Archive

Monthly Archives: June 2015

On what might be the eve of capital controls in Greece – bifurcating the unified currency zone – I want to bring some attention to an 2008 IMF paper and literature review of the costs of sovereign default. The most interesting result is… well, I’ll let the authors speak for themselves:

Perhaps the most robust and striking finding is that the effect of defaults is short lived, as we almost never can detect effects beyond one or two years.

Of course, the paper is richly caveated and many of the regressions performed include Latin American countries which occupy a different role in world trade and the international financial system than Greece, not the least the dual dynamics of default and Grexit that complicate any simple analysis, especially given the beyond monetary interest implicit creditors (i.e. the ECB) have in maintaining the Euro.

The authors, Borensztein and Panizza, identify four primary casualties of default: reputation, freedom to trade, the domestic banking system, and the incumbent government. These can be measured by credit rating or spread, trade balance, currency dynamics, and political upheaval respectively. Their conclusion points to an important pattern in historical defaults (including voluntary restructuring) – they were necessary and, more importantly, markets agreed.

Necessary in contrast to strategic – whereby the government elects to shortchange its financial creditors instead of its political creditors on the expectation that the former will be more forgiving than the latter (such as pensioners who vote). Part of the question might be what qualifies as strategic, and we’ll get to that. For now, the question of Greek default can be captured as:

The “default point” for a sovereign should be the point at which the cost of servicing debt in its full contractual terms is higher than the costs incurred from seeking a restructuring of those terms, when these costs are comprehensively measured.

Here is where the Syriza negotiating position becomes tenuous. If we define strategic default as any default that could be avoided by another negotiating party that could realistically realize general support from the electorate, it’s not clear the Varoufakis argument that Greece has made 75% of the compromise and creditors ought to yield on the rest is correct. With over two-thirds of the population favoring a deal over “rift with Europe”, and approval ratings falling by some 35 percentage points since April – Syriza seems to be overplaying its hand with respect to how much more Greek’s are willing to give up.

This conversation should be divorced from your moral calculus of Greek’s obligation – whether that be from the Left that Greek’s have realized more peacetime austerity, unemployment, and pain than any other nation and cannot reasonably give up more or whether it be from the Right that it’s incredulous Greece can pay out pensioners and maintain living standards well above some implicit creditors like Latvia where living standards are lower. The only thing that matters is the divergence between what the government will give up and what the people are willing to give up – and the people seem to be saying “make that deal now”.

Syriza is, of course, well aware of this and hence delaying default to the latest extent possible (in hope of extracting a deal without further concessions). As the IMF paper suggests, this is generally not a good thing:

High political costs have two important implications. On the positive side, a high political cost would increase the country’s willingness to pay and hence its level of sustainable debt. On the negative side, politically costly defaults might lead to “gambles for redemption” and possibly amplify the eventual economic costs of default if the gamble does not pay off and results in larger economic costs. Delaying default might be costly for at least three reasons: (i) Non-credible restrictive fiscal policies are ineffective in avoiding default and lead to output contractions; (ii) Delayed defaults may prolong the climate of uncertainty and high interest rates and thus have a negative effect on investment and banks’ balance sheets; (iii) Delayed default may have direct harmful effects on the financial sector.

Many of the costs outline here seem to identify precisely the problem Greece is facing today – in extending its negotiation (gamble?) rather than defaulting. I’m an outsider. Maybe Varoufakis really thinks he can get his creditors to eat the rest of burden but it’s important to note here that this would still be default – at this point it really is only a question of partial versus complete default.

Europe really would want to accept this deal – partial capital loss would be much preferable to whatever restructuring Syriza would exact in the absence of a deal – but there is the natural concern of other peripheral countries asking for a similar deal. While I am more optimistic on Greece than some – like Larry Summers – I don’t fully share the confidence that most of the credibility problems would be gone in 2 years.

For one, let’s consider the third cost of default: freedom to trade. They divide this into two categories: (1) the emergence of retaliatory embargoes against defaulters and (2) the evaporation of trade credit necessary for importers to function. (1) is basically a theoretical concern at this point – something international macro papers use in their models but not a real or credible threat, especially with an EU country. (2), the authors find, doesn’t have a genuine long-run impact on existence of trade creditors.

I’d push back against this for Greece, and we don’t need to look further than 2012 to see why. In the first Euro crisis, trade credit insurers uniformly reduced their coverage of Greek debt on the risk that importers would still be obligated to repay their credit in Euros even when Greece gets on the drachma – and no one wants to be exposed to risk of external debt default. This is bad. Headlines such as “Greece Struggles To Keep The Lights On As Trade Credit Crunch Bites” weren’t figurative – energy exporters were no longer comfortable with Greek importers with the absence of trade credit insurance.

