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March 29th, 2010 › account imbalance › admin › Comments Off ›
High levels of current-account surpluses in those countries which are manufacturing exports and producing resources and correspondingly high levels of current-account deficits in the consumer-driven importing economies cannot be sustained indefinitely. Borrowing such a high proportion of income must eventually be curtailed. But there has been considerable room for difference of opinion on how and when this would happen and whether the correction, when it eventually came, would be a gradual and relatively smooth adjustment of incomes and patterns of trade or a jarringly painful forced contraction of expenditure.
To explain what is involved, it is worth recounting the views of some leading economists in 2006, before the financial crisis erupted (for me, as a card-carrying economist holding a London School of Economics Ph.D. this is a natural reference point). The media characterizes economists as being unable to agree about anything. Disagreement on economic issues among professionals is as natural as it is among non-specialists. When policy advice depends on forecasts – which are always uncertain – and on different political standpoints and judgements, then economists do indeed express a wide range of views.
What is striking about this issue is that back in 2006 leading economists, from a wide range of different standpoints, were expressing very much the same views about the world current-account imbalances. They all agreed that the level of savings by exporters of resources and manufactures and correspondingly large borrowing by the importing countries, could not be sustained indefinitely. The reason is simple arithmetic. A country, even a large and great country like the United States, is in the same position as an individual; it cannot keep borrowing 5 per cent of its income forever, spending $105 for every $100 it actually earns.
There were arguments about the statistics. Some, for example, believed that there is hidden income on US overseas assets and that when this is included the deficit looks a little smaller. But almost no one disputed that eventually income and expenditure in the United States and other deficit countries would have to adjust, through some combination of reduced spending on imported goods and services and higher domestic production, to bring total expenditure more into line with total income.
Where there were disagreements was on how this adjustment would come about and how quickly, and on what policy measures might be needed to deal with it. Some were pessimistic about this adjustment process, anticipating what was commonly labelled as a ‘hard landing’. To take one example, Paul Krugman, Professor of Economics at Princeton University and an op-ed writer for the New York Times, wrote on several occasions about the possibility of an abrupt slowdown in US consumption and house prices and a potentially sharp dislocation in exchange and interest rates.2 He was concerned about both the sustainability of consumption and the role of international investors. Household consumption – which accounts for around 70 per cent of all US expenditure – might slow sharply, triggering a sharp decline in national output. There could also be a collapse of confidence by overseas investors, leading them to switch out of dollars into other currencies, and triggering a massive correction to the dollar exchange rate, far more than was required for adjustment of the external deficit, and leading to rising inflation and a major reduction in business confidence and private-sector investment.
Other commentators stressed the ability of the market to self-correct, arguing that households and taxpayers are not entirely short-sighted and would recognize when they, or government on their behalf, are spending beyond their incomes, and then gradually take steps either to reduce expenditures or to increase incomes. Savings, in other words, can be expected to rise gradually to bridge the gap. Market prices will also adjust to encourage this correction, so that we can expect to see a lower dollar exchange rate, at least against the Chinese renminbi and the Japanese yen. These will lead to higher US savings and to greater export growth, and to a slowdown in consumer borrowing and the growth of imports.
Many economists held these views. One elegant statement is to be found in a 2006 paper by the respected economists Guillermo Calvo and Ernesto Talvi.3 They contest Krugman’s argument that reduced investment in the United States by the Chinese government would lead to a sharp fall in US economic activity, arguing instead that the export of savings by surplus economies is unlikely to come to a sudden sharp halt; but they do acknowledge the possibility that a sharp correction in US housing markets could lead to a slowdown in US consumer spending.
It is now clear that the adjustment of the world’s structural currentaccount imbalances is clearly not going to be smooth. But the shock is not one of those identified by Krugman or indeed by any other economic commentator before early 2007. We have not so far seen a complete collapse in household consumption in the deficit countries. Nor have we seen an uncontrolled collapse of exchange rates and withdrawal of foreign capital from the United States, the United Kingdom and other borrowing countries. What has instead happened is an entirely unanticipated major and long-lasting dislocation to credit markets and bank funding.
As a result, far from a gradual adjustment of the world’s current-account balances, we now seem to be heading towards a much sharper correction through a massive contraction of credit, leading to falling household and business expenditure. If this happens it will create a cumulative downward spiral in world economic activity.
