WILL Greece default on its debts and leave the euro? Will Britain decide to leave the European Union? Politicians in the two countries have threatened, implicitly or explicitly, to take these drastic steps if their European colleagues do not offer them inducements to stay.
Many people regard these threats as a bluff. They think that Greece does not really want to leave the euro, and that David Cameron, Britain’s prime minister, does not want his country to exit the EU. When push comes to shove, Greece will do a deal (see article) and Mr Cameron will persuade British voters to stay in the EU in his planned referendum. But there are risks that neither outcome will turn out as planned. In both cases, political leaders are making a risky bet.
The financial analogy is with writing (selling) an option. In the markets, an option is the right to buy (a call) or sell (a put) an asset at a given price; say shares of Apple at $130. In return for granting the buyer of the option this right, the writer receives a payment called a premium, rather like an insurance company receives a premium for protecting a homeowner against fire or theft. But if Apple shares do rise above $130, the buyer of a call option is likely to exercise it, to the writer’s cost; if they fall below it, the holder of a put option is likely to cash in.
Political leaders in Greece and Britain have in effect written an option on exit. The premium they receive is political popularity—for opposing the demands of international creditors, in the case of Greece, or for asserting Britain’s sovereignty, in Mr Cameron’s.
But in the financial markets, option-writing is a very risky strategy, unless the position is properly hedged. A lot of small profits can be earned from the option premia, only for all the gains to be wiped out when an option is exercised at an unfavourable time. Of course, the buyer of an option is most likely to exercise it when the cost to the writer is greatest.
For the political leaders of Greece and Britain, the difficulty is that they do not get to decide whether the option gets exercised. The other nations within the euro zone and the EU may decide to call Greece or Britain’s bluff. In Britain, the electorate also has the right to exercise the option of exit—which they might use in the referendum to protest against government policies in general rather than voting on the merits of EU membership in particular.
This leads to some complex calculations. Unlike Apple’s shares, the price of Grexit or Brexit at any moment is highly uncertain; political leaders cannot be sure what the costs and benefits will be. So this is rather like an option on one of the complex securities that proliferated before 2007—a collateralised debt obligation based on subprime mortgages, for example. The uncertainty makes it less likely that Europe will exercise the option and risk the departure of Britain or Greece.
If that gives the bluffing states an advantage, they also face a difficult trade-off. The more intransigent their demands, the more they may please their electorates (ie, the greater the “option premium”). However, such intransigence may make it more likely that the option will be exercised. European leaders may feel that making too many concessions to Greece or Britain will simply encourage other countries to make similar demands, and thus destroy the European project. In Britain, there may be a huge gap between the expectations fostered during the negotiating process and the reforms that emerge. This may create the impression that the government has failed, making the public more inclined to vote for exit.
This discrepancy between the high-flying nature of political promises and the mundane reality of policy outcomes lies at the heart of recent voter discontent. Promises may result in short-term electoral success but at the cost of increasing disillusionment in the long term. The most significant short-term influences on growth—the oil price, Federal Reserve policy, China’s success in managing its economic growth—are outside the control of European politicians. National leaders are, in effect, bluffing when they say their own policies can make much difference.
Europe’s failure to generate much in the way of economic or wage growth over the past decade means that voters are not just turning against the parties in power—they have lost faith with the mainstream opposition as well. The effect can be seen everywhere, from the rise of Marine Le Pen in France to the emergence of brand new parties like the Five Star Movement in Italy and Podemos in Spain. Years of short-term gains for the mainstream parties have resulted in a long-term loss.
Source: http://www.economist.com/news/finance-and-economics/21652362-when-political-leaders-turn-option-writers-economics-bluffing
Showing posts with label euro. Show all posts
Showing posts with label euro. Show all posts
Friday, May 29, 2015
Wednesday, January 21, 2015
Switzerland's monetary policy: The three big misconceptions about the Swiss franc
ON THURSDAY January 15th Switzerland’s central bank, the Swiss National Bank (SNB), removed the cap on its currency, which it had imposed over three years ago and reaffirmed only three days before its repeal. The doffing of the cap surprised and upset the foreign-exchange markets, hobbling several currency brokers, including Alpari (which happens to sponsor the London football team I support). Many commentators nonetheless welcomed the cap’s removal, arguing that the policy was either unsustainable, protectionist or risky, exposing the SNB to grievous losses. I find these criticisms of the cap unconvincing—and not just because I am a West Ham United fan. Let me address each of them in turn.
Misconception 1: The cap on the Swiss franc was unsustainable
Exchange-rate pegs often fail. To prop up its currency, a central bank might have to buy large amounts of its own money in exchange for dollars or euros. Eventually, it will exhaust its hard-currency reserves forcing it to abandon its peg.
The first thing to understand about the Swiss drama is that it is the exact opposite of this more familiar case. The Swiss central bank was trying to keep its currency down not prop it up. To achieve this goal, the SNB had promised to sell as many Swiss francs as necessary (in exchange for “unlimited quantities” of foreign currency). The promise was credible, because a central bank can print its own currency without limit. It cannot run out of its own money to sell. The cap was, therefore, sustainable if the SNB had wished to sustain it.
If a central bank overworks the printing press, its money will eventually lose value, of course. Inflation and depreciation set a limit on the power of central banks. But the Swiss had imposed the cap precisely because they wanted to raise domestic inflation from dangerously low levels (consumer prices fell by 0.3% in the year to December 2014, according to the Federal Statistics Office). Persisting with the currency cap might have pushed up prices. But that is no objection to the policy; on the contrary, it was the objective of it.
Misconception 2: The Swiss central bank needed to worry about big losses on its euro holdings
The second misconception is less basic. Every economist knows that a central bank cannot run out of its own currency. But many believe the Swiss cap was unsustainable for a different reason.
If the SNB had stuck with its cap, buying as many euros as people were willing to sell at its set price of 1.20 Swiss francs, its holdings of the single currency would have swollen in size. By the end of September 2014, it already held over €174 billion, according to its balance sheet. With the single currency weakening in anticipation of further monetary easing by the European Central Bank, this hoard was likely to grow to epic proportions.
Perhaps because I live in Hong Kong, where the monetary authority’s foreign assets amount to over 120% of the economy’s annual output, big central-bank balance sheets don’t scare me. But others worry. They point out that if the franc were ever permitted to rise against the single currency, the Swiss central bank would suffer an enormous loss on its euro assets. Euro holdings worth, say, 240 billion francs at the capped exchange rate would be worth 40 billion less in the Swiss currency if it rose by 20%.
If the loss were big enough, the central bank’s assets (which include its euro holdings) might end up being worth less than its liabilities (which are overwhelmingly in its home currency). The central bank, known until last week for its quiet conservatism, would be technically insolvent.
That would be a little awkward. It would not be easy to explain the central bank’s predicament to its shareholders, who include the Swiss cantons, or to unsympathetic political parties, such as the Swiss People’s Party—which has already sponsored an unsuccessful referendum to force the SNB to hold at least a fifth of its assets in gold.
But although insolvency is humbling for a central bank, it is far from crippling. “Central banks may operate perfectly well without capital as conventionally defined,” pointed out Peter Stella in a working paper published by the International Monetary Fund back in 1997. Central banks cannot go bust in the way that a commercial bank can. They can always pay their bills, because they print the money they owe.
Their debts are also peculiar. The SNB’s liabilities are chiefly Swiss francs. For the most part, as its balance sheet shows, they take the form of simple banknotes or the deposits that commercial banks hold at the central bank.
The franc, like all fiat money, is not backed by anything tangible. People accept it as payment because they are confident other people (including the tax authorities) will accept it. Try to redeem a banknote at the central bank and all you will get is a newer banknote. That is all that a central bank’s liabilities promise: I owe you an IOU.
These debts are also uniquely easy to service. Banknotes pay zero interest. Deposits at the SNB now yield even less than that: depositors pay the central bank, not the other way around.
Central banks do not, then, have to worry much about satisfying their creditors. Nor are they judged by the returns they earn for shareholders. They are judged by their ability to keep inflation in check and the financial system stable. Their balance sheet—the size and mix of their assets and liabilities—is important insofar as it serves that mission. It is a macroeconomic tool, not a statement of financial success or failure.
The SNB itself understands this. After it reported big losses on its foreign-exchange holdings in 2010 and early 2011, it faced doubts about its financial strength. Some people speculated that it might eventually suffer from negative net worth (also known as “negative equity”). In a 2011 speech, Thomas Jordan, who now heads the institution, answered these concerns directly.
