uncertainty is high,” it said.
The gloomy assessment follows the release of data earlier this week showing the Japanese economy was in its worst slump in 35 years.
Japan’s gross domestic product contracted sharply in the third quarter, by a seasonally adjusted 3.3 per cent, as export demand evaporated.
However, the Japanese government has been paralysed by political instability following the sudden resignation of the finance minister on Tuesday, which has hardened the political opposition’s stance against passage of the 2009 budget.
The central bank’s move, which was widely anticipated, failed to ease concerns about the outlook for the Japanese economy.
“There were no surprises,” said Masaaki Kanno, chief economist at JP Morgan in Tokyo.
The BoJ’s moves have had somewhat of an impact, “but this is not going to solve (companies’) credit problems,” he said.
The latest measures come on the heels of the BoJ’s decision to buy a total of up to Y3,000bn in commercial paper by the end of the fiscal year, increase its purchases of government bonds and accept corporate bonds issued by real estate investment trusts as collateral for loans to financial institutions.
The central bank has also re-introduced a stock purchase programme under which it will buy up to Y1,000bn in shares held by financial institutions.
Analysts, including the central bank’s own chief economist, expect the Japanese economy to suffer another large decline in the fourth quarter as well, prompting calls that the BoJ needs to do more to support the economy.
“We fear that Japanese policymakers will continue to do too little, too late,” said Julian Jessop, chief international economist at Capital Economics.
Feb. 19 (Bloomberg) -- The Bank of Japan said it will buy 1 trillion yen ($10.7 billion) in corporate bonds from financial institutions and extend lending programs to prevent a shortage of credit from deepening the recession.
Governor Masaaki Shirakawa and his colleagues said the bank will buy bonds rated A or higher from March 4 to Sept. 30. The board kept the overnight lending rate at 0.1 percent in a unanimous vote, it said in a statement in Tokyo today.
The recession is making it hard for companies to raise finance by selling debt or shares, and banks are struggling to meet an increase in demand for loans. The cost to protect Japanese corporate debt against default soared to a record this week on concern bankruptcies will increase after the economy shrank last quarter by the most since the 1974 oil shock.
“So far the scale of asset purchases has been fairly modest, but at least a framework has been established that could be developed into a more ambitious program,” said Julian Jessop, chief international economist at Capital Economics Ltd. in London.
The central bank said it will extend programs to buy commercial paper and provide unlimited collateral-backed loans to financial institutions until September and continue accepting lower-rated assets as collateral until December.
Suda Opposes
The yen traded at 93.59 per dollar at 3:59 p.m. in Tokyo from 93.46 before the announcement. The currency’s 17 percent gain in the past six months has eroded the value of exporters’ sales made abroad. The yield on Japan’s 10-year bond rose half a basis point to 1.26 percent.
Board member Miyako Suda opposed the plan to buy corporate bonds, the central bank said. The bank will purchase as much as 1 trillion yen of bonds with maturities of up to one year at competitive auctions with minimum set yields. About 5 trillion yen of those securities are outstanding in Japan, and about 90 percent of them are rated at least A, the bank said. Overall corporate bonds in issue total 44 trillion yen.
Exporters are losing money as demand collapses and the yen rises. Nissan Motor Co., facing its first loss in nine years, plans to tap European capital markets, win government loans and sell real estate to maintain cash. The automaker has been “burning cash in the first nine months,” Chief Financial Officer Alain Dassas said in an interview yesterday.
Earlier this week, the bank said it will resume buying stocks owned by lenders on Feb. 23, a step it took between 2002 and 2004, to help them replenish capital and lend more.
Political Gridlock
While the central bank is attempting to channel funds to companies, the government is doing little to spur demand. Political gridlock has delayed the implementation of a 10 trillion yen stimulus package. Finance Minister Shoichi Nakagawa’s resignation this week amid lawmakers’ accusations he was drunk at a Group of Seven briefing has further damaged Prime Minister Taro Aso’s administration.
The government’s weakness makes it unlikely there will be a “major fiscal expansion financed by central bank purchases of government bonds,” Jessop said.
Gross domestic product shrank at an annual 12.7 percent pace last quarter, more than twice as fast as declines in the U.S. and Europe, as exports plunged the most on record.
Policy makers added a sentence to today’s statement saying the bank must watch “the risk of a decline in mid- and long- term inflation expectations of firms and households.” The board predicts consumer prices will start falling in the next few months.
Worsen Further
The central bank said the economy is likely to keep worsening for now, and that “uncertainty is high” over whether it will start to recover around the last quarter of 2009 as forecast. Economic and Fiscal Policy Minister Kaoru Yosano, who took over Nakagawa’s job, this week said Japan is going through “the worst postwar economic crisis.”
Governor Shirakawa’s next moves may include adding stocks as eligible collateral and increasing monthly government bond purchases from 1.4 trillion yen, economists said. Analysts are divided on whether he will resort to lowering rates to zero.
“A cut in the key rate would do little to boost growth but would at least show the central bank’s commitment to shoring up the economy,” said Hiroaki Muto, a senior economist at Sumitomo Mitsui Asset Management Co. in Tokyo.
Others said the policy board will try to avoid a reduction because cutting rates would make it unprofitable for investors to trade in the money market.
The low-rate policy is already impairing money-market trading. Lenders are hoarding cash at the central bank because it pays 0.1 percent on their excess deposits there, the same as the benchmark borrowing cost. The central bank said today that it will keep paying that interest until Oct. 15, extending a program that was due to end on April 15.
The Bank of Japan stepped up measures to help embattled companies weather the credit crisis, unveiling plans to buy up to Y1,000bn in corporate bonds and extend its purchases of other assets in an acknowledgement that Japan’s economic downturn would last longer than it had initially expected.
The BoJ said it would buy corporate bonds rated A and higher from financial institutions as well as extend its programme to buy commercial paper and provide unlimited collateral-backed loans to financial institutions, but kept its key policy rate unchanged at 0.1 per cent.
“Economic conditions have deteriorated significantly and are likely to continue deteriorating for the time being,” the BoJ said in a statement, adding that Japan was likely to see prices falling by the spring.
Although the central bank continues to predict that the Japanese economy will start recovering from the latter half of fiscal 2009, “uncertainty is high,” it said.
The gloomy assessment follows the release of data earlier this week showing the Japanese economy was in its worst slump in 35 years.
Japan’s gross domestic product contracted sharply in the third quarter, by a seasonally adjusted 3.3 per cent, as export demand evaporated.
However, the Japanese government has been paralysed by political instability following the sudden resignation of the finance minister on Tuesday, which has hardened the political opposition’s stance against passage of the 2009 budget.
The central bank’s move, which was widely anticipated, failed to ease concerns about the outlook for the Japanese economy.
“There were no surprises,” said Masaaki Kanno, chief economist at JP Morgan in Tokyo.
The BoJ’s moves have had somewhat of an impact, “but this is not going to solve (companies’) credit problems,” he said.
The latest measures come on the heels of the BoJ’s decision to buy a total of up to Y3,000bn in commercial paper by the end of the fiscal year, increase its purchases of government bonds and accept corporate bonds issued by real estate investment trusts as collateral for loans to financial institutions.
The central bank has also re-introduced a stock purchase programme under which it will buy up to Y1,000bn in shares held by financial institutions.