Tags: account imbalance
October 19th, 2009 › insurance › admin › Comments Off ›
A price floor establishes a minimum price that can legally be charged. The government imposes price floors on some agricultural products, for example, in an effort to artificially increase the prices that farmers receive. When a price floor is imposed above the current market equilibrium price, it will alter the market’s operation. A surplus (Qs – Q,) of the good will result, as the quantity supplied by producers exceeds the quantity demanded by consumers at the new controlled price. Just like a price ceiling, a price floor reduces the quantity of the good exchanged, and reduces the gains from trade.
As in the case of the price ceiling, nonprice factors will play a larger role in the rationing process. But because there is a surplus rather than a shortage, this time buyers will be in a position to be more selective. Buyers will purchase from sellers willing to offer them nonprice favors- better service, discounts on other products, or easier credit terms, for example. When it’s difficult to alter the product’s quality- in this case, improve it to make it more attractive for the price that must be charged- some producers will be unable to sell it.
It is important to note that a surplus doesn’t mean the good is no longer scarce. People still want more of the good than is freely available from nature, even though they want less of it at the controlled price than sellers want to bring to the market. A decline in price would eliminate the surplus, but the item will be scarce in either case.
Tags: Exchange rates, insurance, minimum price, price floors, real estate
September 27th, 2009 › real estate › admin › Comments Off ›
Because price no longer rations rental housing, other forms of competition will develop. Landlords will rely more heavily on nonmonetary discriminating devices. They will favor friends, people of influence, and those whose lifestyles resemble their own. In contrast, applicants with many children or unconventional lifestyles, and perhaps racial minorities, will find fewer landlords who will rent to them. Since the cost to landlords of discriminating against those they do not like is lower, discrimination will become more prevalent in the rationing process. In New York City, where rent controls are in force, a magazine article suggested that “joining a church or synagogue” could help people make the connections they need to get an apartment. Can you imagine having to devote this amount of effort to finding an apartment? If your city enacts rent controls, you just might have to.
Tags: housing, landlords, mortgage, price
September 26th, 2009 › Short Selling › admin › Comments Off ›
Shorting a stock involves selling a stock that an investor does not hold in the expectation that it can be bought back at a later date at a lower price. This provides a way to make absolute returns when stock prices are falling. Custodian banks act as facilitators to this process. Custodian banks approach their fund management clients to make stock lending agreements. Stock lending provides a means for fund managers to enhance returns, they lend the stock to the short seller, but retain all of their rights to the stock (dividends, rights issues etc.). In return the short seller pays a fee for this facility.
The custodian bank is exposed to counterparty risk and will also require a margin deposit from the short seller. The short seller sells the borrowed stock into the market. The proceeds from the sale cover the margin requirement and fees and leave a balance that can be invested elsewhere, usually in the money market.
Closing a short position requires a reversal of these flows. The short seller withdraws their money market deposit, buys back the borrowed stock in the market, returns the stock to the custodian bank and receives back its margin deposit.
Tags: Business, credits, loans, Short Selling
July 4th, 2009 › Capital › admin › Comments Off ›
As the capital account surplus is reduced while the current account deficit remains high, the pressure through the balance of payments is expressed through rising local interest rates and increasing downward pressure on the local currency. In order to maintain the peg, the central bank again intervenes, this time buying local currency (when capital was flowing in, it was forced to sell its own currency) and selling the base currency. In order to do so, it has to sell its foreign exchange reserves, which are denominated in that base currency. As local currency is bought from the market so supply is reduced and the interest rates attached to that local currency forced higher. The central bank has the unpalatable choice of sterilizing this effect by injecting liquidity back into the money market and thus effectively nullifying the effect of its foreign exchange intervention or allowing interest rates to rise and hurting the economy and asset markets in turn. As interest rates rise, so asset markets fall, forcing those investors who have stayed to cut their losses — and their positions — thus putting yet more pressure and so on and so forth. A vicious cycle develops, the length of which is decided only by the ability or the willingness of the central bank to expend its foreign exchange reserves. Eventually, one of two things happen, either the central bank runs out of reserves or the economic and financial cost of maintaining the currency peg becomes too great and the central bank scraps the peg and allows the currency to “float” (i.e. free-fall).
