The post crisis economy - tentative and risk-averse.

A firm’s aversion to capital markets can persist for decades after a recession. A recent paper by Antoinette Schoar and Luo Zuo, from MIT’s Sloan School of Management, concludes that managers who begin their career during a recession have a conservative management style when compared with their non-recession peers. The authors find that early career experiences are important and can influence firm-level decisions even decades later, when the “recession manager” becomes a CEO. The companies headed by these managers are reluctant to access public markets, have lower capital budgets and pay higher effective tax. If the pattern from previous downturns holds, then we can expect the next generation of business leaders to eschew capital markets in favour of self-sufficiency. Firms will invest less in capital-intensive projects and in research and development (R&D) to tightly control finances.

This strain of financial conservatism could also impact start-ups that seek to commercialise innovative technology. Typically, in the aftermath of a recession, the flow of money to early-stage companies is reduced. This may not be a bad thing. It is possible that during boom times, excess capital dents financial discipline, and leads investors to fund mediocre ventures. In contrast, during a recession, investors are more diligent about their investment. In fact, a study by the Kauffman Foundation found that more than half of the companies on the 2009 Fortune 500 list were launched during a recession or bear market.

My full post is here.

Can Asia ever decouple from the West?

There is some evidence to support this. The bank’s data show that the Asian recovery has been driven by the region’s own economic demand - there has been a rebound in intra-regional trade. The region is also less dependent on foreign capital than before. The impact of the European debt crisis has been minimal, with bond yields falling as capital continues to flow in.

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Yet the region is still vulnerable to shocks from the West. Despite an increase in domestic demand, Asia depends heavily on exports. Most countries in the region continue to undervalue their currencies, making it difficult to move away from developed-world demand and toward domestic consumption. Stimulus spending has driven much of Asia’s blistering growth this year, but if America and Europe continue to face sluggish growth, no amount of fiscal or monetary pump-priming can prevent a slowdown. 

My full post is here.

The latest Big Mac index suggests the euro is still overvalued

Covering the annual movement in the Big Mac index has to be one of the most fun topics to write about. Where else can you “chomp” at over valued currencies, attract “yield-hungry investors” and ask readers to take your analyses with a “generous pinch of salt”?

Sample this:

Other currencies are dearer still. Investors looking for a safe place to put their money have sought refuge in the Swiss franc. Despite attempts by the Swiss central bank to stem the appreciation, the Swiss franc is overvalued by 68%. Those on the hunt for a value meal should also steer clear of Scandinavia. In Norway a Big Mac would set you back by 45 kroner or $7.20, nearly twice the cost in America.

Place an order for my full piece here (subscription needed).

Moving away from the dollar as the global reserve currency will not be easy. A natural experiment from Hungary demonstrates just how difficult it is.

A reserve currency must have a deep and liquid market. This is where the dollar scores over other currencies. Even the euro, which was a viable alternative before the current crisis, has not been able to displace the dollar’s dominant position as an international medium of exchange. One explanation is obviously inertia. Banks are used to dealing with a set of bilateral exchange rates and will continue to do so. But these attitudes can change, particularly with a crisis. What is more difficult to get over is network externalities—if dollars can be exchanged easily against other foreign currencies, then any domestic currency can be exchanged against dollars.

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Beyond just a store of value, the currency must be at the centre of international banking and cross-border lending. Introducing a new currency into this network will be hard, even if it’s the right thing to do.

The full text of my post is here.

The coming Euro-zone storm.

As Buttonwood reports, the three-month dollar Libor rate is almost as high as the two-year bond yield. Banks are reluctant to lend to Spanish and Greek banks because they are deemed too risky. This chart from the FT shows that European banks deposited €305 billion with the ECB on Monday night, despite getting only 0.25%. Banks prefer to forgo excess rates from other banks in favour of safety. Compare this to the €196 billion that the euro-zone banks had deposited with the central bank during the height of the crisis to understand how nervous they are at the moment.

Next, Simon Derrick makes an interesting comparison between the behaviour of the euro now and during the crisis. He points out that since the Swiss National Bank stopped intervening in the market in June, the Swiss Franc, Yen and Pound have all done well against the Euro, while the Euro has gained against the Australian and Canadian dollar. Why is this important? Well, Simon notes that between September and December of 2008, the Euro collapsed against the Franc and Yen, while it gained on the Australian and Canadian dollars, which are commodity-linked.