Analysts, including the central bank’s own chief economist, expect the Japanese economy to suffer another large decline in the fourth quarter as well, prompting calls that the BoJ needs to do more to support the economy.
“We fear that Japanese policymakers will continue to do too little, too late,” said Julian Jessop, chief international economist at Capital Economics.
Feb. 19 (Bloomberg) -- The Bank of Japan said it will buy 1 trillion yen ($10.7 billion) in corporate bonds from financial institutions and extend lending programs to prevent a shortage of credit from deepening the recession.
Governor Masaaki Shirakawa and his colleagues said the bank will buy bonds rated A or higher from March 4 to Sept. 30. The board kept the overnight lending rate at 0.1 percent in a unanimous vote, it said in a statement in Tokyo today.
The recession is making it hard for companies to raise finance by selling debt or shares, and banks are struggling to meet an increase in demand for loans. The cost to protect Japanese corporate debt against default soared to a record this week on concern bankruptcies will increase after the economy shrank last quarter by the most since the 1974 oil shock.
“So far the scale of asset purchases has been fairly modest, but at least a framework has been established that could be developed into a more ambitious program,” said Julian Jessop, chief international economist at Capital Economics Ltd. in London.
The central bank said it will extend programs to buy commercial paper and provide unlimited collateral-backed loans to financial institutions until September and continue accepting lower-rated assets as collateral until December.
Suda Opposes
The yen traded at 93.59 per dollar at 3:59 p.m. in Tokyo from 93.46 before the announcement. The currency’s 17 percent gain in the past six months has eroded the value of exporters’ sales made abroad. The yield on Japan’s 10-year bond rose half a basis point to 1.26 percent.
Board member Miyako Suda opposed the plan to buy corporate bonds, the central bank said. The bank will purchase as much as 1 trillion yen of bonds with maturities of up to one year at competitive auctions with minimum set yields. About 5 trillion yen of those securities are outstanding in Japan, and about 90 percent of them are rated at least A, the bank said. Overall corporate bonds in issue total 44 trillion yen.
Exporters are losing money as demand collapses and the yen rises. Nissan Motor Co., facing its first loss in nine years, plans to tap European capital markets, win government loans and sell real estate to maintain cash. The automaker has been “burning cash in the first nine months,” Chief Financial Officer Alain Dassas said in an interview yesterday.
Earlier this week, the bank said it will resume buying stocks owned by lenders on Feb. 23, a step it took between 2002 and 2004, to help them replenish capital and lend more.
Political Gridlock
While the central bank is attempting to channel funds to companies, the government is doing little to spur demand. Political gridlock has delayed the implementation of a 10 trillion yen stimulus package. Finance Minister Shoichi Nakagawa’s resignation this week amid lawmakers’ accusations he was drunk at a Group of Seven briefing has further damaged Prime Minister Taro Aso’s administration.
The government’s weakness makes it unlikely there will be a “major fiscal expansion financed by central bank purchases of government bonds,” Jessop said.
Gross domestic product shrank at an annual 12.7 percent pace last quarter, more than twice as fast as declines in the U.S. and Europe, as exports plunged the most on record.
Policy makers added a sentence to today’s statement saying the bank must watch “the risk of a decline in mid- and long- term inflation expectations of firms and households.” The board predicts consumer prices will start falling in the next few months.
Worsen Further
The central bank said the economy is likely to keep worsening for now, and that “uncertainty is high” over whether it will start to recover around the last quarter of 2009 as forecast. Economic and Fiscal Policy Minister Kaoru Yosano, who took over Nakagawa’s job, this week said Japan is going through “the worst postwar economic crisis.”
Governor Shirakawa’s next moves may include adding stocks as eligible collateral and increasing monthly government bond purchases from 1.4 trillion yen, economists said. Analysts are divided on whether he will resort to lowering rates to zero.
“A cut in the key rate would do little to boost growth but would at least show the central bank’s commitment to shoring up the economy,” said Hiroaki Muto, a senior economist at Sumitomo Mitsui Asset Management Co. in Tokyo.
Others said the policy board will try to avoid a reduction because cutting rates would make it unprofitable for investors to trade in the money market.
The low-rate policy is already impairing money-market trading. Lenders are hoarding cash at the central bank because it pays 0.1 percent on their excess deposits there, the same as the benchmark borrowing cost. The central bank said today that it will keep paying that interest until Oct. 15, extending a program that was due to end on April 15.
Monday, February 9, 2009
Investors And Inflation
Prices falling but inflation fears remain at fore
By David Oakley
Published: February 9 2009 19:44 | Last updated: February 9 2009 19:44
The US economy is expected to experience an overall fall in prices this year for the first time since 1955, the world is in the grip of a severe recession and the oil price is 70 per cent below its peaks of last year.
So what are investors currently worrying about? Why, inflation, of course.
Evidence that this apparently perverse anxiety is gripping some traders can be seen in the gold and inflation-linked bond markets. The two assets that protect investors’ portfolios against rising prices have enjoyed strong demand since the turn of the year.
In short, last year’s deflation panic among investors is over. Now there is a great deal of uncertainty over what effect fiscal stimulus plans, in the US and elsewhere, will have on inflation. There may be some reason for these concerns.
The US, for example, is preparing to take on a mountain of debt, with a $800bn-plus stimulus package that will lead to the largest budget deficit as a share of GDP since 1945.
Other countries are also building up debt mountains, with global government bond issuance forecast to hit a record $3,000bn in 2009 – three times more than last year.
Some investors fear that pumping out more debt is simply a short-term fix, which in the long-run could create a bigger disaster, like giving an alcoholic a crate of whisky to temporarily stop him shaking.
Richard Bernstein, chief investment strategist at Merrill Lynch, says: “We have been absolutely inundated in the last week or so with e-mails about inflation. Investors are worried that the US government is ready to print money, which they think will automatically lead to inflation.”
John Reade, strategist at UBS, adds: “I am having more questions about longer term inflation now than for some time. This explains the recent demand for gold and may explain the interest in inflation-linked bonds.”
Indeed, there has been strong demand for all forms of gold in recent days – although prices eased on Monday – with UBS and Goldman Sachs forecasting the precious metal will soon rise to $1,000 an ounce, levels last seen in March. Since January 1, the gold price has risen about 2.5 per cent to about $900 an ounce.
Investors have also been buying gold bars and coins, while exchange-traded funds backed by bullion surged to record highs last week.
In the bond markets, so-called break-even rates, which measure the difference between yields of conventional and inflation-linked bonds – and which are a guide to future inflation rates – have jumped since the start of the year
Break-even rates have risen by about 80 basis points since January 1, suggesting investors think inflation will average out at nearly a percentage point more annually than they thought was the case five weeks ago.
Critically, these market moves underline growing worries that so-called quantitative easing – with the Federal Reserve poised to print dollar bills to buy its own debt – will trigger high rates of inflation some time down the road.
Gary Jenkins, head of fixed income at Evolution, says: “Inflation is clearly not a problem at the moment, but no one really knows what will happen in a few years time. If you are taking a five-year view, then it might make sense to buy inflation-linked bonds.”
Mr Bernstein adds: “Inflation is the next problem. The worry now is the dire health of the economy, but we are living in an uncertain world.”
Scott Thiel, head of European fixed income at BlackRock, believes some investors may be trying to call the bottom of the recession, which explains the rush into inflation-linked bonds as they turn their attention to the next potential threat to the economy: inflation.