Tags: Capital, Currency
July 3rd, 2009 › Exchange rates › admin › Comments Off ›
Asian countries pegged their currencies to the US dollar in order to provide a foundation for economic stability, while they got on with the job of growing their economies. In a sense these dollar pegs did their job too well. With Asian currencies pegged to the US dollar, it appeared that the idea of currency risk had been all but eliminated. Asia in the 1980s and early 1990s had been growing strongly in any case. Thus the Asian currency pegs together with strong domestic growth rates provided the platform for a veritable tidal wave of capital inflows to the region, both of the portfolio and foreign direct investment kind. The lack of currency volatility lulled investors into a false sense of security — though that false sense of security in some cases lasted for more than a decade.
Many Asian countries had relatively high inflation rates, higher than the US whose currency they were pegged to. Ordinarily, this should mean that a currency depreciates to offset its higher inflation rate, however in the case of Asia the sheer weight of massive capital inflows, combined with the currency pegs, meant that Asian currencies appreciated on a real (inflation- adjusted) basis, which was greatly exacerbated by the 35% devaluation of the Chinese yuan in 1994 and the depreciation of the Japanese yen from 1995. The result was widening Asian trade and current account deficits. Put simply, Asian countries were slowly but surely losing export competitiveness. High inflation and currency pegs meant high interest rates, despite the fact that most Asian countries ran healthy fiscal surpluses. This was not a problem for Asian governments since most were not seeking to expand domestic borrowing, but it was a problem for the private sector. Those currency pegs provided the illusion of exchange rate stability, encouraging corporations to borrow offshore at lower interest rates and swap back to domestic currency. As a result, significant external debt burdens were built up. Unlike in Latin America in the 1980s, this was private not public debt and went largely unnoticed in the more transparent public accounts. Thus, Asian corporate and bank balance sheets became increasingly exposed to external, US dollar-priced debt. While Asian currencies could not move, this was not an issue. Implicitly however, it meant if Asian currencies were ever allowed to depreciate, the capital base of those same corporate and banking sectors would be severely depleted if not eliminated. Asian currency devaluation would mean the cost of repaying that external debt would be multiplied by the extent of that devaluation.
By late 1996, real exchange rate appreciation had resulted in significant trade and current account balance deterioration. Thailand was running a current account deficit of some 8% of GDP. Assuming the balance of payments must indeed balance, the other side of a current account deficit must be a capital account surplus. This is indeed what happened in Asia. Massive capital inflows helped cause real currency appreciation, which in turn led to a rising current account deficit. To fund its widening current account deficit, Thailand had to attract an ever increasing amount of capital inflows. It did not get them. Instead, “fundamental” investors became increasingly wary and started if anything to reduce their exposure to Thailand in early 1997 due to a combination of increasing political and economic concerns and diminishing returns on their investments. As that capital fled — selling Thai baht in order to do so — so Thai domestic interest rates edged higher while the Thai baht itself came under increasing downward pressure.
Tags: Business, Exchange rate, finance
July 2nd, 2009 › Exchange rates › admin › Comments Off ›
The very purpose of having a local currency pegged to a base currency (usually the US dollar) is to provide a foundation for economic and financial stability. A currency peg reduces or even eliminates the issue of currency risk, and therefore attracts capital inflows. Those capital inflows become a self-fulfilling prophecy, since they help generate ever higher growth rates, which in turn attract further capital inflows. There are two monetary effects of these inflows. First, the local currency comes under mounting upward pressure. Second, interest rates paradoxically are forced lower. On the first of these, the currency is pegged so it cannot appreciate beyond a certain point. In order to maintain the peg, the central bank intervenes, selling its own currency for the base currency. In the money market, the central bank also conducts open market operations, sterilizing the effect of these inflows by withdrawing excess liquidity. Relative to the size of the inflows coming in, the ability of an emerging market central bank to conduct both of these monetary operations indefinitely is clearly limited. Meanwhile, precisely because interest rates are low and emerging market economies are not fully open, inflation rates are relatively high, higher that is than the inflation rate of the base currency. This should ordinarily mean that the local currency depreciates on a real basis in order to offset the higher inflation rate. The sheer weight of the capital inflows means this cannot happen. Indeed, the opposite happens. The local currency continues to appreciate on a real, inflation-adjusted basis. In turn, this causes widening external imbalances and loss of export competitiveness.