The full post is here.

How do you price the systemic risk posed by banks in a financial system? The Bank of England’s Financial Stability Report has some interesting pointers.

First the cost. The report assumes that banks have sufficient time to transition to the new capital levels. If not, banks would simply shrink their assets to meet the requirements. Assuming that the transition period is long, banks would replace debt with equity on the liability side, while leaving their asset side unchanged. The report calculates the additional financing cost for equity, after accounting for the tax savings of debt. If the bank passes the added cost directly to its customers, a 1% increase in capital requirement would lead to a 7-basis point increase in the lending spread. This increase in lending rate has an effect on the nominal GDP via reduced investments. The 7-basis point increase in lending spread thus leads to a 0.1% permanent decline in GDP (the model uses a simple Cobb-Douglas production function to arrive at this number).

So far so good. This is what the banks have been arguing. But the theory behind higher capital adequacy ratios is that it would allow banks to withstand greater shocks without leading to major crises. Since financial crises are associated with long-run losses in GDP, a reduction in the probability of a crisis generates marginal benefits. The report models the financial system as the five largest British banks whose default risks are correlated. It then calculates the benefit from extra growth by reducing the probability of crisis by 1%. There is a break even point at which the cost of higher capital levels equal the benefits from falling probability of crises. 

The complete text of my post here.

Fears that China’s massive stimulus during the Great Recession may have led to poor investment decisions.

China’s chief auditor warned that local government debt could pose risks to the Chinese economy. The National Accounting Office in its annual report said that borrowing by local governments had created debt burdens which would require assistance from the central government. It estimated that in some provinces,  the ratio of debt to disposable revenues has exceeded 100%, with the highest standing at 365%.

All this is not to say that China will face a Greece-style debt crisis anytime soon. Far from it. China’s debt-to-GDP ratio is 158% compared to 296% for the America and 366% for Spain. And the central government has the capacity to carry these losses. But when you consider the interconnected nature of local governments and the investment companies, any defaults could get very ugly.

The full post is here.

On microeconomic behaviour - how small factors can influence where people stay once they decide to move.

Although commuting costs are a small part of overall household budgets, they do influence the location decisions of those who have already decided to move for job-related or lifestyle reasons. The authors estimate that with more than 10% of households moving every year, changes in location choice can have a measurable effect on local housing markets.

More importantly as housing is durable, these changes have a noticeable impact on urban landscapes. The headline econometric result from the paper is that a 10% increase in gas prices reduces construction by 10%, after 4 years, in locations with a long average commute time compared with other locations. But the market adapts quickly to a reduced demand for houses in suburbs by building fewer houses. As a result, changes in petrol prices only impact the quantity and not the price of houses. Another finding from the study is that even though cars have become more fuel efficient, the proportion of people carpooling or using public transportation has fallen. This magnifies the impact of petrol prices.

My post is here.

The practicalities of identifying and pricking financial bubbles.

This is easier said than done. Knowing which bubble to prick isn’t always easy. It may be possible to spot deviations in specific sectors such as housing, but extending supervision across the financial system is very hard. Eswar Prasadcalls the added responsibility a “mandate creep” that can create additional complications.

“Consider the notion of using regulatory tools to manage asset bubbles and ensure financial stability, while using interest rate policy to manage inflation. This can create tension when the financial well-being of the financial institutions for which the central bank is responsible might be affected by interest rate policy. For instance, low policy interest rates are good for bank profits because they give banks access to cheap money, but low rates could cause a surge in inflation expectations and fuel asset price bubbles”

The crisis has shown the need for an authority that sets pre-emptive rules to make financial markets more resilient to systemic risk. But the danger lies in assigning this mandate without first defining the correct level of asset prices. The idea may be good on paper, but can run into enormous practical difficulties—building the right models, co-ordinating and data-sharing across agencies, obtaining information directly from banks, and so on.

My full post is here.

Capital controls are a great idea in theory. Problem is, they are almost impossible to enforce.

The issue with capital controls though is that it is very hard to gauge if they work in practice. The data show that for countries with a relatively open economy, capital account restrictions do not affect the amount of inflows, but do influence the distribution of flows. And that is where these controls make most sense. All capital flows are not equal. Some are more desirable than others; FDI and portfolio flows are preferable to debt, particularly short-tem debt. To discourage the build-up of foreign currency obligations, taxes on shorter maturity debt may push investors towards longer dates securities or equities.