Ciaran O’Hagan, fixed income strategist at Société Générale, says: “Markets are caught between two stools, wanting to price risks of deflation over the next few years, followed by fears of rising inflation thereafter.”
So are investors right to buy protection against inflation now?
Carl Norrey, head of European rates trading at JPMorgan, insists it is too early. “There are too many deflationary forces at work. Investors would be better rewarded buying high-grade corporate bonds and government-guaranteed bank paper, which offer very attractive yields, rather than inflation-linked bonds.”
Others believe there is an argument for buying corporate bonds for the yield and inflation-linked paper as a hedge. Mr Jenkins says: “We are living in unusual times. A lot of economic forecasts have been proved completely wrong, so if you are a buy-and-hold investor you may want to buy inflation-linked bonds.”
Morgan Stanley’s analysts say investors should take out insurance against a so-called ”black swan” – an unpredictable event that could lead to very high levels of inflation.
Given the number of unpredictable events in the past year – most notably the collapse of Lehman Brothers – they insist this type of insurance is essential.
But one thing bankers, investors and government debt managers all agree on is the need for politicians to pay off the debt once the economies start to revive.
A senior government debt manager said only last week: “While most people in the market think it is right to take on debt to stimulate growth, there is a real concern that the politicians will fail to repay it when there is a turnround. The worry is that governments will build up their debt, and rather than repay it, use the money for public spending. That would lead to an inflation bubble. The debt must be repaid to avoid that.”
Playing chicken with the Fed
John Kemp is a Reuters columnist. The opinions expressed are his own –
Yields on long-term U.S. Treasury debt continued to surge higher yesterday as the market braced for a future upturn in inflation and a tidal wave of long-dated issues that will be needed to fund the bank rescues and the emerging stimulus package.
Yields on three-year notes are up by around 47 basis points from their mid-December low. But yields on ten-year paper have soared 82 points and rates on the 30-year long bond have surged 114 points. Long-bond rates have retraced more than half their decline since the autumn (https://customers.reuters.com/d/graphics/USTREAS.pdf).
Back-end yields would probably have risen even further were it not for persistent hints the Federal Reserve is thinking about buying longer-dated issues to cap them. But the market has started to call the Fed’s bluff.
MANIPULATING THE FRONT END
In the press statement accompanying its most recent interest rate decision, the Federal Open Market Committee (FOMC) gave a clear commitment it will keep short-term rates at “exceptionally low levels for some time.” In practice, the Fed will probably hold rates close to zero for the next two to three years until a cyclical recovery is well underway. But thereafter rates will need to rise to more normal levels to contain inflationary pressures.
The steepening yield curve reflects an assumption the Fed’s zero-interest rate policy will dominate the whole yield on debt maturing in 2009-2011, but have a diminishing effect on securities which mature further in the future.
LENGTHENING THE DEBT PROFILE
Federal debt held by the public has surged almost 25 percent in the last nine months, from $4.64 trillion at the end of March 2008 to $5.78 trillion at the end of December. Net debt is scheduled to increase another $1.0-1.5 trillion over the next twelve months as a result of the cyclical downturn and the huge $700-900 billion stimulus package being considered by Congress.
So far, almost all the increase in debt has been funded by issuing short-term instruments. The proportion of debt maturing within one year has climbed from 38 percent at the end of March to 43 percent at the end of December, and will climb over 50 percent within the next twelve months unless the government’s issuing policy changes.
By increasing the volume of debt that needs to be refunded regularly, the shortening profile is creating a dangerous new form of fragility within the system.
In effect, the federal government is now taking on the maturity-transformation role previously provided by commercial banks, corporations issuing commercial paper, and special investment vehicles (SIVs). Like them, it is borrowing short-term from the money markets to make long-term investments secured against tax revenues receivable over decades.
But like the private borrowers, the government will also face a liquidity crisis if at any point the market balks at rolling over the maturing short-term notes.
For the moment, a liquidity crisis is unlikely. The short-term ultra-safe instruments the Treasury is issuing are a good fit for the type of securities which investors want to hold.
But once conditions begin to normalize, investors are likely to want to withdraw some funds from the short-term Treasury market to deploy them more profitably in other assets. And overseas investors will eventually want to reduce their exposure to dollar-denominated assets.
At that point, short rates will have to jump to persuade investors to keep sufficient funds in the market to roll over all the maturity bills and notes.
This risks creating a highly unstable dynamic. Even the slightest sign of stabilization and recovery will trigger a sharp run up in short and medium term government bond yields, cascading across the rest of the bond market into higher borrowing costs on commercial paper and commercial loans.
With so much short-term debt needing constant refunding, the Fed would struggle to control the pace of future monetary tightening. Both the Fed and the Treasury therefore have a strong interest in lengthening the government debt profile.
A much higher proportion of forthcoming debt issues will be placed in the middle and at the back end of the yield curve, which is why debt prices at these maturities have been falling, and their yields rising fastest.
MANIPULATING THE BACK END
The Fed’s open market operations are normally restricted to short-term U.S. Treasury bills. But the central bank has already expanded them to include purchases of commercial paper and mortgage-backed securities issued by Fannie Mae and Freddie Mac. It will soon start funding third parties to buy securities issued by credit card companies, student lenders and motor manufacturers.
The FOMC has stated it is also “prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.”
In effect, the Fed has said it is prepared to enter the market as a “buyer of last resort” for longer-dated Treasury securities if their prices fall too much and yields rise too high. Fed officials have talked about buying longer-dated Treasuries for several months. But so far the Fed has hesitated to pull the trigger, because buying long-dated bonds is fraught with danger.
The principal purpose of open market operations is to provide liquidity by making an active two-way market when other banks and institutions fail to do so in sufficient volume. To the extent the volume of open market operations increases, and the total quantity of securities owned by the Fed rises over time, the central bank is also printing money.
When the Fed first started to expand its open market purchases in early autumn, the cost was covered by additional deposits of Treasury money into the central bank. The Treasury issued short term cash management bills, deposited the proceeds with the Fed, and the Fed used them to buy private-sector debts. In effect, the Fed and the Treasury substituted private borrowing from the money markets for public borrowing, so the impact on the total money and credit supply was neutral.
The Fed and Treasury have since run down the supplementary financing program and allowed the cash management bills to mature without replacing them. The increase in the Fed’s balance sheet has started to expand the money supply. But the increase is mostly showing up in a rise in the volume of excess bank reserves, rather than lending, so the impact on business activity and inflation is muted.
There is more inflationary risk in future once conditions normalize and demand for cash liquidity falls. But at that point the Treasury could issue more government debt, or the Fed could sell some of the government and other securities in its portfolio, absorbing excess cash from the banks. In principle, the Fed is still swapping private debt (now) for government debt (later).
But once the Fed begins to purchase long-dated Treasuries it will be unambiguously creating money. It would be turning on the printing press and monetizing the federal government’s deficit.
Since all the Fed’s operations are ultimately backstopped by the U.S. Treasury, the Fed would be using the government’s own money to buy the government’s own debt. The Fed would find itself bracketed with Germany’s interwar Reichsbank and the central bank of Zimbabwe. This is most definitely not a comparison the Fed wants drawn.
The market would almost certainly respond by labeling a long-term Treasury purchase program “deficit financing” and brace for even higher inflation. The market-clearing yield on long-dated Treasuries would rise further. If the Fed wanted to continue holding yields down below this level, it would be forced to buy a substantial proportion — in the limiting case all — of the new issues.
