Discrediting euro area crisis-driven austerity

February 23, 2013

Paul de Grauwe and Yuemei Ji have produced disarmingly simple charts that show why the euro area’s 2010-12 crisis response is being discredited. Essentially they illustrate that (i) market conditions rather than fundamentals have driven large absolute changes of credit spreads, (ii) fiscal tightening has been a mechanical response to credit spreads, and (iii) austerity has largely been self-defeating. Such evidence of failed excessive austerity dovetails anti-euro populism, underpinning euro area policy change towards more accommodation.

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On the risks of a new U.S. credit overheating

February 17, 2013

An interesting speech by Jeremy Stein emphasizes the ingrained tendency of financial institutions to boost earnings by selling tail risk insurance in forms not covered by covered risk measures and regulation. Hence, financial innovation, changes in regulation, and macroeconomic changes often result in credit market overheating through implicit subordination in conjunction with excessive maturity transformation. At present such tendencies may materialize in the rising share of low-grade credit issuance, the rapid expansion of agency mortgage REITs, and the increasing maturity of securities in bank portfolios. For the future, the expansion of collateral swaps and other forms of collateral transformation deserves attention.

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IMF reminder of incomplete euro area banking union

February 16, 2013

A new IMF Staff Discussion Note provides opinion and advice on the euro area banking union. It reiterates the urgent need for a single regulatory, resolution, and deposit insurance mechanism. The present legal and institutional reality falls well short of it and even last year’s adopted directives and plans only deal with the harmonization of rules and the creation of a single supervisory mechanism (SSM). A credible euro area-wide resolution and deposit insurance seems to be still a distant goal. The ESM’s ability to bear recapitalization losses, whether from “legacy assets” or not, remains uncertain.

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ECB summary of China’s imbalances and risks

February 9, 2013

The ECB’s new “due diligence” paper on China reiterates why severe imbalances are inherent in the country’s high-growth model. Without a fundamental overhaul the key imbalances, such as overinvestment, large state control, and financial repression are likely to persist. For now, supply side conditions suggest that this model may still deliver sufficient (8% or higher) GDP growth. Yet as trend growth will inevitably slow, severe tail risks such as “widespread corporate defaults, systemic banking sector stress and social unrest” are looming.

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How inventory levels affect commodity futures curves and returns

January 27, 2013

A new Review of Finance article investigates the link between commodity inventories on the one hand and futures returns and curve backwardation on the other. Most prominently, low inventories mean that the convenience yield of physical holdings is high (more need of insurance against a “stock-out”). In this case, producers and inventory owners are willing to pay a surcharge for immediate access to the physical. This will (normally) translate into a higher risk premium, more backwardation, and higher expected excess returns. Moreover, external factors, such as price volatility, can induce producers and physical inventory holders to pay a higher premium for future price certainty that translates into a positive basis and expected return on futures positions. The inventory connection explains why commodity futures returns and futures curve shape are correlated, i.e. backwardation is more often than not a profit opportunity. According to this paper, mainstream theory is backed by empirical evidence for 31 commodities over more than 40 years.

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Currency dynamicis in risk-off episodes

January 14, 2013
A new IMF paper suggests that there is much more to exchange rate dynamics in “risk-off” periods than correlation-driven risk shedding. Indeed, it provides evidence that economic fundamentals, particularly external balances, re-assert themselves precisely during the first twelve weeks after market turmoil has erupted, when the asking price for incremental economic and policy risk is steep.

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Risks related to central counterparties in derivatives markets

January 11, 2013

The large volumes of notionals and market values in OTC (rates and credit) derivatives markets have spurred a regulatory enhancement of risk buffers at banks. However, an IMF working paper by Li Lin and Jay Surti points out that no commensurate prescriptions apply to the two monopolistic central counter parties (CCPs) that clear a large share of the OTC derivatives market. This bears the risks that CCPs could become a medium of regulatory arbitrage of even systemic pressure.

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BIS on safe asset shortage and need for low real interest rates

January 6, 2013

A recent BIS working paper reminds us that the securitized credit and euro area sovereign credit crises have structurally diminished the world’s reserves of perceived safe assets. As safe assets are essential for institutional finance (pensions, insurances) and transactions (collateralization) their continued shrinkage would propagate a financial sector meltdown. This is why persistent negative real interest rates on sovereign and central bank liabilities are a critical stabilizer: they increase safe asset supply, reduce demand, and stabilize the finances of sovereign borrowers. Central banks play the lead role in sustaining this real rate compression, as they have often done in history.

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The tipping point in the Japanese government bond market

December 19, 2012

Low government bond yields (0.76% for 10-year maturity at present) allow Japan to preserve debt sustainability despite a gross debt-to-GDP ratio of over 220%. However, a working paper published (a while ago) by Takeo Hoshi and Takatoshi Ito argues that a tipping point may be ahead. Thus far yields have been kept low thanks to large domestic savings with a strong home bias and low returns in other assets. Under current trends, however, the nominal public debt stock will have reached the overall level of private sector financial assets by 2016. Meanwhile, attempts to reflate assets and stimulate the economy will raise the opportunity costs of holding government debt.

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