“Might the SNB lose its capacity to act as a result of a negative equity level? And, if its equity were negative, would the SNB have to be recapitalised, or might it even have to go into administration?...[T]he short answer to all these questions is ‘No’.”
If the SNB ever became insolvent, it would not be the first central bank to suffer such an indignity. The Czech central bank and the Bank of Chile, among others, functioned perfectly well for years with liabilities that exceeded their assets.
Some economists argue that negative net worth is damaging for other reasons. It undermines a central bank’s “institutional credibility”, even if it doesn’t impair its day-to-day viability. These economists worry that a broke central bank might compromise its independence by going cap in hand to the government, asking to be recapitalised. Or it might print currency willy nilly to cover its losses and earn its way out of its financial hole. Either response would damage its standing as the guardian of the nation’s money.
But these worries hardly apply to the SNB. It has suffered losses (now and in the past) because its currency has strengthened, a reflection of the confidence foreigners place in it. If anything, “institutional credibility” is a cause of its balance-sheet problem not a potential casualty of it. Right now, the Swiss National Bank’s ability to prevent inflation is not in doubt. What is in doubt is its ability to create it.
Besides, a central bank’s financial strength is not ultimately the source of its operational independence. If a society is not, on balance, committed to price stability, the central bank will struggle to achieve it, no matter how strong its balance sheet. By the same token, if inflation is sufficiently unpopular, the state will give its central bank the leeway it needs to prevent it. That remains the case even if the central bank needs recapitalising once in a while.
Misconception 3: The cap was protectionist
When the SNB imposed the cap back in September 2011, the Swiss franc was strengthening fast, bid up by “refugee-capital” seeking a safe haven from the eurozone’s troubles. The strong franc made Switzerland’s upscale goods even pricier abroad, damaging its exporters’ competitiveness.
The cap put a stop to that. It thus drew criticism from economists worried about the impact on Switzerland’s trading partners. Ted Truman of the Peterson Institute for International Economics has described the cap as “openly protectionist”. According to other commentators, the cap contributed to the “currency wars”, in which countries try to seize market share from each other by weakening their exchange rates. By removing the cap, Switzerland was acting like a “good world citizen”, according to Dean Baker of the Center for Economic Policy Research, giving an “economic boost” to other countries that will enjoy healthier trade balances as a result.
When the SNB introduced the cap, it was indeed concerned about the “massive overvaluation” of the Swiss franc. Safe-haven flows were driving up the currency, displacing its manufacturers, just as oil or gas earnings can hollow out a country’s industrial base. The Swiss cap was helpful in preventing Dutch disease.
But the central bank’s main motivation for imposing the cap was not protectionism. It was trying instead to avert the risk of deflation. In keeping the currency down, it was trying to drive prices up. This ambition to raise prices is at odds with the notion that it was seeking to protect Swiss exporters. Because in raising inflation, the SNB would have reduced Switzerland’s competitiveness (all else equal) not sharpened it. If an exporter’s local prices and wages go up, it becomes less competitive abroad, even if the exchange rate remains the same.
Currencies, it is fair to point out, move much faster than goods prices or wages. So although inflation would have eroded the competitiveness of Swiss exporters eventually, it would have taken time. Currency appreciation, on the other hand, worked with brutal speed.
In seeking gradual inflation rather than abrupt currency appreciation, the SNB was therefore helping the country’s exporters. But in doing so, it was not defying fundamental market forces. It was instead choosing to expose exporters to one set of market forces rather than another: the sluggish forces of the goods market, rather than the bone-shaking forces of the foreign-exchange market. Neither market is perfect. The goods market is bogged down by inertia, transaction costs and long-term contracts that inhibit price flexibility. The currency markets, on the other hand, are swayed by bouts of speculation and skittishness. Neither does an unimpeachable job of setting an economy’s terms of exchange with the rest of the world.
In practice, there is an easy way to tell the difference between the SNB’s policy and that of the “currency warriors”, mercantilist central banks that suppress their exchange rates for competitive gain. Like the SNB, the currency warriors buy dollars or euros to keep their currencies cheap. In so doing, they create additional local money, just as the SNB did. But unlike the SNB, they “sterilise” their interventions, withdrawing this extra money from circulation (either by selling other assets or raising reserve requirements on banks). This prevents prices from rising, thus preserving the competitive advantage their cheap currency provides.
The SNB was not waging this kind of warfare. In printing francs it was keeping its currency down but not its prices. If its policy had hurt its trading partners, they were free to retaliate by printing more money themselves. This tit-for-tat monetary easing would not have resulted in a zero-sum scramble for a fixed amount of global demand. It would instead have helped to increase world demand, in a process of mutually-assured reflation.
The Swiss policy was not, then, protectionist in intent, nor was it unsustainble. It exposed the Swiss National Bank to a loss of face, but not to a financial loss of any great economic consequence. I believe currency pegs remain a legitimate monetary choice—as long as central banks allow prices to adjust accordingly—if not always a wise one. I also think the removal of the Swiss cap was unnecessarily disruptive. The SNB must now find a new way to fend off deflation. And West Ham must find a new sponsor for its kit.
Disclaimer: This article does not represent investment advice or any kind of professional counsel, nor does it represent an offer to buy or sell securities or investment services. The opinions, which are subject to change, are those of the author not BNY Mellon Investment Management.
Source: http://www.economist.com/blogs/freeexchange/2015/01/switzerlands-monetary-policy
Misconception 1: The cap on the Swiss franc was unsustainable
Exchange-rate pegs often fail. To prop up its currency, a central bank might have to buy large amounts of its own money in exchange for dollars or euros. Eventually, it will exhaust its hard-currency reserves forcing it to abandon its peg.
The first thing to understand about the Swiss drama is that it is the exact opposite of this more familiar case. The Swiss central bank was trying to keep its currency down not prop it up. To achieve this goal, the SNB had promised to sell as many Swiss francs as necessary (in exchange for “unlimited quantities” of foreign currency). The promise was credible, because a central bank can print its own currency without limit. It cannot run out of its own money to sell. The cap was, therefore, sustainable if the SNB had wished to sustain it.
If a central bank overworks the printing press, its money will eventually lose value, of course. Inflation and depreciation set a limit on the power of central banks. But the Swiss had imposed the cap precisely because they wanted to raise domestic inflation from dangerously low levels (consumer prices fell by 0.3% in the year to December 2014, according to the Federal Statistics Office). Persisting with the currency cap might have pushed up prices. But that is no objection to the policy; on the contrary, it was the objective of it.
Misconception 2: The Swiss central bank needed to worry about big losses on its euro holdings
The second misconception is less basic. Every economist knows that a central bank cannot run out of its own currency. But many believe the Swiss cap was unsustainable for a different reason.
If the SNB had stuck with its cap, buying as many euros as people were willing to sell at its set price of 1.20 Swiss francs, its holdings of the single currency would have swollen in size. By the end of September 2014, it already held over €174 billion, according to its balance sheet. With the single currency weakening in anticipation of further monetary easing by the European Central Bank, this hoard was likely to grow to epic proportions.
Perhaps because I live in Hong Kong, where the monetary authority’s foreign assets amount to over 120% of the economy’s annual output, big central-bank balance sheets don’t scare me. But others worry. They point out that if the franc were ever permitted to rise against the single currency, the Swiss central bank would suffer an enormous loss on its euro assets. Euro holdings worth, say, 240 billion francs at the capped exchange rate would be worth 40 billion less in the Swiss currency if it rose by 20%.
If the loss were big enough, the central bank’s assets (which include its euro holdings) might end up being worth less than its liabilities (which are overwhelmingly in its home currency). The central bank, known until last week for its quiet conservatism, would be technically insolvent.
That would be a little awkward. It would not be easy to explain the central bank’s predicament to its shareholders, who include the Swiss cantons, or to unsympathetic political parties, such as the Swiss People’s Party—which has already sponsored an unsuccessful referendum to force the SNB to hold at least a fifth of its assets in gold.
But although insolvency is humbling for a central bank, it is far from crippling. “Central banks may operate perfectly well without capital as conventionally defined,” pointed out Peter Stella in a working paper published by the International Monetary Fund back in 1997. Central banks cannot go bust in the way that a commercial bank can. They can always pay their bills, because they print the money they owe.