As in the currency market, limited intervention risks backfiring, while large-scale intervention would stoke fears about inflation. So this is a policy the Fed must hope to hold in reserve, and never have to use.
By David Oakley
Published: February 9 2009 19:44 | Last updated: February 9 2009 19:44
The US economy is expected to experience an overall fall in prices this year for the first time since 1955, the world is in the grip of a severe recession and the oil price is 70 per cent below its peaks of last year.
So what are investors currently worrying about? Why, inflation, of course.
Evidence that this apparently perverse anxiety is gripping some traders can be seen in the gold and inflation-linked bond markets. The two assets that protect investors’ portfolios against rising prices have enjoyed strong demand since the turn of the year.
In short, last year’s deflation panic among investors is over. Now there is a great deal of uncertainty over what effect fiscal stimulus plans, in the US and elsewhere, will have on inflation. There may be some reason for these concerns.
The US, for example, is preparing to take on a mountain of debt, with a $800bn-plus stimulus package that will lead to the largest budget deficit as a share of GDP since 1945.
Other countries are also building up debt mountains, with global government bond issuance forecast to hit a record $3,000bn in 2009 – three times more than last year.
Some investors fear that pumping out more debt is simply a short-term fix, which in the long-run could create a bigger disaster, like giving an alcoholic a crate of whisky to temporarily stop him shaking.
Richard Bernstein, chief investment strategist at Merrill Lynch, says: “We have been absolutely inundated in the last week or so with e-mails about inflation. Investors are worried that the US government is ready to print money, which they think will automatically lead to inflation.”
John Reade, strategist at UBS, adds: “I am having more questions about longer term inflation now than for some time. This explains the recent demand for gold and may explain the interest in inflation-linked bonds.”
Indeed, there has been strong demand for all forms of gold in recent days – although prices eased on Monday – with UBS and Goldman Sachs forecasting the precious metal will soon rise to $1,000 an ounce, levels last seen in March. Since January 1, the gold price has risen about 2.5 per cent to about $900 an ounce.
Investors have also been buying gold bars and coins, while exchange-traded funds backed by bullion surged to record highs last week.
In the bond markets, so-called break-even rates, which measure the difference between yields of conventional and inflation-linked bonds – and which are a guide to future inflation rates – have jumped since the start of the year
Break-even rates have risen by about 80 basis points since January 1, suggesting investors think inflation will average out at nearly a percentage point more annually than they thought was the case five weeks ago.
Critically, these market moves underline growing worries that so-called quantitative easing – with the Federal Reserve poised to print dollar bills to buy its own debt – will trigger high rates of inflation some time down the road.
Gary Jenkins, head of fixed income at Evolution, says: “Inflation is clearly not a problem at the moment, but no one really knows what will happen in a few years time. If you are taking a five-year view, then it might make sense to buy inflation-linked bonds.”
Mr Bernstein adds: “Inflation is the next problem. The worry now is the dire health of the economy, but we are living in an uncertain world.”
Scott Thiel, head of European fixed income at BlackRock, believes some investors may be trying to call the bottom of the recession, which explains the rush into inflation-linked bonds as they turn their attention to the next potential threat to the economy: inflation.
Ciaran O’Hagan, fixed income strategist at Société Générale, says: “Markets are caught between two stools, wanting to price risks of deflation over the next few years, followed by fears of rising inflation thereafter.”
So are investors right to buy protection against inflation now?
Carl Norrey, head of European rates trading at JPMorgan, insists it is too early. “There are too many deflationary forces at work. Investors would be better rewarded buying high-grade corporate bonds and government-guaranteed bank paper, which offer very attractive yields, rather than inflation-linked bonds.”
Others believe there is an argument for buying corporate bonds for the yield and inflation-linked paper as a hedge. Mr Jenkins says: “We are living in unusual times. A lot of economic forecasts have been proved completely wrong, so if you are a buy-and-hold investor you may want to buy inflation-linked bonds.”
Morgan Stanley’s analysts say investors should take out insurance against a so-called ”black swan” – an unpredictable event that could lead to very high levels of inflation.
Given the number of unpredictable events in the past year – most notably the collapse of Lehman Brothers – they insist this type of insurance is essential.
But one thing bankers, investors and government debt managers all agree on is the need for politicians to pay off the debt once the economies start to revive.
A senior government debt manager said only last week: “While most people in the market think it is right to take on debt to stimulate growth, there is a real concern that the politicians will fail to repay it when there is a turnround. The worry is that governments will build up their debt, and rather than repay it, use the money for public spending. That would lead to an inflation bubble. The debt must be repaid to avoid that.”
Playing chicken with the Fed
John Kemp is a Reuters columnist. The opinions expressed are his own –
Yields on long-term U.S. Treasury debt continued to surge higher yesterday as the market braced for a future upturn in inflation and a tidal wave of long-dated issues that will be needed to fund the bank rescues and the emerging stimulus package.
Yields on three-year notes are up by around 47 basis points from their mid-December low. But yields on ten-year paper have soared 82 points and rates on the 30-year long bond have surged 114 points. Long-bond rates have retraced more than half their decline since the autumn (https://customers.reuters.com/d/graphics/USTREAS.pdf).
Back-end yields would probably have risen even further were it not for persistent hints the Federal Reserve is thinking about buying longer-dated issues to cap them. But the market has started to call the Fed’s bluff.
MANIPULATING THE FRONT END
In the press statement accompanying its most recent interest rate decision, the Federal Open Market Committee (FOMC) gave a clear commitment it will keep short-term rates at “exceptionally low levels for some time.” In practice, the Fed will probably hold rates close to zero for the next two to three years until a cyclical recovery is well underway. But thereafter rates will need to rise to more normal levels to contain inflationary pressures.
The steepening yield curve reflects an assumption the Fed’s zero-interest rate policy will dominate the whole yield on debt maturing in 2009-2011, but have a diminishing effect on securities which mature further in the future.
LENGTHENING THE DEBT PROFILE
Federal debt held by the public has surged almost 25 percent in the last nine months, from $4.64 trillion at the end of March 2008 to $5.78 trillion at the end of December. Net debt is scheduled to increase another $1.0-1.5 trillion over the next twelve months as a result of the cyclical downturn and the huge $700-900 billion stimulus package being considered by Congress.
So far, almost all the increase in debt has been funded by issuing short-term instruments. The proportion of debt maturing within one year has climbed from 38 percent at the end of March to 43 percent at the end of December, and will climb over 50 percent within the next twelve months unless the government’s issuing policy changes.
By increasing the volume of debt that needs to be refunded regularly, the shortening profile is creating a dangerous new form of fragility within the system.
In effect, the federal government is now taking on the maturity-transformation role previously provided by commercial banks, corporations issuing commercial paper, and special investment vehicles (SIVs). Like them, it is borrowing short-term from the money markets to make long-term investments secured against tax revenues receivable over decades.
But like the private borrowers, the government will also face a liquidity crisis if at any point the market balks at rolling over the maturing short-term notes.
For the moment, a liquidity crisis is unlikely. The short-term ultra-safe instruments the Treasury is issuing are a good fit for the type of securities which investors want to hold.
