Friday, 31 October 2014

Goodbye QE, hello rate rises? Not so fast.....

 A Landmark - L.S. Lowry

My latest at Pieria debunks the notion - heavily promoted by hawkish analysts and impatient journalists - that the FOMC's announcement that QE has ended means that interest rate rises are imminent. And it raises a worrying question. The FOMC -and others - talk about "normalising" policy. But what does "normal" even mean? Is there such a thing as a "normal" setting for interest rates? We do not know.....

Read the post here.

Thursday, 30 October 2014

Germany's dark future

Inflation is falling fast in Germany. Today's figures show a fall in annualised CPI growth to 0.7%. And this is in the supposedly powerful core of the Eurozone. Out in the periphery, things are much worse.

But whereas disinflation or even outright deflation in periphery countries has little effect on Eurozone aggregate inflation, German disinflation is an entirely different matter. Thomson Reuters has helpfully produced a chart showing the relationship between German and Eurozone inflation:

Nicely correlated. In fact it is so well correlated that it is probably fair to say that ECB monetary policy is really determined by inflation expectations in Germany.

In the last year there has been some divergence because of the awful performance of Spain and Italy and the stagnation of France, which has led the ECB to attempt to introduce a credit easing programme against the wishes not only of the Bundesbank, but of German politicians. But although disinflation in Germany doesn't seem worry its politicians or its central bankers despite the consequences for the rest of the Eurozone, the threat of recession should:

Germany's exports to Russia have collapsed due to sanctions. This may of course only be a temporary problem: the German export machine is not going to be derailed by a few Russian difficulties. A much bigger problem is the slowdown in China, to which Germany is a major exporter of intermediate goods. Whatever the cause, Germany's exports have suffered a substantial drop:

More worryingly, industrial production figures for August showed a fall of 4%:

And factory orders fell off a cliff:

Ouch. No wonder investor confidence is falling:

But this is very bad news for a country where investment is already shockingly low and government is ideologically averse to spending money. The IMF's call for Germany to invest should be seen in the light of these awful figures. The wheels are coming off Germany's export-led, demand-deficient economy - and that is very bad news not only for Germany, but for Europe and indeed for the world.

The ECB has been accused of putting the interests of "profligate periphery countries" ahead of prudent German savers. But in fact it is trying to reflate the German economy through monetary stimulus. It is utter madness for German politicians and Bundesbankers to oppose this. They should back off and let the ECB do its job.

But it will take more than credit easing to sort out this mess. Germany desperately needs a change of stance from its fiscal authorities, too. Unless it invests in its own future, dark days lie ahead.

Related reading:

Should the UK be more like Germany? - Pieria
Fear the fear

Wednesday, 29 October 2014

Two very stressful posts

At Pieria, I deliver my verdict on the EU's stress tests. The ECB did a good job with the AQR, but the EBA's stress tests were not stressful enough.

And then I turn my attention to the UK's forthcoming stress tests. On Forbes, I complain that despite the Bank of England's intention to make its stress tests both more severe and more realistic, it fails on both counts. The UK's stress tests are just as flawed as the EU's.

Oh dear.

Saturday, 25 October 2014

Financial hurricanes

I recently wrote a post on Pieria about the (sizeable) role of the Eurodollar market in the 2007-8 financial crisis, or rather in the credit boom that led to the crisis. In order to explain the vast increase in transatlantic two-way flows (round-trips) from 1997 to 2007, I used this diagram from Hyung Song Shin's 2011 paper on the "global banking glut":

But there's a problem. This diagram appears to show that all money lent by both US and European banks came from US households. Where did they get their money? It wasn't wages. We know that US wages have been stagnating for two decades. No doubt some will suggest it came from Asian savers - the "global saving glut" that is apparently caused by thrifty Chinese households. But how could thrifty Chinese households provide US households with money? Most Chinese households save in yuan. It is Chinese government and corporations that lend to the US, and it is not households they lend to. Mainly, it is the US government. No, the "Asian savers" argument won't wash either. Where US households obtained the extraordinary amounts of money that crossed the Atlantic in the decade before the financial crisis is a mystery. It grew on trees, perhaps?