Therefore, unlike other countries which would default on their own currencies, Greece faces the legitimate struggle of feeding itself with baklava and olive oil – further escalating the political incentive to delay default.

You might reply that default need not imply Grexit and you might well be right, but that’s not the point. Default will with certainty bring about harsh capital controls on real and financial assets. A Euro in Greece will no longer be a real Euro and, unless importers have huge foreign balances with which to collateralize their purchases, the depreciation of the Greek Euro versus the Euro Euro will unleash similar dynamics on trade credit insurers as in 2011.

Unless, of course, investors have a credible schedule of when capital controls would be relaxed but if the government was in any position to give markets that relief it’s highly unlikely they would need capital controls in the first place.

But I’m less pessimistic than someone like Summers because my key reading of the IMF paper is that reputational costs remain small in the medium-term. If Greece defaults there’s no reason – after extensive depreciation of the drachma – why Greece couldn’t credibly commit to increasing revenues given the rapid external devaluation of its labor and obtain financing to scale those revenues and invest in, well, whatever.

I’m not as sanguine as Krugman, with his exception that he cannot think of “any examples that fit this story”. The trade credit disaster in 2011 is enough to provide one of an example of what might happen in a drachma world. And here economic recovery stands in one-to-one contrast with financial stability, i.e. to what extent can Greece dramatically undervalue the drachma.

If Greece defaults this will be the important dynamic it needs to figure out. One good bet might be to determine a drachma level that is sufficiently weak – but strong enough to finance highly price-inelastic imports such as energy inputs without entering into another fiscal death-spiral – and use its Eurosystem collateral (which would be expropriated in the event of default) to guarantee that level. By definition, there has to be an optimal level, and if Greece comes close enough to this, markets should have faith that it will defend against further devaluation. This would be a critical first step in reentering international debt markets.

There would be little margin of error here, as it works in the same sense that a one-time wealth tax “works” (as they are, in principle, the same thing). Further devaluation, or inflation that puts pressure on Greece’s FX reserves, could result in a currency crisis that is much harder to solve the second time around.

I’m not nearly an expert on the subject, but I imagine if the right thing happens, it will happen in the next 2 days. If and when Greece defaults and imposes capital controls it will always have been better, after the fact, for it to have happened before it actually did. Barclays noted that capital controls could provoke a political crisis bringing a moderate, Eurocrat party into power – “default without EA exit”, it wrote.

This might be necessary, if not sufficient, given the bargaining platform of Syriza – which seems to be leverage Europe’s commitment to the Euro and preference of partial over complete default to minimize its concessions – over a maximal commitment not to default. Krugman likes to denounce VSPs, but if default happens (as the IMF paper confirms) it is better it be supervised by a internationally credible party that would default only in the worst of circumstances.

Regardless who is in power, it will be prudent for the Greek government, if forced into default (i.e. involuntary restructuring), to offer a restructuring no worse than that to which it has already committed in negotiations – this may at least temper future market turmoil.

Advertisements

A few weeks ago I wrote about the unusually strong US net international position. I missed Brad Delong’s rejoinder:

Where Ashok Rao shies at the jump here is in failing to specify where he thinks the market failure is, and how to correct it. Is the demand by foreigners for safe dollar-denominated assets an improper one? And why today is it only the U.S. government–rather than, say, Apple or Wal-Mart–that can tap this funding source? Or is there a deeper problem in that Apple and Wal-Mart could tap this funding source but really do not want to–that they already have all the capital and funding that they think they can use? These are the questions that people are worrying…

I’m going to shoot at the hip here because the honest answer is that I’m really not sure.

To define the terms, I’m not really sure “market failure” is the right concept to think about here. We are talking about certain events led by single actors with a lot of agency and market power (foreign central banks, state owned exporters, finance ministry policy directives, among others). But we can begin to answer the question: are Treasuries unfairly valued given a concerted foreign interest in maintaining high dollar reserves.

There are multiple equilibria here, and that’s exactly what China doesn’t like. On the one hand, China (and its less reserve-oriented neighbors) would like to be free of the “dollar trap” – and yet any move that would motivate such a shift would open domestic central banks to incredible balance sheet risk. So the current equilibrium is maintained by foreign taxpayers who are unwilling to eat the fiscalized risk of prevailing monetary policies.