But once conditions begin to normalize, investors are likely to want to withdraw some funds from the short-term Treasury market to deploy them more profitably in other assets. And overseas investors will eventually want to reduce their exposure to dollar-denominated assets.
At that point, short rates will have to jump to persuade investors to keep sufficient funds in the market to roll over all the maturity bills and notes.
This risks creating a highly unstable dynamic. Even the slightest sign of stabilization and recovery will trigger a sharp run up in short and medium term government bond yields, cascading across the rest of the bond market into higher borrowing costs on commercial paper and commercial loans.
With so much short-term debt needing constant refunding, the Fed would struggle to control the pace of future monetary tightening. Both the Fed and the Treasury therefore have a strong interest in lengthening the government debt profile.
A much higher proportion of forthcoming debt issues will be placed in the middle and at the back end of the yield curve, which is why debt prices at these maturities have been falling, and their yields rising fastest.
MANIPULATING THE BACK END
The Fed’s open market operations are normally restricted to short-term U.S. Treasury bills. But the central bank has already expanded them to include purchases of commercial paper and mortgage-backed securities issued by Fannie Mae and Freddie Mac. It will soon start funding third parties to buy securities issued by credit card companies, student lenders and motor manufacturers.
The FOMC has stated it is also “prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.”
In effect, the Fed has said it is prepared to enter the market as a “buyer of last resort” for longer-dated Treasury securities if their prices fall too much and yields rise too high. Fed officials have talked about buying longer-dated Treasuries for several months. But so far the Fed has hesitated to pull the trigger, because buying long-dated bonds is fraught with danger.
The principal purpose of open market operations is to provide liquidity by making an active two-way market when other banks and institutions fail to do so in sufficient volume. To the extent the volume of open market operations increases, and the total quantity of securities owned by the Fed rises over time, the central bank is also printing money.
When the Fed first started to expand its open market purchases in early autumn, the cost was covered by additional deposits of Treasury money into the central bank. The Treasury issued short term cash management bills, deposited the proceeds with the Fed, and the Fed used them to buy private-sector debts. In effect, the Fed and the Treasury substituted private borrowing from the money markets for public borrowing, so the impact on the total money and credit supply was neutral.
The Fed and Treasury have since run down the supplementary financing program and allowed the cash management bills to mature without replacing them. The increase in the Fed’s balance sheet has started to expand the money supply. But the increase is mostly showing up in a rise in the volume of excess bank reserves, rather than lending, so the impact on business activity and inflation is muted.
There is more inflationary risk in future once conditions normalize and demand for cash liquidity falls. But at that point the Treasury could issue more government debt, or the Fed could sell some of the government and other securities in its portfolio, absorbing excess cash from the banks. In principle, the Fed is still swapping private debt (now) for government debt (later).
But once the Fed begins to purchase long-dated Treasuries it will be unambiguously creating money. It would be turning on the printing press and monetizing the federal government’s deficit.
Since all the Fed’s operations are ultimately backstopped by the U.S. Treasury, the Fed would be using the government’s own money to buy the government’s own debt. The Fed would find itself bracketed with Germany’s interwar Reichsbank and the central bank of Zimbabwe. This is most definitely not a comparison the Fed wants drawn.
The market would almost certainly respond by labeling a long-term Treasury purchase program “deficit financing” and brace for even higher inflation. The market-clearing yield on long-dated Treasuries would rise further. If the Fed wanted to continue holding yields down below this level, it would be forced to buy a substantial proportion — in the limiting case all — of the new issues.
As in the currency market, limited intervention risks backfiring, while large-scale intervention would stoke fears about inflation. So this is a policy the Fed must hope to hold in reserve, and never have to use.
Sunday, February 8, 2009
Coming (rather wonkishly) Up To Date On The Great Depression
"Has anyone else noticed that the current crisis sheds light on one of the great controversies of economic history?" Paul Krugman asked his readers recently. In fact I could have answered, him with a "yes me", since - to plagiarise Robert Lucas here - scarcely a day has passed since the 9 August 2007 (the day PNB Paribas found themselves short of $2 billion dollars to "close" their books) when I have not been thinking about this. In fact, depsite the many bad things that can obviously be said about the present crisis, it does have the one saving virtue - it enables many of us economists to really see up at first hand how things may actually have worked back then. In this sense I would like to extend my profound thanks to 45 million Spanish men and women and 140 million odd Russians for running round and round the treadmill for the last year and a half helping me triangulate, and sort out a few nagging problems I ahve had since late adolesence.
Monetary Policy On The Zero Bound
The controversy Krugman is refering to concerns the role of monetary policy in what we could call "extreme situations". For present purposes we could describe an extreme situation as one in which either (or both) a severe credit crunch and a liquidity trap are present. The liquidity trap would normally be associated with the presence of general consumer price deflation, while former may, or may not, be, but if it is it certainly complicates things a lot. But before I go any farther, what do we really mean by a credit crunch, and what is a liquidity trap?
Crunch, Crunch Crunch
One of the principal factors which may produce a severe loss effectiveness in conventional monetary policy (or its inability to stimulate an economy) is the presence of what we nowadays call a "credit crunch". Such a credit crunch normally consists of a sharp contraction in the supply of bank credit as a result of a massive loss of inter-bank trust which is produced by the accumulation of a large quantity of nonperforming loans and semi-worthless assets inside the financial system.
Credit crunches would normally characterised by the fact that - despite the presence of a low interest rate environment - a sharp tightening of credit conditions occurs. The "lending attitudes" of financial institutions, at least from the borrower's perspective, suddenly become much more stringent.
A credit crunch implies that injections of liquidity (base and narrow money expansion) do not increase private credit and aggregate lending. This is exactly what we have seen happening in Japan from the mid 1990s onwards. Base and narrow money increased at a robust pace, but the broader money aggregates most directly related to corporate investment and consumer spending only grew modestly, as can be seen in the chart below, which comes from Gauti Eggertsson and Jonathan D. Ostry, Does Excess Liquidity Pose a Threat in Japan? (IMF Working Paper, April 2005 - please click on image for better viewing).
At the same time aggregate bank lending to the private sector decreased sharply, directly producing a tightening of credit conditions as faced by Japanese enterprises, while government borrowing increased substantially, in a pattern we are now getting used to seeing in the United States and Western Europe.
Krugman is now presenting us with evidence that this pattern may well be repeating itself in the United States. As he says, the Federal Reserve has been spectacularly aggressive about expanding the monetary base see chart below), yet bank lending has remained pretty much stationary.
Conclusions
Finally, (below) some more charts on Japan, prepared by the Japanese economist Richard Koo. In the first chart the thick blue line (please click over chart if you can't see adequately) shows the perception of large businesses of the willingness of banks to lend to them, as surveyed by the Bank of Japan for the Tankan index. You will note the line plunges twice, and it is the second plunge, or "credit crunch", which interests me at the moment. This was the crunch that finally drove Japan decisively off into deflation, and produced that now famed "liquidity trap". Basically the first credit crunch was resolved via large scale government contruction spending, the guaranteeing of bank deposits, and the swallowing by the banks of a large number of non-performing loans. Does all this sound familiar? It should. But then Japan reached a point were the financial system could struggle forward no further. So the crunch broke out again, and this time the only way to resolve the problem was with two massive injections of capital into the banking system.
The problem is that these injections - as can be seen below - served to push the Japan government debt to GDP ratio sharply upwards, nd it is this part of the story that I feel we will see repeating itself now in countries like the United States and Spain.