Their debts are also peculiar. The SNB’s liabilities are chiefly Swiss francs. For the most part, as its balance sheet shows, they take the form of simple banknotes or the deposits that commercial banks hold at the central bank.
The franc, like all fiat money, is not backed by anything tangible. People accept it as payment because they are confident other people (including the tax authorities) will accept it. Try to redeem a banknote at the central bank and all you will get is a newer banknote. That is all that a central bank’s liabilities promise: I owe you an IOU.
These debts are also uniquely easy to service. Banknotes pay zero interest. Deposits at the SNB now yield even less than that: depositors pay the central bank, not the other way around.
Central banks do not, then, have to worry much about satisfying their creditors. Nor are they judged by the returns they earn for shareholders. They are judged by their ability to keep inflation in check and the financial system stable. Their balance sheet—the size and mix of their assets and liabilities—is important insofar as it serves that mission. It is a macroeconomic tool, not a statement of financial success or failure.
The SNB itself understands this. After it reported big losses on its foreign-exchange holdings in 2010 and early 2011, it faced doubts about its financial strength. Some people speculated that it might eventually suffer from negative net worth (also known as “negative equity”). In a 2011 speech, Thomas Jordan, who now heads the institution, answered these concerns directly.
“Might the SNB lose its capacity to act as a result of a negative equity level? And, if its equity were negative, would the SNB have to be recapitalised, or might it even have to go into administration?...[T]he short answer to all these questions is ‘No’.”
If the SNB ever became insolvent, it would not be the first central bank to suffer such an indignity. The Czech central bank and the Bank of Chile, among others, functioned perfectly well for years with liabilities that exceeded their assets.
Some economists argue that negative net worth is damaging for other reasons. It undermines a central bank’s “institutional credibility”, even if it doesn’t impair its day-to-day viability. These economists worry that a broke central bank might compromise its independence by going cap in hand to the government, asking to be recapitalised. Or it might print currency willy nilly to cover its losses and earn its way out of its financial hole. Either response would damage its standing as the guardian of the nation’s money.
But these worries hardly apply to the SNB. It has suffered losses (now and in the past) because its currency has strengthened, a reflection of the confidence foreigners place in it. If anything, “institutional credibility” is a cause of its balance-sheet problem not a potential casualty of it. Right now, the Swiss National Bank’s ability to prevent inflation is not in doubt. What is in doubt is its ability to create it.
Besides, a central bank’s financial strength is not ultimately the source of its operational independence. If a society is not, on balance, committed to price stability, the central bank will struggle to achieve it, no matter how strong its balance sheet. By the same token, if inflation is sufficiently unpopular, the state will give its central bank the leeway it needs to prevent it. That remains the case even if the central bank needs recapitalising once in a while.
Misconception 3: The cap was protectionist
When the SNB imposed the cap back in September 2011, the Swiss franc was strengthening fast, bid up by “refugee-capital” seeking a safe haven from the eurozone’s troubles. The strong franc made Switzerland’s upscale goods even pricier abroad, damaging its exporters’ competitiveness.
The cap put a stop to that. It thus drew criticism from economists worried about the impact on Switzerland’s trading partners. Ted Truman of the Peterson Institute for International Economics has described the cap as “openly protectionist”. According to other commentators, the cap contributed to the “currency wars”, in which countries try to seize market share from each other by weakening their exchange rates. By removing the cap, Switzerland was acting like a “good world citizen”, according to Dean Baker of the Center for Economic Policy Research, giving an “economic boost” to other countries that will enjoy healthier trade balances as a result.
When the SNB introduced the cap, it was indeed concerned about the “massive overvaluation” of the Swiss franc. Safe-haven flows were driving up the currency, displacing its manufacturers, just as oil or gas earnings can hollow out a country’s industrial base. The Swiss cap was helpful in preventing Dutch disease.
But the central bank’s main motivation for imposing the cap was not protectionism. It was trying instead to avert the risk of deflation. In keeping the currency down, it was trying to drive prices up. This ambition to raise prices is at odds with the notion that it was seeking to protect Swiss exporters. Because in raising inflation, the SNB would have reduced Switzerland’s competitiveness (all else equal) not sharpened it. If an exporter’s local prices and wages go up, it becomes less competitive abroad, even if the exchange rate remains the same.
Currencies, it is fair to point out, move much faster than goods prices or wages. So although inflation would have eroded the competitiveness of Swiss exporters eventually, it would have taken time. Currency appreciation, on the other hand, worked with brutal speed.
In seeking gradual inflation rather than abrupt currency appreciation, the SNB was therefore helping the country’s exporters. But in doing so, it was not defying fundamental market forces. It was instead choosing to expose exporters to one set of market forces rather than another: the sluggish forces of the goods market, rather than the bone-shaking forces of the foreign-exchange market. Neither market is perfect. The goods market is bogged down by inertia, transaction costs and long-term contracts that inhibit price flexibility. The currency markets, on the other hand, are swayed by bouts of speculation and skittishness. Neither does an unimpeachable job of setting an economy’s terms of exchange with the rest of the world.
In practice, there is an easy way to tell the difference between the SNB’s policy and that of the “currency warriors”, mercantilist central banks that suppress their exchange rates for competitive gain. Like the SNB, the currency warriors buy dollars or euros to keep their currencies cheap. In so doing, they create additional local money, just as the SNB did. But unlike the SNB, they “sterilise” their interventions, withdrawing this extra money from circulation (either by selling other assets or raising reserve requirements on banks). This prevents prices from rising, thus preserving the competitive advantage their cheap currency provides.
The SNB was not waging this kind of warfare. In printing francs it was keeping its currency down but not its prices. If its policy had hurt its trading partners, they were free to retaliate by printing more money themselves. This tit-for-tat monetary easing would not have resulted in a zero-sum scramble for a fixed amount of global demand. It would instead have helped to increase world demand, in a process of mutually-assured reflation.
The Swiss policy was not, then, protectionist in intent, nor was it unsustainble. It exposed the Swiss National Bank to a loss of face, but not to a financial loss of any great economic consequence. I believe currency pegs remain a legitimate monetary choice—as long as central banks allow prices to adjust accordingly—if not always a wise one. I also think the removal of the Swiss cap was unnecessarily disruptive. The SNB must now find a new way to fend off deflation. And West Ham must find a new sponsor for its kit.
Disclaimer: This article does not represent investment advice or any kind of professional counsel, nor does it represent an offer to buy or sell securities or investment services. The opinions, which are subject to change, are those of the author not BNY Mellon Investment Management.
Source: http://www.economist.com/blogs/freeexchange/2015/01/switzerlands-monetary-policy
Thursday, November 21, 2013
France in Fed taper line of fire
When France’s weak economy and public finances are panned by international critics, its politicians have an easy riposte: just look at our bond yields.
Paris can borrow at lower costs than London, and the spread between French over German 10-year bonds has remained remarkably stable over the past year. Standard & Poor’s early morning announcement two weeks ago of another downgrade – this time to double A – failed to cause markets to choke on their croissants. Investing in French assets cannot be so awful.
Could that change as the US Federal Reserve starts to wind back its exceptional stimulus measures? Among investors I have spoken to recently, a school of thought is developing that it might.
During the global “taper turmoil” earlier this year – the weeks after May 22, when Ben Bernanke, Fed chairman, first hinted at his plans to taper, or scale back Fed asset purchases – eurozone bond markets remained surprisingly tranquil, even as emerging markets sold off sharply.
But while global policy makers and economists still struggle to understand the interlinkages between Fed actions and global markets, it seems implausible that Europe can escape unscathed when tapering becomes real, perhaps as early as December. After all, “global QE” – quantitative easing by the Bank of Japan as well as the Fed – drove European bond prices higher and yields lower; taper turmoil showed the potential for disruption when it goes into reverse.
Stabilising factors
If there will be European fallout, where will the effects be worst? Intuitively, the weaker eurozone “periphery” economies seem most at risk of a market correction as global QE ebbs, especially if fresh taper turmoil increases investors’ risk aversion.
In fact, countries such as Spain, Italy and Ireland have benefited from four stabilising factors this year.
First has been their transition – thanks to the European Central Bank acting as a backstop – from existential crises to something nearer normal economic conditions. Growth is low and unemployment alarmingly high, but the danger of imminent ejection from the euro has gone.
More video
Second, at least Irish and Spanish bonds have benefited as turnround stories, with tangible evidence of structural reforms improving competitiveness and growth prospects.