The next question becomes why aren’t other liquidity providers offering competition to the US Treasury (which, per my argument, would be “undersupplied” in some sense). The simple answer is US corporations with the credibility to offer safe, liquid debt are already sitting on piles of cash without any meaningful investment opportunities – they themselves are funders, and do not need any funding source. Moreover, for risk and liquidity reasons these bonds are undesirable from a central bank perspective. US Treasuries are traded 8-10 times as frequently as all AAA corporate debt, on a volume basis. The liquidity and risk is reflected in a historically high AAA10Y spread:

Screen Shot 2015-06-16 at 6.12.53 PM

The spread spiked in the late-1990s for the reasons previously outlined – Asian markets suddenly rocked by the instability of large external debts and low dollar reserves instituting policies to maintain defensive central bank positions. The mid-2000s decline is a little puzzling – as Asian countries continued to pour into Agencies and Treasuries – “reach for yield” hypotheses and a declining trade position might serve to explain the decline in spread – though this is still an open question.

The important point is that we’ve returned, and never really recovered from, the 1990s environment of relatively high spreads.

So the first question is whether this spread by itself is a “market” failure. From a Chinese perspective, I can’t answer the question – though I imagine the freedom to trade huge quantities without rattling the markets is part of the problem, especially since all AAA credit isn’t really securitized into a hyper-safe and hyper-liquid AAA tranche.

The simpler answer seems to be that people want the US government to be a bank. This is a role it fulfilled with glee in the mid-2000s – not just through its fiscal deficit, but the flurry of agency-backed mortgage origination which, in a foreign investors eye, was a guaranteed dollar deposit (the high liquidity basically means it was always callable). This is a role it didn’t play before 2002 and is one it hasn’t played since 2007. In a sense spreads are returning to the old normal in which the US government is refusing to be a bank. (Note this would also be politically hard to maintain without the guise of Agencies as it effectively requires the issuance of debt without any corresponding increase in spending or decreases in taxes).

In that case, there’s nothing fundamentally improper about the situation today – the big change isn’t an attitude from Asian central banks as much as the withdrawal of US liquidity provision thereof.

This doesn’t answer the question of whether Asian policy is correct, but it does make the question sort of irrelevant – foreign demand (i.e. the alleged global saving glut) isn’t what seems to matter here as much as the decrease in government-guaranteed securities. (Or, more accurately, in their expected stock some n years from now).

Here’s a tangential puzzle. Equity prices are relatively high (implying, given a constant risk preference, an increase in expected earnings growth rate) and yields are relatively low (implying, given a constant capital share of output, a decrease in expected earnings growth rate). So one of the “givens” must be incorrect. Yet if risk premium really fell meaningfully a number of previously unprofitable investments should be in the black, on the margin, encouraging further spending and borrowing by the Apples and Walmarts of the world. That’s not what happened. Maybe, as Tyler Cowen has prompted (if not advocated) to me, it was a fall in labor’s share – but that’s a decades-long process and probably can’t explain short-run dynamics.

More on this soon.

Steve Schwarzman has an op-ed more or less arguing that capital requirements magnify procyclical financial dynamics forcing banks to stop lending when the economy needs it the most. A lot of his points don’t seem wholly unreasonable – if a little unlikely, though we’re obviously talking about tail risk situations – though I find it implausible that this isn’t better than what we had before.

Regardless I want to offer a simpler framework to debate the topic. In short, we need market regulation of risk. This isn’t to say we need an unfettered free market as much as a market informed and credible policy towards regulation. In theory one could potentially achieve this by truly committing against any bailout. Actually achieving such a commitment seems impossible (short of a Rand Paul White House, Elizabeth Warren Senate, and Allen West House). Nothing I’m about to say is especially new, I’m sure it’s been written by a number of commentators before – but it is worth rehashing what a market-determined regulatory system would look like.

A pure market pricing of risk is hard, especially when noting that bank events don’t follow a normal distribution. (One could otherwise imagine banks facing a penalty if their CDS spread breaches a pre-set value). To keep it simple lets restrict acceptable capital to paid-in equity. The core of a market mechanism for regulation must somehow make it easy for a bank to issue equity in a liquidity crisis without paying a steep discount.

Of course there’s nothing free in this world and this discount must be financed by some haircut on the value of its debt as an insurance premium. Further, this discounting mechanism ought to kick in only in a “crisis” situation. One simple solution would require a bank to buy very far out of the money barrier puts on its shares struck at a reasonable measure of its value proportional to its risk-weighted debt.