The problem is that the US economy became, as I am sure everyone is now only too aware, very highly leveraged with total (private and public) debt to GDP ratios of around 350% of GDP. This is now unsustainable. The government is basically - via the various bailout processes trying to reduce the part of this ratio which is held by the private sector and hence reduce the degree of leveraging to within a range that will allow bank lending to function again.
The problem is that as these bailouts take effect US GDP is itself contracting, and at the same time prices are pushing the frontier between price increases and price decreases. It is really very important to not allow systematic price falls to set in, and doubly important not to allow expectations for inflation to turn negative.
Monetary Policy On The Zero Bound
The controversy Krugman is refering to concerns the role of monetary policy in what we could call "extreme situations". For present purposes we could describe an extreme situation as one in which either (or both) a severe credit crunch and a liquidity trap are present. The liquidity trap would normally be associated with the presence of general consumer price deflation, while former may, or may not, be, but if it is it certainly complicates things a lot. But before I go any farther, what do we really mean by a credit crunch, and what is a liquidity trap?
Crunch, Crunch Crunch
One of the principal factors which may produce a severe loss effectiveness in conventional monetary policy (or its inability to stimulate an economy) is the presence of what we nowadays call a "credit crunch". Such a credit crunch normally consists of a sharp contraction in the supply of bank credit as a result of a massive loss of inter-bank trust which is produced by the accumulation of a large quantity of nonperforming loans and semi-worthless assets inside the financial system.
There will be close to no growth in lending by Spanish banks in 2009 as the economy contracts, the head of Spanish bank Sabadell said on Tuesday. "Credit this year is going to grow by zero or nearly zero due to the steep adjustment in the economy as it undergoes deleveraging," Sabadell's Chief Executive Officer Jaime Guardiola told a press breakfast.Such a crunch would normally have two components; a) a decline in bank capital due to the accumulation of bad loans held by the banking sector with a resulting fall in the capital asset ratio large financial institutions. The banks normally respond to such a situation by reducing the amount of loans they are prepared to supply and; b) the emergence of a cautious lending attitude on the part of banks following their experience with a combination of bankruptcies, nonperforming loans, and recession. Such circumstances make firms and households less desirable potential borrowers than they used to be, and they also have the self-reinforcing effect of tightening credit conditions and worsening the developing recession, which is, of course, itself partly a by-product of the initial credit crunch. Thus when the thing locks tight, you need more than some 3 in 1 rapid-ease to unlock it.
Credit crunches would normally characterised by the fact that - despite the presence of a low interest rate environment - a sharp tightening of credit conditions occurs. The "lending attitudes" of financial institutions, at least from the borrower's perspective, suddenly become much more stringent.
A credit crunch implies that injections of liquidity (base and narrow money expansion) do not increase private credit and aggregate lending. This is exactly what we have seen happening in Japan from the mid 1990s onwards. Base and narrow money increased at a robust pace, but the broader money aggregates most directly related to corporate investment and consumer spending only grew modestly, as can be seen in the chart below, which comes from Gauti Eggertsson and Jonathan D. Ostry, Does Excess Liquidity Pose a Threat in Japan? (IMF Working Paper, April 2005 - please click on image for better viewing).
At the same time aggregate bank lending to the private sector decreased sharply, directly producing a tightening of credit conditions as faced by Japanese enterprises, while government borrowing increased substantially, in a pattern we are now getting used to seeing in the United States and Western Europe.
Krugman is now presenting us with evidence that this pattern may well be repeating itself in the United States. As he says, the Federal Reserve has been spectacularly aggressive about expanding the monetary base see chart below), yet bank lending has remained pretty much stationary.
Running On Empty Aka The Liquidity Trap
The other type of extreme situation which needs to be kept in mind is danger of a liquidity trap. Discussion of liquidity traps (or the danger they represent) came back into vogue in the late 1990s following a renewed focus on the problem by Krugman himself in the Japanese context.
In fact most of recent discussion of the liquidity trap problem has been focused on Japan, for the simple reason that Japan was the first major industrial economy to face serious and ongoing price deflation since the 1930s episodes. It was, of course, during the 1930s that Keynes first drew serious attention to the liquidity trap explanation for why monetary policy might be ineffective when interest rates come up against what we now call the "zero bound".
Basically the risk of entering a liquidity trap is heightened when interest rates are at or near zero, and domestic demand contracts with sufficient force to produce a substantial and ongoing fall in prices, since the implicit rate of return on simply holding cash is not that different from holding short term government bonds, and especially when transaction costs are taken into account. (If prices drop at a 2% annual rate, for example, this gives you an implicit rate of return of 2% on bank notes).
Now we need to be careful here, since while monetary policy in one economy after another gradually coming to rest around the zero bound, by and large price inflation has not (yet) fallen below zero (or not for a sufficient length of time), and while it is evident that a number of countries face the imminent risk of this happening (Germany, Spain, Ireland, the UK, Japan and the United States most notably) we are not there yet, and the central banks are working furiously (well I'm not too sure about the ECB) to unblock the credit crunch before the associated contraction in economic activity produces the sort of price deflation which increases the risl of one country after another getting stuck in some kind of liquidity trap.
The simplest explanation for why it is that an increase in the monetary base may have only limited effects on inflationary expectations and real macroeconomic variables goes back to Keynes. Keynes argued that monetary policy ran the risk of becoming impotent in stimulating demand and raising spending since interest rates were already at there lowest possible level. Essentially he argued that increasing the monetary base by buying short-term government bonds is irrelevant at zero interest rates since money and short-term government bonds become perfect substitutes. Therefore, it matters little for economic activity if commercial banks (or private individuals) hold money or government bond as the two assets effectively perfect substitutes.
This argument has been challenged of late, most notably by Ben Bernanke, since while the central bank may remain impotent in the face of short term interest rates, by buying longer term instruments (10 or 30 year bonds) the bank may influence rates all the way up the yield curve.
But there was another dimension to Keynes thinking here, and this was associated with the causal chain between the monetary base (which the central bank evidently controls) and the level of output and prices (which it apparently doesn't). Keynes suggested that the relation between monetary base and the level of output was not a linear one, and indeed in a credit driven economic the chain might run from sentiment to credit availability to the output level to broad money, leaving the central bank free to move the level of base money around at will, but effectively impotent to influence the level of lending and output. This sounds horribly like the sitaution we are seeing around us at the present time.
This is why Keynesian has become so closely associated with the idea of government spending, since given that the central bank has only limited ability to regulate the output level by using monetary policy, he considered direct demand management by via fiscal injections to be much more effective. Indeed in one of his last interviews Milton Freidman himself conceded the point, declaring that "The use of the quantity of money as a target has not been a success".
The core of Krugman's analysis is the idea that the equilibrium real interest rate - that is, the real rate that would match saving and investment - and thus bring output back up towards its capacity level - turns negative in a liquidity trap. Thus we can have an economy which is struggling to find its equilibrium point but which is unable to do so since it effectively cannot generate the rate of interest which would make this possible.
But how can the equilibrium real interest rate be and remain negative? Because, argues Krugman, poor long-run growth prospects (a debt deflationary environment) make investment demand so low that a negative short-term real interest rate would be needed to match saving and investment. Given a nominal interest rate floor of zero a positive expected rate of inflation becomes necessary to generate negative real interest rates, which will stimulate aggregate demand and restore full employment.