Third has been the “re-domestication” of Spanish and Italian bond markets – fickle foreign investors have fled.
Fourth, eurozone periphery countries have moved decisively from current account deficits to surpluses; they no longer rely on capital from overseas.
All four supporting factors will remain in place even as the Fed tapers. None, however, apply to France. Instead other reasons explain the impressive performance of France’s bond market this year – and why it might now be vulnerable.
Higher bond yields
When the Fed was ramping up its asset purchases and US Treasury yields were falling, global investors looking for higher returns were attracted by France’s large and liquid bond markets. Until June this year, French 10-year yields were higher than US equivalents.
France was considered part of the eurozone’s safe, northern core, which made it attractive to investors for whom German Bund yields were simply too low. The Swiss central bank was an avid buyer of French bonds, as were Japanese banks.
"Whatever the risks posed by Fed tapering, it is hard right now to see what might trigger another big sell off"
The case against France is that if the Fed slows its asset purchases and US Treasury yields rise, those inflows could start to reverse and French bonds would sell off – perhaps sharply.
Eric Chaney, chief economist at Axa, points out the very different debt profile between France and Germany. As a share of GDP, French public sector debt will soon be 20 percentage points higher than Germany’s. Without action to alter France’s debt dynamics, the spread between French and German bonds could widen by 50 or 100 basis points, warns Mr Chaney.
French politicians probably need not worry just yet. Investors shorting French bonds have often lost their berets.
When French yields have hit instability in the past, it has been because of obvious systemic risks – the exposure of its banks to the eurozone “periphery” economies in 2011, for example. Whatever the risks posed by Fed tapering, it is hard right now to see what might trigger another big sell off. As the eurozone crisis has lost intensity, eurozone bonds have performed more like “rates” markets, with yields linked to growth and inflation prospects, rather than default risks. France’s economy is contracting, which will curb any uptick in yields.
Still, as Fed tapering draws near, markets may make life less comfortable for French politicians – and limit their bond yield bragging possibilities.
Source: http://www.ft.com/intl/cms/s/0/d1742d9e-5149-11e3-b499-00144feabdc0.html#axzz2lIoVJMpj
Paris can borrow at lower costs than London, and the spread between French over German 10-year bonds has remained remarkably stable over the past year. Standard & Poor’s early morning announcement two weeks ago of another downgrade – this time to double A – failed to cause markets to choke on their croissants. Investing in French assets cannot be so awful.
Could that change as the US Federal Reserve starts to wind back its exceptional stimulus measures? Among investors I have spoken to recently, a school of thought is developing that it might.
During the global “taper turmoil” earlier this year – the weeks after May 22, when Ben Bernanke, Fed chairman, first hinted at his plans to taper, or scale back Fed asset purchases – eurozone bond markets remained surprisingly tranquil, even as emerging markets sold off sharply.
But while global policy makers and economists still struggle to understand the interlinkages between Fed actions and global markets, it seems implausible that Europe can escape unscathed when tapering becomes real, perhaps as early as December. After all, “global QE” – quantitative easing by the Bank of Japan as well as the Fed – drove European bond prices higher and yields lower; taper turmoil showed the potential for disruption when it goes into reverse.
Stabilising factors
If there will be European fallout, where will the effects be worst? Intuitively, the weaker eurozone “periphery” economies seem most at risk of a market correction as global QE ebbs, especially if fresh taper turmoil increases investors’ risk aversion.
In fact, countries such as Spain, Italy and Ireland have benefited from four stabilising factors this year.
First has been their transition – thanks to the European Central Bank acting as a backstop – from existential crises to something nearer normal economic conditions. Growth is low and unemployment alarmingly high, but the danger of imminent ejection from the euro has gone.
More video
Second, at least Irish and Spanish bonds have benefited as turnround stories, with tangible evidence of structural reforms improving competitiveness and growth prospects.
Third has been the “re-domestication” of Spanish and Italian bond markets – fickle foreign investors have fled.
Fourth, eurozone periphery countries have moved decisively from current account deficits to surpluses; they no longer rely on capital from overseas.
All four supporting factors will remain in place even as the Fed tapers. None, however, apply to France. Instead other reasons explain the impressive performance of France’s bond market this year – and why it might now be vulnerable.
Higher bond yields
When the Fed was ramping up its asset purchases and US Treasury yields were falling, global investors looking for higher returns were attracted by France’s large and liquid bond markets. Until June this year, French 10-year yields were higher than US equivalents.
France was considered part of the eurozone’s safe, northern core, which made it attractive to investors for whom German Bund yields were simply too low. The Swiss central bank was an avid buyer of French bonds, as were Japanese banks.
"Whatever the risks posed by Fed tapering, it is hard right now to see what might trigger another big sell off"
The case against France is that if the Fed slows its asset purchases and US Treasury yields rise, those inflows could start to reverse and French bonds would sell off – perhaps sharply.
Eric Chaney, chief economist at Axa, points out the very different debt profile between France and Germany. As a share of GDP, French public sector debt will soon be 20 percentage points higher than Germany’s. Without action to alter France’s debt dynamics, the spread between French and German bonds could widen by 50 or 100 basis points, warns Mr Chaney.
French politicians probably need not worry just yet. Investors shorting French bonds have often lost their berets.
When French yields have hit instability in the past, it has been because of obvious systemic risks – the exposure of its banks to the eurozone “periphery” economies in 2011, for example. Whatever the risks posed by Fed tapering, it is hard right now to see what might trigger another big sell off. As the eurozone crisis has lost intensity, eurozone bonds have performed more like “rates” markets, with yields linked to growth and inflation prospects, rather than default risks. France’s economy is contracting, which will curb any uptick in yields.
Still, as Fed tapering draws near, markets may make life less comfortable for French politicians – and limit their bond yield bragging possibilities.
Source: http://www.ft.com/intl/cms/s/0/d1742d9e-5149-11e3-b499-00144feabdc0.html#axzz2lIoVJMpj
Saturday, October 6, 2012
Currencies: The weak shall inherit the earth
OVER most of history, most countries have wanted a strong currency—or at least a stable one. In the days of the gold standard and the Bretton Woods system, governments made great efforts to maintain exchange-rate pegs, even if the interest rates needed to do so prompted economic downturns. Only in exceptional economic circumstances, such as those of the 1930s and the 1970s, were those efforts deemed too painful and the pegs abandoned.
In the wake of the global financial crisis, though, strong and stable are out of fashion. Many countries seem content for their currencies to depreciate. It helps their exporters gain market share and loosens monetary conditions. Rather than taking pleasure from a rise in their currency as a sign of market confidence in their economic policies, countries now react with alarm. A strong currency can not only drive exporters bankrupt—a bourn from which the subsequent lowering of rates can offer no return—it can also, by forcing down import prices, create deflation at home. Falling incomes are bad news in a debt crisis.
Thus when traders piled into the Swiss franc in the early years of the financial crisis, seeing it as a sound alternative to the euro’s travails and America’s money-printing, the Swiss got worried. In the late 1970s a similar episode prompted the Swiss to adopt negative interest rates, charging a fee to those who wanted to open a bank account. This time, the Swiss National Bank has gone even further. It has pledged to cap the value of the currency at SFr1.20 to the euro by creating new francs as and when necessary. Shackling a currency this way is a different sort of endeavour from supporting one. Propping a currency up requires a central bank to use up finite foreign exchange reserves; keeping one down just requires the willingness to issue more of it.
When one country cuts off the scope for currency appreciation, traders inevitably look for a new target. Thus policies in one country create ripples that in turn affect other countries and their policies.
The Bank of Japan’s latest programme of quantitative easing (QE) has, like most of the unconventional monetary policy being tried around the world, a number of different objectives. But one is to counteract an unwelcome new appetite for the yen among traders responding to policies which have made other currencies less appealing. Other things being equal, the increase in money supply that a bout of quantitative easing brings should make that currency worth less to other people, and thus lower the exchange rate.
Ripple gets a raspberry
Other things, though, are not always or even often equal, as the history of currencies and unconventional monetary policy over the past few years makes clear. In Japan’s case, a drop in the value of the yen in response to the new round of QE would be against the run of play. Japan has conducted QE programmes at various times since 2001 and the yen is much stronger now than when it started.
