In a spin. A bearish perspective on the market in 2011

Dec 29th 2010 | from PRINT EDITION
Economist.com/blogs/buttonwood

BEFORE reality TV ruled the airwaves, the Saturday night schedules on the BBC would often feature a variety show with singers, comedians and novelty acts. One favourite was a man spinning plates on top of poles, an act that involved a lot of dashing about to avoid disaster.

Central banks have been performing a version of that act for the past three years. In 2008 they were racing around trying to save one bank after another, and were unable to prevent a few smashes. In 2010 the fragile plates were the sovereign countries of the euro zone. The authorities just managed to keep them intact.

But the loss of just one tiny saucer could result in a lot of broken crockery. The banks are still in a delicate state with many dependent on the European Central Bank (ECB) for finance. The advice of Walter Bagehot, a 19th-century editor of The Economist, was that central banks should lend freely in a liquidity crisis, against good collateral. But this support was supposed to be short-term, not continuous: a central bank should be an emergency room, not a hospice.

Indeed, for all the efforts of governments and central banks, many of the global economy’s long-term problems have yet to be solved. The banks are weak, the American housing market is still in the doldrums and the global imbalances have not gone away.

Just as the ECB bought time for European banks, rescues have been attempted for the struggling governments of Greece and Ireland. But these seem like temporary expedients: lending the countries money for extended periods at rates neither can afford. The packages have not been sufficient to calm the markets or stop the rot from spreading: 2010 ended with Fitch downgrading Portugal and putting Greece on negative rating watch.

The rest of Europe is now talking about imposing penalties on private-sector lenders in future rescues. That will turn each crisis into a game of chicken as bondholders sell before they get penalised. And financing packages do not deal with an underlying lack of competitiveness in many European economies. Without the ability to devalue, the restoration of competitiveness requires painful austerity measures and wage restraint.

That leads to another potential flashpoint for 2011: the lack of global co-ordination. Gone is the consensus seen at the G20 meeting in April 2009. Europe will be pursuing austerity, China is trying to rein in bank lending but America has opted for another fiscal stimulus. This is a throwback to pre-crisis 2007, with American deficit-financed consumption set against Chinese surplus-creating exports.

It seems certain that the Federal Reserve will continue to accompany fiscal stimulus with the monetary equivalent in the form of near-zero interest rates and further quantitative easing. The need for such extraordinary measures is an indication of how weak the economy continues to be. But while the developed world is still fighting off deflation, the developing world is worrying about inflationary pressures, with gold near $1,400 an ounce and oil back above $90 a barrel.

Easy monetary policy in America also creates the incentive for further speculative money to flow into emerging markets via carry trades and other strategies. That creates a dilemma for developing-country governments: they may want to head off inflation with higher interest rates but that would only encourage the speculators. Some have tried capital controls instead but it is not clear such measures are effective. Bubbles in emerging markets are likely to develop in 2011.

Whether all-out currency wars (in the form of trade protection) will emerge in 2011 is harder to tell. The aim of most developing countries is to prevent their currencies rising against the dollar at a faster pace than the Chinese yuan. Oddly enough, the European fiscal crisis eased some of the strains in late 2010: a weaker euro meant a stronger dollar.

But it is quite possible that the dollar could suffer another round of weakness in the coming year. After all, the currency has no yield support, a continuing trade deficit and the prospect of endless fiscal deficits. The sorry condition of municipal and state finances could yet be the trigger for a loss of confidence.

This list of problems is the reason why it is so hard for Buttonwood to join the bullish consensus for 2011. The authorities have kept the plates spinning by dint of an enormous effort and some unprecedented monetary measures. But the underlying problems have not been solved. And the law of gravity cannot be suspended for ever.

Economist.com/blogs/buttonwood

from PRINT EDITION | Finance and Economics

Chinese banks

Hole sale

Feb 25th 2010 | HONG KONG
From The Economist print edition

Capital calls by Chinese financial institutions elicit questions

THE bill for China’s bank-lending spree is coming due. An announcement on February 23rd by China’s fifth-largest lender, the Bank of Communications (BoCom), of a 42 billion yuan ($6.15 billion) rights offering, created a stir in Asian financial markets—not because it was unexpected, but because it represents the biggest fund-raising effort by a mainland company since the heady days of 2007.

The move follows similar announcements by two other Chinese financial institutions, the Bank of China and China Merchants Bank. Smaller institutions have also been busily raising money, either through initial public offerings or direct placements to state-owned industrial companies. All told, some 200 billion-250 billion yuan has been raised in the past six months, according to Bill Stacey, an analyst with Aviate Global, a Hong Kong brokerage firm.

At the very least the money is needed to offset a massive lending boom last year. To augment stimulus spending by the central government, China’s state-controlled banks expanded their balance-sheets by one-third, or almost 10 trillion yuan. An increase in loans inevitably requires an increase in capital in order to maintain prudent buffers. When expansion of credit occurs gradually, this can come from reinvested profits. When lending explodes as it did in China, fresh funds are a necessity.

By raising money, BoCom’s core Tier-1 capital ratio will jump from a barely adequate 8% to more than 10.4%. Believers in China’s banking system will say this not only fills the capital hole but creates room for yet more growth ahead. Sceptics will lean toward another conclusion, wondering whether the capital boost is an effort to get ahead of a massive surge in bad debts that will emerge from the remarkable surge in credit last year.