Straight talk from Xu Xiaonian where he claims that “China is drinking tainted economic waters”

Mr Xu makes some very targeted criticisms that cut at the heart of China’s economic policies. First he says that China’s recovery was almost entirely based on government stimulus:

“I believe that the excessive credit supply of last year and the extremely loose monetary policy both resulted in recovery, which I regard as the result of squandering money. Whether the effects of squandering money will last depends on the government’s decision on whether to keep throwing money about.”

Next he discusses fundamental problems with the rebalancing notion:

“China’s economy has structural problems that cannot be easily solved by palliatives. Too much investment, too little consumption and purely relying on domestic investment and external demand-driven economic growth will no longer support sustainable development.”

And if this wasn’t enough, he takes on the policy-makers:

“Cantonese like the number eight because they believe the number is lucky. I have no idea why decision-makers in the government like the number eight when it comes to growth figures. What is their logic? Where is their evidence?”

Ouch.

Full post here.

Switzerland is surprisingly active in the currency markets 

WHEN talking about nations that have excess foreign exchange reserves, Switzerland probably wouldn’t be at the top of your list. It doesn’t fit the pattern that characterises the hoarders. It isn’t a developing economy, distrustful of large capital inflows or a rich oil-exporting country. Yet Switzerland is now the world’s seventh-largest reserve asset holder, after massive intervention in the currency markets by the country’s central bank.

But is it effective? Full post here.

Two questions. With the standard econometric preamble (holding all other factors constant…) 

1. Does one percentage point increase in the effective tax rate lead to a $1.8 billion decrease in annual private equity investment?
2. Does one percentage point increase in the effective tax rate lead to a 1.07% decrease in annual private equity investment?

First, the study uses a simple econometric model that regresses private equity investment on time and taxes. Clearly a host of other factors, prominently macroeconomic and industry specific, impact investment. By not accounting for these variables in the model, the parameter for the tax rate is a catch-all that may be biased.

Second, the figure of a “1.07% decrease in annual investment for a one percentage point increase in taxes” is based on a regression that is not statistically significant. So why include it in the analysis?

Finally, the last section of the report includes a table that measures growth in private equity investment in the four years before and after each tax change. Except, this includes periods in which tax rate on carried interest was probably not the most important consideration in making investment decisions. For instance, investment soared in 1997-2000 (with a lower tax rate), and 1999-2002 saw a drop accompanied, not surprisingly, by higher taxes. But it was probably the run-up to the dot com boom and the subsequent bust that drove investment rather than increased taxes.

The full post is here.

This month the Reserve Bank of India (RBI), the country’s central bank, celebrates its seventy-fifth anniversary. Officials at the bank have much to be pleased about. In the wake of the crisis in 2008, the RBI’s decisive actions to cut interest rates and arrest the fall of the rupee through a sale of $80 billion in foreign reserves helped the economy avert a significant slowdown. Latest estimates put the growth in 2009 at 7.2 percent, despite a poor monsoon. The bank’s conservative regulations on lending and capital reserves also protected the domestic banking sector from the excesses that plagued other financial institutions around the world. Yet the good news around the RBI’s handling of the crisis hides signs that the bank’s approach to monetary policy is increasingly outdated and is stifling the growth of India’s capital markets.

Consider the central bank’s view on capital inflows. After the Asian financial crisis, the RBI has taken a very cautious approach in allowing the flow of foreign funds into the country. But studies of emerging market crises have shown that rather than capital inflows themselves, it is the lack of a well-developed domestic financial system capable of channeling money efficiently that leads to crises. Instead of focusing on building institutions that can handle large inflows in a stable manner, the RBI has drawn the wrong lesson and continues to place barriers on the flow of foreign investments.

As an example, foreign investors are prevented from holding rupee denominated government debt and have ceilings on corporate bond investments. This fails to make much sense. Foreign participation can act as a catalyst for the development of local bond markets, by creating greater liquidity and diversifying the investor base. Capital controls are also leaky, and interested investors always find ways around regulations. But in doing so investors demand a higher return to account for the added annoyance, which translates to a higher borrowing cost for Indian institutions.