Nor has QE’s effect on other currencies been what traders might at first have expected. The first American round was in late 2008; at the time the dollar was rising sharply (see chart). The dollar is regarded as the “safe haven” currency; investors flock to it when they are worried about the outlook for the global economy. Fears were at their greatest in late 2008 and early 2009 after the collapse of Lehman Brothers, an investment bank, in September 2008. The dollar then fell again once the worst of the crisis had passed.
The second round of QE had more straightforward effects. It was launched in November 2010 and the dollar had fallen by the time the programme finished in June 2011. But this fall might have been down to investor confidence that the central bank’s actions would revive the economy and that it was safe to buy riskier assets; over the same period, the Dow Jones Industrial Average rose while Treasury bond prices fell.
After all this, though, the dollar remains higher against both the euro and the pound than it was when Lehman collapsed. This does not mean that the QE was pointless; it achieved the goal of loosening monetary conditions at a time when rate cuts were no longer possible. The fact that it didn’t also lower exchange rates simply shows that no policies act in a vacuum. Any exchange rate is a relative valuation of two currencies. Traders had their doubts about the dollar, but the euro was affected by the fiscal crisis and by doubts over the currency’s very survival. Meanwhile, Britain had also been pursuing QE and was slipping back into recession. David Bloom, a currency strategist at HSBC, a bank, draws a clear lesson from all this. “The implications of QE on currency are not uniform and are based on market perceptions rather than some mechanistic link.”
In part because of the advent of all this unconventional monetary policy, foreign-exchange markets have been changing the way they think and operate. In economic textbooks currency movements counter the differences in nominal interest rates between countries so that investors get the same returns on similarly safe assets whatever the currency. But experience over the past 30 years has shown that this is not reliably the case. Instead short-term nominal interest-rate differentials have persistently reinforced currency movements; traders would borrow money in a currency with low interest rates, and invest the proceeds in a currency with high rates, earning a spread (the carry) in the process. Between 1979 and 2009 this “carry trade” delivered a positive return in every year bar three.
Now that nominal interest rates in most developed markets are close to zero, there is less scope for the carry trade. Even the Australian dollar, one of the more reliable sources of higher income, is losing its appeal. The Reserve Bank of Australia cut rates to 3.25% on October 2nd, in response to weaker growth, and the Aussie dollar’s strength is now subsiding.
So instead of looking at short-term interest rates that are almost identical, investors are paying more attention to yield differentials in the bond markets. David Woo, a currency strategist at Bank of America Merrill Lynch, says that markets are now moving on real (after inflation) interest rate differentials rather than the nominal gaps they used to heed. While real rates in America and Britain are negative, deflation in Japan and Switzerland means their real rates are positive—hence the recurring enthusiasm for their currencies.
The existence of the euro has also made a difference to the way markets operate. Europe was dogged by currency instability from the introduction of floating rates in the early 1970s to the creation of the euro in 1999. Various attempts to fix one European currency against each other, such as the Exchange Rate Mechanism, crumbled in the face of divergent economic performances in the countries concerned.
European leaders thought they had outsmarted the markets by creating the single currency. But the divergent economic performances continued, and were eventually made manifest in the bond markets. At the moment, if you want to predict future movements in the euro/dollar rate, the level of Spanish and Italian bond yields is a pretty good indicator; rising yields tend to lead to a falling euro.
The reverse is also true. Unconventional interventions by the European Central Bank (ECB) over the past few years might have been expected to weaken the currency, because the bank was seen as departing from its customary hardline stance. They haven’t because they have normally occurred when the markets were most worried about a break-up of the currency, and thus when the euro was already at its weakest. The launch of the Securities Market Programme in May 2010 (when the ECB started to buy Spanish and Italian bonds), and Mario Draghi’s pledge to “do whatever it takes”, including unlimited bond purchases, in July 2012 were followed by periods of euro strength because they reduced fears that the currency was about to collapse.
Currency war, what is it good for?
Currency trading is, by its nature, a zero-sum game. For some to fall, others must rise. The various unorthodox policies of developed nations have not caused their currencies to fall relative to one another in the way people might have expected. This could be because all rich-country governments have adopted such policies, at least to some extent. But it would not be surprising if rich-world currencies were to fall against those of developing countries.
In September 2010 Guido Mantega, the Brazilian finance minister, claimed that this was not just happening, but that it was deliberate and unwelcome: a currency war had begun between the North and the South. The implication was that the use of QE was a form of protectionism, aimed at stealing market share from the developing world. The Brazilians followed up his statement with taxes on currency inflows (see Free Exchange).
But the evidence for Mr Mantega’s case is pretty shaky. The Brazilian real is lower than it was when he made his remarks (see chart). The Chinese yuan has been gaining value against the dollar since 2010 while the Korean won rallied once risk appetites recovered in early 2009. But on a trade-weighted basis (which includes many developing currencies in the calculation), the dollar is almost exactly where it was when Lehman Brothers collapsed.
Many developing countries have export-based economic policies. So that their currencies do not rise too quickly against the dollar, thus pricing their exports out of the market, these countries manage their dollar exchange rates, formally or informally. The result is that loose monetary policy in America ends up being transmitted to the developing world, often in the form of lower interest rates. By boosting demand, the effect shows up in higher commodity prices. Gold has more than doubled in price since Lehman collapsed and has recently reached a record high against the euro. Some investors fear that QE is part of a general tendency towards the debasement of rich-world currencies that will eventually stoke inflation.
The odd thing, however, is that the old rule that high inflation leads to weak exchange rates is much less reliable than it used to be. It holds true in extreme cases, such as Zimbabwe during its hyperinflationary period. But a general assumption that countries with high inflation need a lower exchange rate to keep their exports competitive is not well supported by the evidence—indeed the reverse appears to be the case. Elsa Lignos of RBC Capital Markets has found that, over the past 20 years, investing in high-inflation currencies and shorting low-inflation currencies has been a consistently profitable strategy.
The main reason seems to be a version of the carry trade. Countries with higher-than-average inflation rates tend to have higher-than-average nominal interest rates. Another factor is that trade imbalances do not seem to be the influence that once they were. America’s persistent deficit does not seem to have had much of an impact on exchange rates in recent years: nor does Japan’s steadily shrinking surplus, or the euro zone’s generally positive aggregate trade position.
In short, foreign-exchange markets no longer punish things that used to be regarded as bad economic behaviour, like high inflation and poor trade performance. That may help explain why governments are now focusing on other priorities than pleasing the currency markets, such as stabilising their financial sectors and reducing unemployment. Currencies only matter if they get in the way of those goals.
Tuesday, June 12, 2012
Why the Bailout in Spain Won’t Work
It was not enough. And it may never be enough.
The euro zone’s offer of $125 billion to bail out Spanish banks over the weekend was hailed by finance ministers and officials across Europe as a masterstroke. Germany’s finance minister, Wolfgang Schäuble, suggested no further bailouts would be needed, saying, “Spain is on the right track.” On Sunday, some analysts and investors even applauded, with David R. Kotok, co-founder and chief investment officer of Cumberland Advisors, proclaiming: “Euro zone leaders rose to the occasion.” How wrong they were.
By now, it should be apparent that the bailout has failed — or is at least on its way to failing.
After a brief rally Monday morning, stock markets in Spain swooned. The 10-year Spanish bond — perhaps the greatest indicator of confidence, or in this case a lack of confidence — jumped higher, to about 6.5 percent, demonstrating that investors were now even more anxious about the country’s ability to pay back its debts than they were the day before the bailout was announced. Seven percent was the threshold that preceded the government bailouts for Greece, Ireland and Portugal in 2010 and 2011. The cost on Monday of buying credit-default swaps — or insurance — on Spanish debt spiked, too.
Indeed, it now appears that the bailout could make things in Spain worse, not better. And market indicators for the next domino in line for a bailout, Italy, point in the wrong direction.
This was bound to happen. That’s because bailing out the banks in each European country individually is a fool’s errand.
Experts often note — wrongly — that TARP, the Troubled Asset Relief Program that pumped $700 billion into the banking system in the United States, arrested the financial crisis in 2008. TARP, to some degree, has become the model for Europe.
But we forget history: TARP was only one component of the bailout. Perhaps more important — consider it the unsung hero of ending the crisis — was the government’s unilateral move to raise the amount of money the Federal Deposit Insurance Corporation could insure, increasing the account limit to $250,000 from $100,000 and fully backstopping the entire money-market industry.