Tags: Business, Exchange rate
July 2nd, 2009 › Crisis › admin › Comments Off ›
The type of exchange rate regime is important for normal market trading conditions, but it is especially important for abnormal periods of market stress that may lead ultimately to a “currency crisis”.
In the wake of the emerging market crises in Mexico (1994–1995), Asia (1997–1998), Russia (1998), Brazil (1999) and Turkey (2001), considerable effort has been made by the academic and financial communities to create models that might be able to predict such crises in the future. As with long-term valuation models aimed at finding a currency’s “equilibrium” level, most of these are based on highly complex mathematical formulae and make certain key assumptions about human behaviour and psychology. Equally, like the equilibrium models, the results of these have been mixed at best to date. No-one has as yet come up with the definitive model capable of predicting currency crises ahead of time on a consistent basis. The best that has been achieved is some degree of success, albeit claimed after the fact.
For my part, I make no claim either as to a definitive breakthrough. What I would lay claim to however is having approached the issue of currency crisis from a different angle. Most of the existing models focus largely on the rationality of human behaviour. In a financial context, this implies rational investors investing where the best returns are to be found. If those returns diminish or if better returns are available elsewhere, it is assumed that they will leave. Such a rationally-dominated view does not allow for herd behaviour, that buying may continue long past the point at which yield returns have diminished significantly. There is an emotional hang-up, both within economic theory and within the official community, which labels buyers as investors and sellers as speculators. Yet, buyers can also be speculating. Indeed, some of the best examples of speculative excess gone mad have come from buying rather than selling, notably the internet bubble. Markets are ruled by such fundamental sentiments as greed and fear, and it is safe to say that in 1999–2000 greed was running rampant. Easy money was to be had — as it always is during such periods of market hysteria. The financial bubble got bigger and bigger and then burst spectacularly in mid-2000. We are still feeling the after-effects of the bursting of the economic bubble, that tidal wave of increasingly unprofitable investment. This is just one example of the “speculative” excess with which human history is littered. In trying to create a model to predict currency crises, my aim has not been to fit economic theory around the facts, but rather to start the other way around, examining patterns within those facts and then aligning the theory to fit. The effort has been that of a forensic detective, rather than a psychic. Thus, the rather simple — though hopefully not simplistic — model that I created in 19981 is based not on complex mathematical formulae, but instead on the sum of those patterns that have been seen in the emerging market currency crises of the past 10 years. For want of a more pithy title, I called it the Classic Emerging Market Currency Crisis (CEMC) model, a title that is long-winded but hopefully captures the repetitious nature of currency crisis patterns. Our detective did find if not a smoking gun, then at least enough forensic evidence to discover the “how” and the “why”.
The model focuses on emerging markets and more specifically the Asian currency crisis in large part because I witnessed the latter at first hand, having lived and been involved in the financial markets in Hong Kong during the second part of the 1990s. Because the model’s initial aim was to discover patterns that specifically reflected the Asian crisis, it was de facto a model that focused on fixed or pegged exchange rate regimes and how those broke down. This is not to say it is only reflective of the Asian crisis. CEMC should be viewed as a template for emerging market currency pegged regimes generally. Indeed, it works remarkably well in explaining the key dynamics behind the currency crises in Mexico, Russia, Brazil and Turkey. The model is based on five key phases that appeared to take place during the Asian crisis, and were also mirrored in subsequent emerging market crises in Russia, Brazil and Turkey. Throughout, I use Thailand, seen as the catalyst for the Asian currency crisis, as an example of the general phenomenon at work.
Tags: Crisis, Currency, Exchange rate, finance
July 1st, 2009 › Exchange rates › admin › Comments Off ›
Up to now, this blog has largely focused on exchange rate regime theory. This post deals with how the choice of exchange rate regime actually affects currency market practitioners in practice. As the exchange rate regimes of both developed and emerging markets are still evolving, it is difficult to find definitive answers. That said, based on what we have already looked at we can draw some useful conclusions. For a start, “fixed” currency pegs are not necessarily fixed forever — if you get caught long a currency that has just devalued it can kill your balance sheet or portfolio. For instance, on February 19, 1982, the Mexican peso lost some 29% of its value. Some 15 years later, on July 2, 1997, the Thai baht lost 10% of its value in a single day. How do we avoid the kind of portfolio or balance sheet losses such disastrous events imply? Currency market practitioners within fixed or pegged exchange rate regimes need to consider the following points:
Does the currency peg contribute to economic stability or instability? Currency pegs can provide monetary credibility by using the exchange rate to force inflation lower, but they can also attract substantial and potentially destabilizing capital flows.
