A brief review of China’s vulnerabilities

August 8, 2014

The IMF’s latest staff report on China serves as a reminder of key vulnerabilities. With repressed real interest rates corporate leverage remains high and particularly so in state-owned enterprises. Shadow banking has exceeded 50% of GDP and is still growing. Economic growth and credit quality are exposed to an unbalanced real estate sector. And the augmented fiscal deficit is already close to 7.5% of GDP, due mainly to local governments’ net borrowing through financing vehicles.

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A lecture in euro area money markets

August 2, 2014

Paul Mercier, principal adviser at the ECB, has summarized the basics and recent history of euro area money markets. His tale emphasizes what investors often miss. First, the ECB balance sheet and excess liquidity are poor measures of lending conditions. Second, the great financial crisis has generated a structural rise in banks’ borrowing from the Eurosystem, over and above their liquidity needs. Third, full allotment policies in conjunction with (sub-) zero deposit rates have led to large and potentially volatile excess reserve holdings.

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Updated summary: U.S. non-conventional monetary policy

July 26, 2014

The arrival of short-term interest rates at the zero bound has changed U.S. monetary policy irrevocably. The Fed’s asset purchases have exceeded a quarter of concurrent GDP over the course of 6 years, compressing term and credit premiums by unprecedented margins, with no reversal in sight. Forward guidance has reduced market uncertainty and raised the credibility of a persistently expansionary stance. Excess stimulus and economic conditionality have become prevalent. The flipside is increased dependency of the financial system on the continuation of such accommodative conditions.

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The 1×1 of financial repression

July 12, 2014

Financial repression is a policy that channels cheap funding to governments, typically supported by accommodative monetary policy. After the global financial crisis various forms of financial repression have prevailed in most developed and many emerging countries. These policies have been effective in containing public debt but bear risks for future financial stability.

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Volatility markets: a practitioner’s view

July 6, 2014

Christopher Cole argues that volatility markets are about trading both known and unknown risks. These risks require different pricing and cause different “crashes”. Most portfolio managers either hold implicit short volatility or long volatility positions. After the great financial crisis, monetary policy has suppressed volatility, but steep volatility curves are indicating a “bull market in fear”.

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The Federal Reserve’s reliance on macroprudential policy

July 5, 2014

In a recent speech Federal Reserve Chair Yellen has emphasized the economic cost of making financial risk a key consideration of monetary policy. While accommodative and non-conventional monetary policy may boost risk taking, enhanced regulation should secure financial system resilience and contain excesses. Only when macroprudential policy cannot achieve that goal should monetary policy step in. That time would not be now.

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The volatility paradox

June 29, 2014

Brunnermeier and Sannikov illustrate in a formal model why fundamental risk and asset market volatility can be out of sync. They focus on endogenous market dynamics, such as “collateral amplification” (the mutual reinforcement of credit conditions and asset values). These endogenous dynamics imply that [i] low-risk environments foster systemic risk, [ii] market reactions to negative fundamental shocks are non-linear (i.e. can become catastrophic when the shock is large) and [iii] financial market risk can de-couple from fundamental risk.

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Why governments have financial interest in higher inflation

June 21, 2014

With G7 public debt stocks at record highs, inflation has become a key fiscal concern. A new IMF paper estimates that a fall of inflation to zero would raise debt ratios by another 5-6%-points. A rise of inflation to 6% would lower debt ratios by 11-18%-points of GDP through real debt erosion. Inflation would offer additional fiscal benefits, such as higher revenues through “seigniorage” and progressive income tax tariffs.

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How human stress increases financial crisis risk

June 15, 2014

John Coates gives a neuroscience view on how human “stress response” can aggravate financial crises. Rising market volatility causes a bodily response in form of a sustained elevation of the stress hormone cortisol in traders and investors. This raises risk aversion and may contribute to institutional paralysis. Central banks’ policies aimed at keeping markets calm in normal times may weaken traders’ immune system.

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How statistical risk models increase financial crisis risk

June 14, 2014

Regulators and financial institutions rely on statistical models to assess market risk. Alas, a new Federal Reserve paper shows that risk models are prone to creating confusion when they are needed most: in financial crises. Acceptable performance and convergence of risk models in normal times can lull the financial system into a false sense of reliability that transforms into model divergence and disarray when troubles arise.

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