Investors and bank customers who were considering taking their deposits and running in 2008 no longer had reason to do so once deposits and money-market funds had been guaranteed. Keeping your money at Citigroup or Bank of America was relatively indistinguishable from a safety standpoint.
That is not the case in Europe. Customers of Spanish banks still have reason to worry about the solvency of their banks — and their country — making it reasonable for them to take their money from Spanish banks and send it to banks in safer countries like Germany. Indeed, the bailout makes it less likely Spain can pay back its debts because the new loan of up to $125 billion was just added to its huge debt pile. Worse, Spanish banks had been the biggest buyers of Spanish debt (a farce of a way to prop up the economy) and that most likely won’t continue.
As a result, it could be argued that it would be irresponsible for an individual or company, which has a fiduciary duty to its shareholders, not to move its money out of Spanish banks. Of course, money leaving the banks can become a self-fulfilling vicious cycle that virtually no amount of bank bailouts can plug. (By the way, countries like Spain have their own version of F.D.I.C., but it is all but worthless if you believe the country could collapse under its own debt.)
Ultimately, the only real way to begin to ensure the safety of the banks in Spain — and all of Europe — is to create a euro zone deposit guarantee system so that there would be no reason for a depositor to withdraw money. European leaders are expected to address the idea, along with regional banking regulation and a way to recapitalize ailing euro zone institutions, at a summit meeting at the end of the month. Oddly enough, such a deposit guarantee would probably be pretty cheap. The psychological effect of such a guarantee would most likely ensure the solvency of more banks than the guarantee would ever have to pay out. That was the experience in the United States.
Of course, there’s a catch. A euro zone deposit guarantee would require agreement from all the countries that use the euro, which is something that the leaders there seem incapable of reaching because ultimately it would mean tighter integration and, yes, a loss of sovereignty.
And here’s another problem with a euro zone deposit guarantee: Unless you believe the euro is going to remain the standard — that countries like Greece or Spain won’t be forced out or secede from the currency — even the guarantee might not be enough, unless the guarantee holds for all currencies. For example, if a Spanish bank customer is worried that his euros might one day turn into pesetas — even with a deposit guarantee in place — he may well move his money.
In the meantime, this piecemeal approach is bound to fail. Kicking the can down the road, to use again an overused phrase, at some point will fail — and that’s what may have just happened.
Source: http://dealbook.nytimes.com/2012/06/11/why-the-bailout-in-spain-wont-work/
The euro zone’s offer of $125 billion to bail out Spanish banks over the weekend was hailed by finance ministers and officials across Europe as a masterstroke. Germany’s finance minister, Wolfgang Schäuble, suggested no further bailouts would be needed, saying, “Spain is on the right track.” On Sunday, some analysts and investors even applauded, with David R. Kotok, co-founder and chief investment officer of Cumberland Advisors, proclaiming: “Euro zone leaders rose to the occasion.” How wrong they were.
By now, it should be apparent that the bailout has failed — or is at least on its way to failing.
After a brief rally Monday morning, stock markets in Spain swooned. The 10-year Spanish bond — perhaps the greatest indicator of confidence, or in this case a lack of confidence — jumped higher, to about 6.5 percent, demonstrating that investors were now even more anxious about the country’s ability to pay back its debts than they were the day before the bailout was announced. Seven percent was the threshold that preceded the government bailouts for Greece, Ireland and Portugal in 2010 and 2011. The cost on Monday of buying credit-default swaps — or insurance — on Spanish debt spiked, too.
Indeed, it now appears that the bailout could make things in Spain worse, not better. And market indicators for the next domino in line for a bailout, Italy, point in the wrong direction.
This was bound to happen. That’s because bailing out the banks in each European country individually is a fool’s errand.
Experts often note — wrongly — that TARP, the Troubled Asset Relief Program that pumped $700 billion into the banking system in the United States, arrested the financial crisis in 2008. TARP, to some degree, has become the model for Europe.
But we forget history: TARP was only one component of the bailout. Perhaps more important — consider it the unsung hero of ending the crisis — was the government’s unilateral move to raise the amount of money the Federal Deposit Insurance Corporation could insure, increasing the account limit to $250,000 from $100,000 and fully backstopping the entire money-market industry.
Investors and bank customers who were considering taking their deposits and running in 2008 no longer had reason to do so once deposits and money-market funds had been guaranteed. Keeping your money at Citigroup or Bank of America was relatively indistinguishable from a safety standpoint.
That is not the case in Europe. Customers of Spanish banks still have reason to worry about the solvency of their banks — and their country — making it reasonable for them to take their money from Spanish banks and send it to banks in safer countries like Germany. Indeed, the bailout makes it less likely Spain can pay back its debts because the new loan of up to $125 billion was just added to its huge debt pile. Worse, Spanish banks had been the biggest buyers of Spanish debt (a farce of a way to prop up the economy) and that most likely won’t continue.
As a result, it could be argued that it would be irresponsible for an individual or company, which has a fiduciary duty to its shareholders, not to move its money out of Spanish banks. Of course, money leaving the banks can become a self-fulfilling vicious cycle that virtually no amount of bank bailouts can plug. (By the way, countries like Spain have their own version of F.D.I.C., but it is all but worthless if you believe the country could collapse under its own debt.)
Ultimately, the only real way to begin to ensure the safety of the banks in Spain — and all of Europe — is to create a euro zone deposit guarantee system so that there would be no reason for a depositor to withdraw money. European leaders are expected to address the idea, along with regional banking regulation and a way to recapitalize ailing euro zone institutions, at a summit meeting at the end of the month. Oddly enough, such a deposit guarantee would probably be pretty cheap. The psychological effect of such a guarantee would most likely ensure the solvency of more banks than the guarantee would ever have to pay out. That was the experience in the United States.
Of course, there’s a catch. A euro zone deposit guarantee would require agreement from all the countries that use the euro, which is something that the leaders there seem incapable of reaching because ultimately it would mean tighter integration and, yes, a loss of sovereignty.
And here’s another problem with a euro zone deposit guarantee: Unless you believe the euro is going to remain the standard — that countries like Greece or Spain won’t be forced out or secede from the currency — even the guarantee might not be enough, unless the guarantee holds for all currencies. For example, if a Spanish bank customer is worried that his euros might one day turn into pesetas — even with a deposit guarantee in place — he may well move his money.
In the meantime, this piecemeal approach is bound to fail. Kicking the can down the road, to use again an overused phrase, at some point will fail — and that’s what may have just happened.
Source: http://dealbook.nytimes.com/2012/06/11/why-the-bailout-in-spain-wont-work/
Saturday, May 19, 2012
Some European Companies Try Bonds to Raise Cash
Among the midsize, family-owned companies that power the German economy,
it has long been an article of faith: credit comes from the friendly
local banker, not from cold and distant capital markets.
Andreas Dombret, a member of the executive board of
the Bundesbank, said the sale of debt by companies was “limited in
scope” but a “welcome response” to tighter lending by banks.
So Peter H. Leibold was breaking from the norm last year when he decided
to finance the expansion of his company, which makes wood pellets for
heating and energy generation, by selling corporate bonds. The company,
German Pellets, raised more than 80 million euros ($102 million).
Now he is a convert.
“The advantage of a bond is that you can raise a large amount from a
completely different group of investors,” said Mr. Leibold, the founder
and chief executive of the company, which is based in Wismar, on the
coast in northern Germany.
Corporate bonds — essentially, interest-bearing i.o.u.’s that companies
sell to whomever is willing to buy — have long been an essential
borrowing tool for companies in the United States.
But in Europe, borrowing from banks, whether local ones or big
multinationals, has traditionally been the preferred way to raise money.
Just 9 percent of corporate credit in the euro zone comes from debt
markets, according to the Bundesbank, Germany’s central bank, compared
with 64 percent in the United States.
But as the euro zone’s financial crisis has forced many banks to hoard
cash and curtail lending, more European companies are turning to bond
markets. If the trend continues, it could not only begin reversing the
Continent’s longstanding preference for bank credit, but also make the
region less prone to banking crises.
There might be resistance, however, from European regulators, who regard
such borrowing as a form of shadow banking that they cannot control. In
addition, bank lobbyists might fight what they see as competition.
“People are afraid of a financial system not based on what they know,
which is financial intermediation by banks,” said Nicolas Véron, a
senior fellow at Bruegel, a research group in Brussels.
The fears are not unfounded. The propensity of banks in the United
States to turn loans into securities that can be sold to investors
arguably helped create the subprime mortgage crisis.