“Reasonable measure” can be defined in any number of ways and doesn’t really change the theme of the framework. It could be a moving average of closing prices over the past two years. It could be some credible and formulaic measure of the capital it needs to finance its current liabilities. It could be some function of its price-to-book value. The measure doesn’t matter so long as it is well-correlated with general financial health, as the market will price and adjust for any relative discrepancies.

If the puts kick in at some predetermined, low fraction of the bank’s “reasonable value” it can sell its shares for a large premium to current prices – transferring wealth from insurers to shareholders in an elastic and predetermined manner. Because the number of puts it holds is proportional to its relevant, current liabilities, it can in principle finance itself through any liquidity shortages without systematic distortions.

Further, the maturity of the puts it sells should match one-to-one with the debt it issues (and hence, obviously, doesn’t work for deposits) – forcing the bank to constantly be cognizant that it finance its current liabilities without any problems.

These puts can even be traded between banks to stabilize and spread risk in an even and efficient manner. Since the writer of the put obligation owns the right to buy bank shares this – in a fundamental sense – represents high-quality equity (as they will be called upon only in the times when equity matters). So if the barrier kicks in at 50% of current value, and the bank’s “reasonable value” is its current value, the put represents (at worst) one share of the bank to its writer. (Since the bank would obviously sell it at a premium – though I still haven’t fully teased through this, it might be easier to consider as a convertibility clause though I’ll leave that for another post – in theory it really shouldn’t be very different. I can’t find it now but I think someone at either PIIE or AEI has written about this: links would be appreciated).

The government a requirement like the one outlined above would achieve three things:

  • Dampen (maybe even counter) procyclicality.  Banks are able to issue shares at a premium in bad times compared to a steep discount they would face today. It becomes easier to raise capital in a crisis relative to balance sheet than any other time. The worse the crash the bigger the premium.
  • Incentivize better risk allocation. Because banks are forced to buy puts that effectively gauge the probability the bank and financial system will fail to the extent that its share price falls below the barrier, they will actively mitigate risk in a manner convincing to markets (not just regulators) and hence be rewarded for prudence and punished for recklessness. Because of this, we wouldn’t need crazy Basal rules to judge “risk-weighted debt” and have meaningless Tiers of capital, as the market will discount each to the extent necessary. (And, so, limiting the actual procedure to equity capital doesn’t render the other stuff meaningless but channels their value through a simpler avenue).
  • Actively reduce the need for outside (government) assistance during a crisis.

This doesn’t mean relegating any genuine regulatory decisions to the market, but rather only helps government policymakers to focus on the questions that matter: not how various assets should be discounted by risk, but what role is the government willing to take in financial stability and when will it act. In this sense, we can sort of explicate the too-big-too-fail subsidy. Therefore government can make important decisions such as what “reasonable value” means, and the extent to which a bank needs to be able to finance itself in any situation (that is the high level situation we are trying to answer now, anyway, but this leaves the hard work up to the competence of the market).

The government can even play simpler but more powerful role – require banks to hold capital in whatever manner such that the option-implied probability of crisis (as defined over the barrier range) is below some, small n percent. Indeed, perhaps this should be the inspiration for such regulation: banks issue disaster puts on its stock and by government diktat must keep the price of these low enough to keep the probability of said disaster below a socially acceptable level (which could be determined by correlation of failure – that, again, is for another post).

Received wisdom among India watchers holds that gold imports are a threat to Indian economic development, the rupee, the current account, and everything else we hold economically dear. This fear manifested itself in an outright (if ineffective) ban for the better part of the country’s history post-Independence, and has more recently involved all sorts of quirky taxes and duties to prevent the import of gold.

A few things are clear. Indians are crazy about gold. Last year India overtook China as the world’s largest consumer, which was particularly detrimental to the official balance of payments, where gold was 3% of the country’s 4.7% trade deficit. This frenzy reached a point where, this April, an executive director of the RBI proposed a loony scheme of a government gold monetization plan arguing that the government wouldn’t invest the capital in other schemes as it would open itself to delta risk unless it is perfectly hedged (as, astonishingly, financial transactions tend to work…)

The Indian financial commentary hive mind would be better off understanding the systematic reason for gold imports (and fixing that) rather than obsessing over imports using terms that make little sense in this context, such as current account deficit. Even the Economist seems to completely miss the context of such “imports”:

Some argue that India’s gold imports should be reclassified as a capital flow, which would make the current-account deficit look less scary. But the official fear of gold is rational. Whatever the accounting treatment, money flowing out of India to buy bullion strains its balance of payments. And wealth stored in ingots or jewellery rather than bank deposits or shares is unavailable for investment. India’s household savings rate is high, but as much as half is now squirrelled away in physical form.