Equally importantly, injections of liquidity by the central bank which raise base money (or bank reserves) turn out to be pretty ineffective in raising the growth rate of broader money aggregates. Krugman shows that Japan's monetary base grew 25% from 1994 to 1997, but that the broader monetary aggregate (M2 + Certificates of Deposit) grew only 11%, and bank credit didn't grow at all. And more recent statistics indicated that "money hoarding" continued to be evident in 1998-1999, as an expansion of the monetary base in the range of 8% to 10% resulted in only about a 3% growth in M2 + CDs. Posterior Bank of Japan data show that between March 2001 and May 2004 while Japanese bank reserves grew by 800% the monetary base (which is bank reserves plus cash in circulation) only increased by 67%.
Now, as I say, there little evidence at the present time that we are already in a liquidity trap, but the danger that some countries (including Japan, yet one more time) may fall into one, is certainly real, and non-negligible.
Economics Is Giving Me A Depression
So what has all this got to do with the great depression? Well quite a lot actually.
As Krugman argues, a central theme of Keynes’s General Theory was the impotence of monetary policy in depression-type conditions. But Milton Friedman and Anna Schwartz, in their magisterial monetary history of the United States, claimed that the Federal Reserve could have prevented the Great Depression — a claim that in later, popular writings, including those of Friedman himself, was transmuted into the claim that the Federal Reserve "caused" the Depression.
(As we have seen, what the Fed really controlled was the monetary base — currency plus bank reserves. As the chart displayed below - which comes from Krugman - shows, the base actually rose during the great slump, which is why it’s hard to make the case that the Fed caused the Depression. Although arguably had the Fed acted more aggressively earlier - eg if it had expanded the monetary base faster and done more to rescue banks in trouble - the blow might have been softened, even though as we are seeing at the present time, there are no guarantees, this will always and forever have to remain a huge "what if").
Underlying everything the whole Friedman & Schwartz view of The Depression is the assumption that (in both the short amd long term) the "velocity" of money reflects the "money holding propensities of the community" (p679). Under the normal ceteris paribus convention, tastes are taken to remain unchanged. Thus, the authors feel authorised to write as though a movement in the monetary aggregate in and of itself implied a simple and direct influence on real output. This idea that velocity remains constant has been repeatedly question by critics of the Monetary History, most notably by Irving Fisher who in argued in a now famous Econometrica paper that debt liquidation leads to distress selling and which leads to a contraction in current deposits plus currency as bank loans are paid off, and thus to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes a general fall in the level of prices. Sound familiar?
Friedman & Schwartz for the most part take a pretty simple of the cause of the monetary contraction in The Great Depression:
the monetary authorities could have prevented the decline in the stock of money
- indeed could have produced almost any desired increase in the stock of money.
(P.301: note the almost]. The monetary decline from 1929 to 1933 was not an
inevitable consequence of what had gone before. It was the result of policies
followed during those years (p.699).
On the question of how the authorities could have controlled the money stock, they answer, in words quite evocative of things we have been hearing of late by conducting "extensive open market purchases" to increase bank reserves: What they say of the first year of the depression expresses their view reasonably clearly:
It has been contended with respect to later years (particularly during the years
after 1934....) that increases in high-powered money, through expansion of
Federal Reserve credit or other means, would simply have added to bank reserves
and would not have been used to increase the money stock.... we shall argue
later that the contention is invalid, even for the later period. It is clearly
not relevant to the period from August 1929 to October 1930. During that period,
additional reserves would almost certainly have been put to use promptly. Hence
the decline in the stock of money is not only arithmetically to the decline in
federal Reserve credit outstanding: it is economically a direct result of that
decline. (pp341-2)
Basically Friedman & Schwartz never really seriously consider the possibility that bank lending was held back by factors other than their reserve position. This is becuase they seem to pay practically no attention to the asset side of banks' balance sheets. This view of the world would seem to allow precious little place for the banks' role as financial intermediaries who live by striking a balance between the needs of two types of client: depositors (the public as asset owners) and borrowers (the public as investors and debtors). Nor does it allow for the fact that banks as intermediaries operate in a world of uncertainty, that banks' assessment of their client's creditworthiness varies, and that in the short term their lending determines the size of the money stock.
If these effects are accepted as important, the stock of money has to be seen as determined at least in large part by the business situation, and this is exactly what we are seeing now. It thus becomes more and more plausible that the scale of bank lending during the Great Depression was significantly restrained by the state of the bank loan book, and by their increased caution in lending to customers whose profit expectations had deteriorated drastically, as well as by the capital adequacy position and it was these considerations, and not the size of their reserves, that imposed a limit on the size of the money stock.
The government is losing its patience with the banks,” Spanish Industry Ministry
Miguel Sebastian said just hours after the labour ministry said the number of
people out of work in Spain rose to over 3.3 million as of the end of January, a
12-year high, “I will tell them, with all my power and conviction, that this is
not the time for large profits. It’s the time to support credit and financing
for families and companies in this country,”
Spain's largest union, the CCOO, went a step further and said banks had to start
dolling out credit, or face state efforts to control lending. The demands, and
word the Bank of Spain Governor and other bank sector leaders would address
Congress in coming weeks, raised talk the government could create a state bank
or take stakes in private banks to influence their credit policy. "We shouldn't
rule out the government taking a stake (in a private bank) and, in an extreme
case, creating a public bank," said Paloma Lopez, CCOO employment secretary
general. "If they don't free up financing, if the banks keep putting up
objections, the government has to go a step further."
The point is that one must believe that the fall in income had a major effect on personal consumption, and the great fall in output a major influence on business investment, and the interaction of the two (once the process started) a dominating influence. At most, then, monetary influences could have initiated the depression, or worsened it when it started, but they could not have been the sole dominating influence through its course. The parallel fall in the money stock cannot then be taken as evidence of the latter's causal significance.
“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
Ben Bernanke,
Banco Popular followed the lead of other Spanish banks on Friday, opting to sacrifice 2008 profits to increase provisions against bad loans amid the deepening economic slowdown. Popular posted a 16.8 percent drop in net profit for 2008 on to 1.05 billion euros ($1.4 billion), below analysts' forecasts, as loan loss provisions increased. Popular has one of the highest exposures to Spain's property sector, currently in a steep downturn after a decade-long boom. Many property developers are defaulting.
Popular is expected to post an around 8 percent rise in net interest revenue in 2009. Loans grew 6.1 percent, with 44 percent to small and medium-sized businesses, and client deposits grew 21.1 percent. Higueras said he sees, at best, low digit loan growth in 2009, but stressed that Popular would continue to lend money to businesses and private individuals. "We are not giving up on lending .... We will come through this crisis however long it lasts," he said.
Conclusions
Finally, (below) some more charts on Japan, prepared by the Japanese economist Richard Koo. In the first chart the thick blue line (please click over chart if you can't see adequately) shows the perception of large businesses of the willingness of banks to lend to them, as surveyed by the Bank of Japan for the Tankan index. You will note the line plunges twice, and it is the second plunge, or "credit crunch", which interests me at the moment. This was the crunch that finally drove Japan decisively off into deflation, and produced that now famed "liquidity trap". Basically the first credit crunch was resolved via large scale government contruction spending, the guaranteeing of bank deposits, and the swallowing by the banks of a large number of non-performing loans. Does all this sound familiar? It should. But then Japan reached a point were the financial system could struggle forward no further. So the crunch broke out again, and this time the only way to resolve the problem was with two massive injections of capital into the banking system.