No it didn't. It came from banks. To show this, I've produced a diagram of my own:

Shin's diagram is a "loanable funds" model, whereas mine is endogenous money. Note the two-way flows. Property (and derived securities) flow clockwise: money flows anti-clockwise. The red lines are the two regulatory boundaries: US (Basel I) and Europe (Basel II). The gap between them contained not only the Atlantic, but most of the shadow banking sector.

In my diagram the flows can start anywhere. All actors in this diagram should properly be regarded as part of the "pump" that maintained the two-way flow. In my earlier post I suggested that the principal driver of the pump was regulatory arbitrage by banks between the Basel I and Basel II regimes, with the shadow banking sector and money market funds facilitating. But the desire of borrowers for loans and households & corporations (particularly construction companies) for property sales are important too. Without these, the US banks would have lent much less and the European banks would have had much less funding.

However, although this is a circular flow, the quantities of money and property/securities circulating are not constant. As the money flows around this model, it expands: and correspondingly, property and securities also expand.

Money was created by US banks when they lent. The "Loans" arrow at the left hand side is always new money. Similarly, money was created by European banks when they purchased securities. The "Payment" arrow at the top right hand side is also new money.

Lending against property created not only new money, but also new securities. The loans were sold by US banks to securitizers, who pooled them, tranched them and created new securities, which they sold into the capital markets. In the "shadow banking" box is not only the securitization process itself, but also rehypothecation and leveraging of the ensuing RMBS products. The value of the securities that came out of the other side of that box was far higher than the value of the loans that went into it. The "Payment" arrow was enlarged both by the ability of European banks to create new money AND the ability of the shadow banking sector to leverage up property-backed securities.*

So the Eurodollar transatlantic flows grew enormously in the decade before the financial crisis, both money and property-backed securities. US lending against property expanded enormously, and there was as a result a construction bubble - the "Property" arrow at the bottom left-hand side itself expanded. But it expanded less than the other arrows. Most of the expansion of money was absorbed in price rises.

Normally, we would expect such a massive expansion of credit to have caused consumer price inflation to rise significantly. But it didn't. This period is known as the "Great Moderation", when consumer price inflation remained low and stable. For me, this is where the "Asian savers" theory gains traction. But the "savers" were not thrifty Chinese households. They were Asian governments, scarred by the Asian financial crisis of 1997 and anxious to protect themselves from damaging flows of capital by building up foreign exchange reserves. Instead of borrowing from Western countries, as they have done in the past - and suffered for it - they exported to them. I have observed before that the "Great Moderation" in the West is paralleled by the "Great Expansion" in the East. I would go further: I think it was caused by it. The massive expansion of low-cost imports to the West depressed consumer price inflation even though spending was increasing as a result of the credit bubble. I would venture to suggest that had there not been a credit bubble, this would actually have been a period of deflation. The stagnation of wages in many Western countries supports this line of argument.

Having said that, it is also clear that spending didn't increase as much as might have been expected. Spending would be a "leak" from the two-way flow in the diagram, reducing the flow and dampening the leverage. But most of the money seems to have stayed within the flow, driving up house prices to an unsustainable level.

Toxic cross-border feedback loops come in many kinds. This was a property-based one. The yen carry trade was a currency-based one, and once again, when it abruptly reversed the consequences were disastrous - although I don't think it was the sole cause of the financial crisis, it was certainly a significant contributor. Capital flows into Eurozone periphery countries prior to 2012 were a similar leveraging cross-border flow system that failed disastrously. So were the capital flows into Asian economies that reversed abruptly in 1997, causing the Asian crisis: I think QE-driven capital flows into emerging markets exhibit similar characteristics, and policy makers should be on their guard. Nor are these flow systems a new phenomenon: going back further, the Latin American debt crisis of the 1980s was the disastrous consequence of the failure of an enormous oil-based leveraging cross-border flow system.

It is difficult to see how conventional monetary policy could have dampened this leveraging cross-border flow without causing outright deflation in domestic consumer prices. And I would add that attempting to interrupt the flow once the system was fully developed - for example, by imposing capital controls - would have been dangerous. All the players in this game depended on the flow continuing. When it was suddenly interrupted, first in 2007 with the freezing of the ABCP market (top RH corner "Funding" and "Securities (collateral) arrows) and secondly in 2008 with the fall of Lehman (collapse of "shadow banking" box) followed by Reserve Primary breaking the buck (failure of "money market funds" box), the results were disastrous. All the players suffered, and many of them failed.