But later on, there was an upside: the practice meant that the fates of
companies in the United States were less coupled to those of banks. Not
so in Europe, where the problems of credit institutions remain a grave
threat to the rest of the economy.
“Euro-area firms are particularly vulnerable to reduction in bank credit
because of their greater reliance on banks for funding,” the
International Monetary Fund said in a report last month.
Companies’ tapping of euro zone bond markets has surged this year, more
than doubling to $107 billion in the first quarter, according to
Dealogic, a data provider. For the first time since 2009, bond issues
surpassed syndicated bank loans as a source of financing for larger
companies.
When even large European banks are cutting back on risk, bond issues
enable companies to raise money from investors outside the euro zone who
are less affected by the crisis.
It remains unclear, though, to what extent debt markets can fill the
vacuum left by troubled European banks. Bond markets might not help the
thousands of smaller companies that form the backbone of the euro zone
economy but are too small to attract investors’ attention.
“The corporate sector in Europe still comprises mostly small- and
medium-sized enterprises that will continue to rely on bank loans,”
Andreas Dombret, a member of the executive board of the Bundesbank, said
in an e-mail.
The countries that need credit most desperately are also the ones with
the highest proportion of small firms least able to gain access to debt
markets. Companies with 50 employees or fewer employ 68 percent of the
work force in Italy and 62 percent in Spain, according to Goldman Sachs.
Those figures compare with 40 percent in Germany.
“For smaller firms in particular, the fixed costs can simply be too
high, rendering a bond issuance uneconomical under all circumstances,”
Dirk Schumacher, an economist at Goldman Sachs in Frankfurt, wrote in a
report last month.
But the experience of German Pellets, which had sales of 275 million
euros ($350 million) last year and has 500 employees, suggests that
bonds could be an alternative for at least some midsize companies.
Mr. Leibold said that it initially had taken some effort to explain to
investors why wood pellets were an interesting business. The pellets are
a source of renewable energy and are cheaper than oil or natural gas, he told them.
Mr. Leibold, who founded the company in 2005 after he saw wood pellets
being made by small operations in Sweden and realized there was an
opening for a mass producer, says his sales are rising — even in Greece —
as people and companies look to cut costs.
Eventually, investors came around. The company used the money it raised
to make several acquisitions and build new manufacturing plants,
including one in Woodville, Tex., that is to employ 250 people when it
is completed later this year.
German Pellets also continues to draw on traditional bank financing, Mr.
Leibold said. But the bond market provides a diversity of fund sources,
without the drawbacks of a stock listing. Like many European
entrepreneurs, Mr. Leibold expresses an aversion to going public.
The company reflects his spirit and that of his colleagues, he said.
“If German Pellets was listed on an exchange, it would change the company from that day on,” he said.
While there has been no broad effort to curtail debt issues, regulators
at the European and national levels are now scrutinizing so-called
shadow banking. That is a broad category that includes hedge funds and
other activities outside the traditional banking system, as well as
corporate bond issuance.
In practice, corporate debt is typically handled within the banking
system, with banks earning hefty fees for marketing the bonds. But
because the business is dominated by large investment banks, the concern
by some regulators is that smaller institutions have trouble competing
in that market and could lose revenue as a result.
Mr. Véron of Bruegel said central bankers might also worry that a shift
from traditional banking could make it harder to control interest rates —
their main policy tool.
“The European Central Bank
sees a need for more credit,” he said. “At the same time they are
concerned about losing the monetary policy transmission channel.”
For all that, though, officials do not seem to be terribly concerned.
Mr. Dombret of the Bundesbank said that the sale of debt by companies
was “limited in scope” and a “rational and welcome response” by
companies to tighter lending by banks in many parts of the euro zone.
Risks that banks will be bypassed “seem to be rather low at this stage,”
he said, but he added that the Bundesbank would “continue to monitor
this area.”
Mr. Leibold of German Pellets, for his part, said he was happy with his
bond experience and planned to tap debt markets again. But he was not
sure bonds would work for all companies. “You need a story for investors,” he said.
Friday, April 27, 2012
Reshaping banking: The retreat from everywhere
SOME signs are subtle. Foreign lenders operating in America are tightening loan standards more sharply than domestic rivals; Hong Kong property developers are scrambling to issue bonds for want of other funding. But others—the “for sale” signs hung on the overseas assets of many European lenders—are pretty blatant. The ability and willingness of banks to compete across borders is unravelling.
The years before the financial crisis saw rapid growth in the cross-border activities of banks. According to the Bank for International Settlements, the average year-on-year growth rate for cross-border bank credit to non-banks during the 2000-07 period was a sizzling 15.2%, compared with 6.7% for total bank credit. Since then cross-border credit has fizzled (see chart 1) and looks likely to fall further.
European lenders were in the vanguard during the era of internationalisation, and around a third of their assets are outside their home markets. They are now under pressure to slim down their balance-sheets quickly, partly to shore up capital and partly because of funding strains. The IMF this week projected that banks in the European Union would undergo a $2.6 trillion deleveraging over the next two years. Much of that will be achieved by running for home.
In March the Reserve Bank of Australia revealed that the departure of European lenders, in particular French banks, had left an A$34 billion ($35 billion) funding gap in the syndicated-loan market for local companies. The story is similar in the Middle East, where a rush this year to issue Islamic bonds, or sukuk, is attributed to a withdrawal of European lenders. Within Europe, too, national boundaries are being reinforced as lenders cut back their exposures to weaker markets (see chart 2). Non-European banks are also trimming their foreign portfolios as they rationalise their businesses: Citigroup agreed to sell its Belgian retail arm in December; HSBC is offloading businesses from Costa Rica to Pakistan.
Some of this is cyclical. After the first contraction of international activity in 2008-09, a rebound occurred, and something similar might be seen in response to the provision late last year of three-year liquidity by the European Central Bank (ECB), which has temporarily eased the strains on euro-area banks. But there is good reason to believe the retrenchment represents a structural change.
Retrenchment need not be disastrous. Much pre-crisis cross-border lending was foolish, after all; think of all the German money in subprime American mortgages. And foreign banks are not the only suppliers of cross-border capital: the importance of foreign direct investment and portfolio flows as a proportion of gross inflows has steadily risen over the past three decades.
But banks matter. There is evidence that cross-border banking relationships between pairs of countries encourage other types of capital flow; reduce them, and the other flows may dry up too. And the availability of bank financing is vital to smaller businesses or long-term asset-based activities such as infrastructure projects. “The alternatives to cross-border banking are autarkic financial systems, which means relying on domestic capital formation and thus higher costs, or international flows via bond markets, which are more volatile,” says Peter Sands, the boss of Standard Chartered, an emerging-markets bank.
Home is where the taxpayer is
Three powerful centripetal forces are at play: politics, regulation and deleveraging. Take politics first. The financial crisis, and the sovereign-debt crisis that followed it, have left no one in any doubt about the relationship between banks and the state. If big lenders get into trouble, taxpayers end up bailing them out.
Now it is payback time. Banks have come under pressure from their governments to prioritise the customers that rescued them. “Project Merlin” set Britain’s biggest banks targets for their lending to small and medium-sized enterprises; Commerzbank, a bailed-out German bank, is committed to concentrating its lending on Germany and Poland. In December Crédit Agricole, a French bank, outlined plans that included the closure of corporate- and investment-banking operations in 21 countries. “Crédit Agricole is mobilised on a day-to-day basis to support the plans of the French people,” ran the press release.
In the case of banks in the euro zone’s peripheral nations, the politics of patriotism also mean propping up the debt of their governments. Italian and Spanish banks have used the ECB’s three-year loans to boost their holdings of domestic government bonds. Spanish lenders increased their holdings by 26% in the two months to January; Italian banks upped theirs by 31% in the three months to February. This reflects, in part, a calculation that few banks can survive without a sovereign that looks solvent.
Regulations are also steering banks (and insurers) into holding domestic government debt. Rules on capital and liquidity label government debt as safe and render domestic government debt peculiarly so. The overall effect is to make balance-sheets look a lot more patriotic. Huw van Steenis of Morgan Stanley reckons that euro-zone banks have an average of 6% of their assets invested in domestic sovereign debt, and that their holdings are growing by the day.