The problem is that these injections - as can be seen below - served to push the Japan government debt to GDP ratio sharply upwards, nd it is this part of the story that I feel we will see repeating itself now in countries like the United States and Spain.
The problem is that the US economy became, as I am sure everyone is now only too aware, very highly leveraged with total (private and public) debt to GDP ratios of around 350% of GDP. This is now unsustainable. The government is basically - via the various bailout processes trying to reduce the part of this ratio which is held by the private sector and hence reduce the degree of leveraging to within a range that will allow bank lending to function again.
The problem is that as these bailouts take effect US GDP is itself contracting, and at the same time prices are pushing the frontier between price increases and price decreases. It is really very important to not allow systematic price falls to set in, and doubly important not to allow expectations for inflation to turn negative.
Friday, February 6, 2009
To Print Or Not To Print, That Is The Question
Well in a week which has seen Kazuo Momma, head of the Bank of Japan’s research and statistics department warning that Japan’s economy now faces faces an “unimaginable” contraction, and Prime Minister Taro Aso's approval rating dropping to a mere 14 percent according to the latest Asahi newspaper survey, it should not surprise us to hear reports that yet another set of "exotic" proposals have been put forward in the search for ways of dragging the Japanese economy out of the mess into which it seems to have fallen.
The proposal I am referring to is the latest "initiative" being quietly cooked up by some members of the ruling Liberal Democratic party. According to reports in the Japanese press the politicians in question, who include Yoshihide Suga, deputy chairman of the LDP’s election strategy council and a close aide to prime minister Aso, have set up a working group and are quietly dusting down plans (first advocated by Nobel economist Joseph Stiglitz on a flying visit to Tokyo) for the government to introduce its own private currency - yes that's right its own currency - to run in tandem as a rival the country's already existing official one (aka the Yen) which is essentially exclusively issued by the Bank of Japan.
The plan would seem to involve the printing of some Y50,000bn ($546bn) worth of a new currency to fund government pump-priming projects and arrives at a time of rising frustration among politicians about the posture being taken by the Bank of Japan who have been notably reluctant to bow to pressure and let the yen printing presses run ever faster in a desperate attempt to stimulate the economy.
Among proposals they have on the table are Y30,000bn of the new money to fund programmes supporting new industries and infrastructure projects, including doubling the size of Tokyo’s Haneda airport. The remaining Y20,000bn would be earmarked for government purchases of stocks and real estate.
The proposals are causing all sorts of controversy in Japan. Prime Minister Taro Aso said on Monday evening that "We are not at all at the stage of considering such an idea", while Chief Cabinet Secretary Takeo Kawamura warned that if the government prints money, it could lead to inflation and weaken the yen against other major currencies. BOJ Gov. Masaaki Shirakawa was also pretty critical of the proposal, saying it could "cause great damage" to the central bank's balance sheet and monetary policy as well as market confidence in the yen.
Of course, what may lie behind such thinking is an extremely literal reading of a very influential academic paper by IMF economist (and former Paul Krugman PhD student) Gauti Eggertsson How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible - right down to the small print. The basic idea is that as expectations of intensifying deflation set in deeper and the economic contraction intensifies a short sharp shock of irresponsibility is needed to convince people that inflation is inevitable.
Weakening the yen, and raising market participants inflation expectations (or their fear that government will irresponsibly monetise its debt), is just what the Eggerston proposal is all about, so fears of such an outcome - as expressed above - would hardly seem to constitute objections, and while it is unlikely that the plan will get very far in the short term (rather than prodding the BoJ into more aggresive action), Japan's crisis is very severe, and getting worse by the day, so clearly they are something out of the ordinary needs to be considered.
Industrial output plunged by a record 9.6 per cent month on month in December,and the consensus opinion among economists suggests GDP may have fallen more than 3 per cent compared with the previous quarter at the end of 2008 – an annualised decline of over 12 per cent.
The proposal I am referring to is the latest "initiative" being quietly cooked up by some members of the ruling Liberal Democratic party. According to reports in the Japanese press the politicians in question, who include Yoshihide Suga, deputy chairman of the LDP’s election strategy council and a close aide to prime minister Aso, have set up a working group and are quietly dusting down plans (first advocated by Nobel economist Joseph Stiglitz on a flying visit to Tokyo) for the government to introduce its own private currency - yes that's right its own currency - to run in tandem as a rival the country's already existing official one (aka the Yen) which is essentially exclusively issued by the Bank of Japan.
The plan would seem to involve the printing of some Y50,000bn ($546bn) worth of a new currency to fund government pump-priming projects and arrives at a time of rising frustration among politicians about the posture being taken by the Bank of Japan who have been notably reluctant to bow to pressure and let the yen printing presses run ever faster in a desperate attempt to stimulate the economy.
Among proposals they have on the table are Y30,000bn of the new money to fund programmes supporting new industries and infrastructure projects, including doubling the size of Tokyo’s Haneda airport. The remaining Y20,000bn would be earmarked for government purchases of stocks and real estate.
“We are facing hyper-deflation, so we need a policy to create hyper-inflation.
We have to do something to undermine the central bank and government’s
credibility or else we won’t be able to halt the yen’s rise. So, while we know
this is drastic medicine, we will do it,” said Koutaro Tamura, an upper house
Diet member who will chair the new group.
The proposals are causing all sorts of controversy in Japan. Prime Minister Taro Aso said on Monday evening that "We are not at all at the stage of considering such an idea", while Chief Cabinet Secretary Takeo Kawamura warned that if the government prints money, it could lead to inflation and weaken the yen against other major currencies. BOJ Gov. Masaaki Shirakawa was also pretty critical of the proposal, saying it could "cause great damage" to the central bank's balance sheet and monetary policy as well as market confidence in the yen.
"The plan would require very careful consideration because it could result in jumps in Japan's long-term interest rates, with market participants losing trust in the government's commitment to repaying its debts," Shirakawa said.
Of course, what may lie behind such thinking is an extremely literal reading of a very influential academic paper by IMF economist (and former Paul Krugman PhD student) Gauti Eggertsson How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible - right down to the small print. The basic idea is that as expectations of intensifying deflation set in deeper and the economic contraction intensifies a short sharp shock of irresponsibility is needed to convince people that inflation is inevitable.
Weakening the yen, and raising market participants inflation expectations (or their fear that government will irresponsibly monetise its debt), is just what the Eggerston proposal is all about, so fears of such an outcome - as expressed above - would hardly seem to constitute objections, and while it is unlikely that the plan will get very far in the short term (rather than prodding the BoJ into more aggresive action), Japan's crisis is very severe, and getting worse by the day, so clearly they are something out of the ordinary needs to be considered.
Industrial output plunged by a record 9.6 per cent month on month in December,and the consensus opinion among economists suggests GDP may have fallen more than 3 per cent compared with the previous quarter at the end of 2008 – an annualised decline of over 12 per cent.
“From October to December the scale of negative growth [in GDP] may have been unimaginable – and we have to consider the possibility that there could be even greater decline between January and March,” Mr Momma said in a speech.
So perhaps the unimaginable in negative growth may also call for what would previously have been unimaginable policy as a response.
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