Policy makers need to watch for the formation of cross-border leveraging flow systems and act EARLY to dampen them. This requires international cooperation, of course: it is depressing that so far the only central banker who seems to have recognised the importance of global monetary policy coordination is India's Raghuram Rajan. It is also unfortunate that there is still no internationally-agreed approach to regulation of the financial system. But worst of all, fiscal authorities don't seem to see any need at all for coordination of national objectives. These flow systems are driven as much by competitive and nationalistic fiscal policy as they are by uncoordinated monetary policy and regulatory arbitrage.

Cross-border leveraging flow systems of the kind I have illustrated above are the storms and hurricanes of the financial system. We ignore them at our peril.

Related reading:

When the Nile floods fail
European banks and the global banking glut - Pieria
Currency wars and the fall of empires - Pieria

* I should emphasise that this diagram ONLY shows the Eurodollar flow. European banks were not the only purchasers of US RMBS and derivative products.

Friday, 24 October 2014

Bulgarian Stalemate

The latest in the Bulgarian bank saga. The audit report on Corporate Commercial Bank is out. It's very grim reading, but does that mean the bank will be closed down? Not necessarily.....

Find out more here. (Forbes)

Wednesday, 22 October 2014

Hypo Alpe Adria: the small bank at the centre of some very big storms

Two posts that centre on the troubled Austrian bank Hypo Alpe Adria. For a small bank in a small country, it is causing an AWFUL lot of trouble.

Firstly, the ongoing saga of HAA's Balkan network, which the Austrian government is attempting to sell. As the bidding enters its final stages, it becomes apparent that the eventual owner will be determined more by politics than money:
The present tension between the EU and Russia creates a difficult dilemma for the Austrian authorities. On the one hand, they should get the best deal for Austrian taxpayers, which would imply that they should accept the higher bid even though it involves a sanctioned Russian bank. On the other hand, allowing a sanctioned Russian bank to buy financial companies in the Balkans would seem contrary to the spirit if not the letter of EU sanctions....
Despite my earlier warning, a consortium backed by a sanctioned Russian bank is still in the running to buy HAA's Balkan network. Read about it here

Secondly, there is the little problem of HAA's subordinated debt and those Carinthian guarantees, about which I have previously written. Let the lawsuits begin! Oh wait, they already have:
So we now have two BayernLB-HAA lawsuits, not one: a petition to the Austrian Constitutional Court regarding the expropriation of 800m Euros of Carinthian-guaranteed loans, and a case in the Munich District Court regarding the non-payment of about 1.5bn Euros. Together, these amounts make up the 2.35bn Euros BayernLB was seeking to recover in the earlier lawsuit.
But BayernLB isn't the only actor in this drama. Dear me, no. We have the World Bank involved in a pari passu saga that could rival Argentina, a lovely spat between Germany and the EU over state aid rules, and the possibility that Germany may have to throw BayernLB to the Austrian wolves in order to recapitalize other Landesbanken after the ECB's stress tests. All documented in my latest post at Forbes.

Friday, 17 October 2014

European banks and the global banking glut

My latest post at Pieria considers the sizeable role of the Eurodollar market in the unsustainable growth of credit that led to the 2007-8 financial crisis. 
In a lecture presented at the 2011 IMF Annual Research Conference, Hyun Song Shin of Princeton University argued that the driver of the 2007-8 financial crisis was not a global saving glut so much as a global banking glut. He highlighted the role of the European banks in inflating the credit bubble that abruptly burst at the height of the crisis, causing a string of failures of banks and other financial institutions, and economic distress around the globe. European banks borrowed large amounts of US dollars through the money markets and invested them in US asset-backed securities via the US's shadow banking system. In effect, they acted as if they were US banks, but in Europe and therefore beyond the reach of US bank regulation......
What was it that drove the expansion of the Eurodollar market and encouraged European banks to leverage up with US mortgage-backed securities?

Read the post here.