Many other rules that are designed to make finance safer also risk making it more parochial. A big lesson of the crisis is that banks which are global in life are national in death. The bankruptcies of Lehman Brothers and MF Global showed regulators how assets could easily get trapped in foreign jurisdictions, leaving a bigger bill for taxpayers back home. There are signs that, in response, regulators are treating foreign assets more harshly than domestic ones. Bankers say that stress tests carried out on American lenders by the Federal Reserve in March put their foreign loans under greater pressure than American ones. Recent guidance from Britain’s Financial Services Authority on lending in areas like commercial property jacked up risk charges on exposures where there is a lack of historical data; Bob Penn of Allen & Overy, a law firm, argues that this has the effect of privileging lending in home markets. With capital scarce, such tinkering matters.
As national regulators seek to stamp their authority on international finance, conflicts and inefficiencies arise in all sorts of areas. Britain has filed lawsuits against the ECB for its proposal to prohibit clearing-houses outside the euro area from being able to handle more than 5% of trading in euro-denominated instruments. Differences between proposed American and European rules on derivatives may mean that banks build separate infrastructures on either side of the Atlantic. Things that matter could fall into the cracks opening up; many worry that trade finance, the lifeblood of cross-border trade, will be heavily penalised under new liquidity rules.
Resolutions and reality
Planning for bank failures is the area where the interests of national regulators collide most forcefully with hopes of international co-ordination. The Financial Stability Board, a global watchdog, wants the big regulators of cross-border banks to work together in the event that banks need resolving, and many banks hope for such agreements. But the regulators’ focus is on their national interests, not those of the world, or of the banks.
As Simon Gleeson of Clifford Chance, a law firm, points out, no government will care as much about treating foreign creditors fairly as it cares about compensating its own people. Iceland, which screwed its banks’ foreign creditors in favour of domestic depositors, is a case in point. A typical regulator wants banks in its purview to have enough assets both to keep operating in times of crisis and to pay back domestic creditors in case of failure, whether the banks are domiciled there or not.
Home-market regulators thus prefer their lenders not to have too great an exposure elsewhere. Austria’s central bank has said that Austrian bank subsidiaries in central and eastern Europe should not exceed a loan-to-deposit ratio of 110%, a way of ensuring that their funding needs do not make too great a call on resources back at headquarters.
Emerging markets, now alive to the possibility that parent banks in the rich world can be a source of instability as well as support, have their own worries about the “portability” of capital, liquidity and assets. Guillermo Ortiz, a former Mexican finance minister who is now chairman of Banorte, a Mexican lender, wants subsidiaries of foreign banks in emerging markets to be ring-fenced so that money cannot be funnelled out of the country.
Particular problems attach to “living wills”, documents in which banks lay out for regulators their plans to survive periods of extreme stress and, if the worst happens, to provide supervisors with the information they need for resolution. The process of agreeing on living wills with regulators in the countries concerned creates pressure for banks to use subsidiaries abroad, which have to have their own capital, rather than branches, which don’t.
The decision to set up a subsidiary in a new market (as opposed to just opening a branch) may be a harder one for boards, since it involves legal incorporation and taking on personal liabilities. Some bankers worry, too, that subsidiary units may be nudged by supervisors into running separate IT and management systems in order to demonstrate that they can keep operating without the support of a parent, making them yet more inefficient. Rules that make it harder to move money around will make it harder to commit to distant opportunities. An executive at a big American bank says that such rules will force his firm to invest less abroad than would be ideal. For emerging markets that have shallow deposit bases and undeveloped domestic bond markets, it all adds up to slower credit growth.
Markets that erect firewalls around their banking systems may also be sacrificing resilience in the event of a future crisis. For all the worries about wobbly international banks, the support of Western parents has proved more helpful than not in eastern Europe so far. Other sources of finance can be flighty, too. When bond markets closed to Dubai in late 2009, international banks kept providing liquidity. “There is a trade-off here between probability of default and loss given default,” says Standard Chartered’s Mr Sands. “People are losing sight of the first and obsessing about the second.”
The LDR of the pack
Even if regulators and politicians were carefree onlookers, the need to deleverage would remain. Once again, Europe is home to the banks with the most work to do, less because of the need to raise more capital than because of the way they fund themselves. European banks are more reliant on wholesale markets than any other big banking system (see chart 3). According to Simon Samuels of Barclays Capital, lending by listed European banks exceeds their deposits by $1.3 trillion. American banks, by contrast, are awash in deposits, with a funding surplus of $1.3 trillion.
The European gap is filled by borrowing on wholesale markets. The capital markets have peeped open in the wake of the ECB’s three-year lending operations. But a peep is not enough. The ECB’s intervention was needed precisely because the euro-zone sovereign crisis and the increased need to factor in the losses that follow when a bank fails have left bond investors a lot less interested in holding bank debt than they were. So lenders have little choice but to bring down their wholesale-borrowing needs.
In practice, that often means pruning back activities abroad. Banks typically establish a presence in new markets by lending, and wait for deposits to catch up later. Foreign subsidiaries that have loan-to-deposit ratios (LDRs) in excess of 100% and that rely on cross-border funding from their parents are obvious deleveraging candidates. Eastern Europe is the region that looks most vulnerable on this score. It is the most reliant on foreign banks; and although those banks also raise local deposits, countries such as Hungary, Romania and the Baltic states are all big recipients of cross-border funding as well (see chart 4).
European banks are not about to shut down their foreign networks altogether, not least because the business they do abroad is often their best prospect of growth. Lenders are more likely to manage LDRs down by letting loans run off or by competing for more deposits than to pull out of countries altogether. But the effect will still be felt in the form of scarcer and dearer credit.
There is a faster route to funding salvation than reducing bread-and-butter commercial lending. One particularly striking feature of the pre-crisis expansion of Europe’s banks was that so much of their activity was in dollar-denominated areas such as commercial-property lending, leveraged buy-outs, syndicated loans and commodity financing.
Some of that dollar activity was funded by deposits gathered by banks’ American units; another wodge of dollar funding came from swapping local deposits into foreign currency. But lots was gathered on wholesale markets, often in the form of short-term debt that needed to be constantly rolled over (think of the money provided to French banks by American money-market funds, whose flight from Europe last year caused so much trouble). This type of funding—short-term, wholesale and with an added dollop of foreign-currency risk for good measure—could not be further removed from the liabilities lenders, or their regulators, now want. With French banks in the vanguard, they are offloading dollar-denominated assets.
Among the sectors most exposed to this retreat are project finance, asset-based lending in shipping and aviation, and infrastructure funding. These are areas where assets tend to remain on banks’ balance-sheets for 10-15 years or more. That makes them unattractive bets: long-term dollar funding is hard to come by; short-term funding presents rollover risk; and lenders are wary of locking up bits of their balance-sheets inflexibly when things are so uncertain. To make matters worse, risks are high, so these kinds of lending use up lots of capital.
Alternatives to bank finance are harder to come by in these areas than in areas like syndicated lending. The risks inherent in shipping, a notoriously cyclical industry, or infrastructure finance, where there is lots of construction risk, mean that credit ratings are low, making them a hard sell to bond investors. New regulations called Solvency 2 could make it harder for European insurers to hold long-dated assets. Bankers are now trying to cook up new ways of distributing such assets to investors. One option in infrastructure finance, says the boss of a big European bank, is for the bank to offer financing for the riskier construction phase and then hand over to bond markets when projects start to generate cash flows (although it is unclear what yield investors would demand in return).
The hidden harm
Such innovations are a reminder that the international financial system has many moving parts. New ways of securitising dollar-denominated assets could mean that banks end up slimming their balance-sheets more slowly. The homeward migration of European lenders opens the door to others: Japanese banks, which sit on a surplus of deposits and are willing to lend on a long-term basis, are now the first port of call for project-finance deals. Banks of no fixed abode, such as HSBC and Standard Chartered, may also be poised to benefit in some markets, and American banks could yet decide to become more expansionist. Corporate-bond markets provide another source of funding for larger firms.
But, for all this, a homeward bias in banking will raise costs for some countries, and some classes of client, a lot. Where the process of retrenchment is too swift, it will be hard to refinance some existing debts. Ring-fenced subsidiaries risk being more brittle in the event of a crisis. The costs of infrastructure finance will go up and its availability decline.
There may also be costs for markets that have previously exported deposits and are now seeing them return: some in Germany already worry that too much credit is sloshing around. Some of the forces pulling banks back home are reasonable ones. But once trillions of dollars are set in motion, getting them to settle back down in an optimal way is next to impossible.
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