There is no hard evidence yet for this concern. Quite the opposite. Ratios tied to non-performing loans held by Chinese banks have been improving. But that is arguably a worry in itself: turbocharged credit creation rarely, if ever, comes without a cost. Anecdotal reports abound that regulators are requiring banks to put aside reserves for as much as 200% of non-performing loans, an egregious amount unless the underlying accounts are suspect.

Such opacity in book-keeping may have been common several years ago, say the system’s supporters, but is less feasible now because Chinese banks have been listed on exchanges, and so answer not only to the Chinese government but also to shareholders, who would not permit credit to be subject to political goals. Reports this week that Chinese banks have been told by their regulators to lend more to small businesses and less to the financing arms of local governments suggests that the truth is rather different.

The case for transparency in financial markets is not clear-cut

Feb 19th 2009
From The Economist print edition

Economics focus

Full disclosure

ITS promises are alluring, yet elusive; everyone, from politician to pundit, calls for more. In its recent report on financial reform, the Group of Thirty, a body of financial experts, mentioned it more than 30 times. Transparency is in vogue. Yet few ask whether it actually works.

Not long ago the cheerleaders of opacity were the loudest. Without privacy, they argued, financial entrepreneurs would be unable to capture the full value of their trading strategies and other ingenious intellectual property. Forcing them to disclose information would impair their incentive to uncover and correct market inefficiencies, to the detriment of all. And for years the so-called shadow banking system thrived, away from prying eyes. Then crisis hit, lending weight to the quip “What you see is what you get; what you don’t see gets you.” Few saw it coming, but if a lack of transparency was pervasive, how could they have?

As clear as mortgage-backed securities

“Sunlight is said to be the best of disinfectants,” wrote Louis Brandeis, later a Supreme Court justice, in 1913, and almost a century later his words have become a maxim. Yet transparency is amorphous; it can, frustratingly, be anything but transparent and, implemented wrongly, may harm the very interests it is supposed to serve. In financial markets, the word is nearly always equated with information disclosure. The trouble is that the information is often incomplete, irrelevant or outright incomprehensible. Subprime-mortgage-backed securities are a case in point. These instruments—whose value remains shrouded in mystery—can have prospectuses of about 500-600 pages, most of which are devoted to intricate legalese. Yet, inexplicably, they do not contain the information about individual loans that is needed to detect default risk.

Nor is transparency free. The Sarbanes-Oxley act, which partly restored confidence after the scandals of Enron, WorldCom and others, came at a cost—not only in terms of the burden of compliance it imposed on companies. In order to shield small firms, those with a stockmarket value of less than $75m were initially exempted. This created a peculiar incentive: at least one study suggests that firms just below the threshold began disbursing unusual amounts of cash to shareholders and making fewer investments. The act has also been accused of stifling risk-taking and increasing directors’ pay.

At its onset, the turmoil in financial markets was described as a liquidity crisis. And transparency and liquidity are close relatives. One enemy of liquidity is “asymmetric information”. To illustrate this, look at a variation of the “Market for Lemons” identified by George Akerlof, a Nobel-prize-winning economist, in 1970. Suppose that a wine connoisseur and Joe Sixpack are haggling over the price of the 1998 Château Pétrus, which Joe recently inherited from his rich uncle. If Joe and the connoisseur only know that it is a red wine, they may strike a deal. They are equally uninformed. If vintage, region and grape are disclosed, Joe, fearing he will be taken for a ride, may refuse to sell. In financial markets, similarly, there are sophisticated and unsophisticated investors, and unless they have symmetrical information, liquidity can dry up. Unfortunately transparency may reduce liquidity. Symmetry, not the amount of information, matters.

The good news is that transparency can work. When information is relevant, standardised and public, it fosters intelligent decision-making. Lenders, for instance, are required to quote interest rates as annual percentage rates, making loans easy to compare. Some behavioural economists call this “simplified transparency”, and think similar requirements should be imposed on complex financial products. Information must also be accurate as the credit-rating debacle shows: an AAA rating is harmful rather than helpful if it describes a CCC asset.

But politics impedes the ideal of transparency for at least two reasons. First, the benefits of transparency are widely dispersed among information users, whereas the costs are borne by few information disclosers; the disclosers therefore dominate the political process. Second, disclosure requirements are often drawn up after crises. They therefore tend to be hurried and haphazard, and support for them fades with memory of the hard times.

And even well-designed disclosure requirements may not suffice. People may make ill-informed choices, simplified transparency or not. In a recent study, two groups (made up of Harvard University staff) were asked to pick mutual funds. One group was given prospectuses which neatly summarised the funds’ objectives, risk profiles, costs and past performance in a few pages. The other group received the standard long-winded and hard-to-understand prospectuses. They nonetheless made nearly identical choices, opting for funds with good past performance and largely neglecting fees. Academic research suggests that people should do precisely the opposite.

Still, for all its difficulties, transparency is usually better than the alternative. The opaque innovations of the recent past, rather than eliminating market inefficiencies, unintentionally created systemic risks. The important point is that financial markets are not created equal: they may require different levels of disclosure. Liquidity in the stockmarket, for example, thrives on differences of opinion about the value of a firm; information fuels the debate. The money markets rely more on trust than transparency because transactions are so quick that there is little time to assess information. The problem with hedge funds is that a lack of information hinders outsiders’ ability to measure their contribution to systemic risk. A possible solution would be to impose delayed disclosure, which would allow the funds to profit from their strategies, provide data for experts to sift through, and allay fears about the legality of their activities. Transparency, like sunlight, needs to be looked at carefully.