To what extent is a country open to global capital flows? If a country allows high capital mobility, a currency peg may not be appropriate unless it abandons monetary independence and adopts the hardest of pegs, such as a currency board. Capital flows are less easily anticipated than trade flows, but much more quickly reversed.
Is the currency pegged at the correct level? This has been an important question not just for emerging but also for developed economies, notably with the ERM. Currency market practitioners should use the lessons learned in previous posts to judge whether the currency peg level is appropriate. Corporations with subsidiaries in the countries concerned are well placed to do this given local pricing and demand knowledge.
Are there clear patterns of distress ahead of a peg’s collapse? Currency market practitioners can use the CEMC model as a test of market conditions.
What do you do if a currency peg collapse appears imminent? The trick of course is to try to anticipate this before the rest of the financial market does. Remember the lessons of the Asian crisis, where the preceding depreciations of the yen and yuan helped make Asian currencies uncompetitive. Remember also that PPP and REER may not be useful over the short term, but they are useful over a long-term horizon in suggesting currency over- or undervaluation. Also, don’t ignore common sense! Did it make sense in 1998 for Russia, a country which was going cap in hand to the IMF for more money, to have some of the most expensive residential property in the world in Moscow? Every boom is characterized by incidents and anecdotes, which after the bubble bursts seem acts not of folly but of sheer lunacy. Look for signs of these.
Currency risk may not be the only consideration. Within the emerging markets in particular, there may be other important considerations as well, such as convertibility and liquidity risk. Is a currency convertible on the capital account? Also, emerging market currencies are by nature much less liquid than those of developed economies. While USD200–300 billion may go through the Euro–dollar exchange rate every day (spot, forward, swaps and options), only USD10 billion goes through the South African rand, the second most liquid emerging market currency in the world behind the Singapore dollar. Finally, there is also political risk, which is a more important consideration in emerging markets.
Hedge when the market doesn’t want to (and neither do you!). When market conditions are benign is clearly when liquidity is best and pricing potentially most favourable. This is also the best time to hedge currency risk, particularly if one is potentially concerned about the sustainability of the currency regime. However, precisely because market conditions are benign this is not the time when markets are looking to hedge currency risk. The temptation to stay with the pack (or rather the flock!) should be strenuously avoided. If valuation considerations suggest a currency peg may be overvalued, hedging should be seriously considered. It is a question of cost vs. risk rather than risk vs. reward. For the cost of an option of around 1–2%, you hedge yourself against the potential risk of a devaluation of around 30–40%. Granted, options are not available in some markets, but in all markets there are benign and also malign market conditions and seasoned currency market practitioners should be able to tell the difference and take the opportunity when it is at hand.
When the market wants to hedge currency risk it is too late! There is no use complaining about adverse pricing and liquidity developments when the market is scrambling to hedge currency risk. By that time, forwards have screamed higher and option risk reversals have blown out. Take the opportunity of favourable pricing and market conditions when it presents itself, based on valuation considerations.
Most of the ideas presented in the bullet points above focus largely on pegged or fixed exchange rate regimes. A different set of considerations may be required when looking at freely floating exchange rates:
Freely floating exchange rates imply high capital mobility. The two tend to go together. The combination should mean in theory that capital flow reversals are transmitted through the exchange rate more efficiently and with less volatility.
Freely floating exchange rates can however still see major bouts of volatility. While they tend to be rarer these days, particularly if there are no major economic imbalances involved, freely floating exchange rates can also see significant bouts of volatility. This is not just the case within the emerging but also within the developed markets. A case in point is the collapse in the dollar–yen exchange rate in the autumn of 1998 from around 135 to 114 in the space of 36 hours. Speculative trends always reverse and when they reverse they tend to do so violently.
As pegged exchange rates may be temporary, so freely floating rates are no panacea.
Freely floating exchange rates also exact costs and involve risks on the part of the currency market practitioner in seeking to manage currency risk.
Tags: Business, Currency, Exchange rate