Pune’s wide boys aside, the traditional gold consumers are southern peasants buying jewellery. They have no access to formal finance; gold requires no paperwork, incurs no tax and is liquid. But over the past decade the mania has spread. By weight consumption has doubled, for several reasons: a surge in money earned on the black market; investors chasing the gold price; and the dismal returns savers get from deposit accounts. Real interest rates are low, reflecting high inflation and a repressed financial system that is geared to helping the state finance itself.

Unfortunately that’s just now how savings works (indeed, by identity, savings are investment – not necessarily business investment, but investment nonetheless and the heart of this debate is whether gold purchases imply deferred consumption and hence greater inventory accumulation, accounted for as investment in national income accounts). In fact, just reading the emphasized, there should be no fear of gold: since deposits seem to be highly oversubscribed and therefore a poor investment, gold seems like a fair alternative for store of value.

But let’s dispel fears of “money flowing out of India” first. Let’s say an Indian exporter sells canonical widgets to an American producer, receiving dollars in return. That is a current account inflow. It can do a few things with this income. Let’s explore three common alternatives:

  1. Reinvestment in US Treasuries,
  2. Purchase of gold, then repatriated to India (though physical location really doesn’t matter),
  3. Investment in India (let’s say a national infrastructure bond).

Surely the accounting effect of the first two options is the same. In the former case India is exporting capital directly to the US government and in the latter case it is exporting capital to the American bank from which it purchased its gold which is then recycling that capital back into the American economy. These are indisputable accounting relations that hold in every transaction.

Now the Economist wants to blindly compare (1) and (2) with (3) without detailing a third transaction in the process. Say the firm wants to “invest in India” and purchase government-issued bonds to build a high-speed rail service between Bangalore and Bombay. That would be rather noble of them, indeed. Unfortunately, having exported to a US firm, the firm has no INR with which to participate in this auction. Therefore, it first needs to identify a US exporter that sold goods to India and received INR in return. Even after it does this, and trades its USD for INR at USDINR, it’s not like investment in India suddenly improves – indeed the original INR was already invested in India in the first place. (Of course, this doesn’t mean both investments are equal and one might perform much better than the other. If this is your anti-gold argument I suggest you open a hedge fund shorting gold rather than writing for the Economic Times).

A household buying gold really is no different. It either has to buy it in rupees or dollars, but ultimately someone ends up with the rupee which is in some form invested in India. A current account surplus is a capital account deficit – that’s how these things work.

The question we’re implicitly answering is whether gold constitutes deferred consumption (investment) or not. To the extent there is a strong consumption aspect to gold (and there might well be) the fear is self-contradictory as it reflects nothing about inability to invest the savings as the Economist reports: indeed in this case these purchases wouldn’t be savings at all.

But the more likely situation is that gold does, in many ways, confer deferred savings and many other attributes of wealth including:

  1. A store of value,
  2. A source of liquidity – as gold-collateralized loans are an effective means by which an otherwise underbanked population can access financing,
  3. A source of wealth effect consumption increases.

Indeed the official fear about gold treats it as if it is a poor investment, which ipso facto means it shouldn’t be included in the current account. Even then, for many poorer Indians gold offers access to a banking system that otherwise requires 10th grade board exam results to borrow money at reasonable rates. Gold is an investment in an alternative source of financing to loan sharks that charge annualized rates north of 60% on a good day. Gold also doesn’t depreciate or perish. It might loose value but that is completely a capital loss.

This is a mistake that anyone who doesn’t understand why S = I might be prone to make. Business investment, i.e. a firm investing in machinery or platform development, isn’t the only form of investment. If I earn $1000 and place it under a mattress that is an interest-free investment in the form of deferred consumption (indeed if I burn it, it will be an investment to that amount rolled over in perpetuity, with an ultimate value of (1/discount rate)*1000).

This isn’t intuitive to most people. It’s very, very common to hear that gold is an unproductive investment or that “Americans are saving too much and not investing enough”. In fact, what they really mean to say is that interest rates as they stand are creating an investment situation in which an inefficient amount of funds are invested in very low return areas (such as inventory) and are not optimally productive.

In India this means opening up sources of safe, high quality investment allowing just the sort of liquidity transformation that finances the “development” everyone wants. In fact, if anything, gold import bans and taxes worsen the current amount by the premium one has to pay for smuggled gold, which in some part accrues to foreign smugglers and miners who have some claim on the delta between black market and open market gold. That is a pure current account loss and one which Indian policymakers need to address by removing import controls completely.