John Hussman’s words of wisdom

These two concluding paragraphs from the latest market comment of John Hussman are worth paying attention to:

That doesn’t mean that stocks can’t advance further, and it’s impossible to rule out potential enthusiasm that the Treasury “public-private partnership” idea might engender. But the relentless failure to properly respond to this crisis has increased the probable duration of the economic downturn, deepened the likely extent of job losses and deleveraging, and has lowered the expected level of future profit margins, all which erode the fundamental value of U.S. companies. Meanwhile, with the market no longer deeply compressed, there is less pressure for a rebound on the basis of easing risk aversion.

In all, I view the general market’s condition somewhat less favorably than when we first observed these levels last year. Too much has gone wrong in factors that will have persistent effects, and having consolidated the losses, prices are not nearly as compressed as they were then. It is very true that the market tends to bottom when the economic news is still poor, but the economic difficulties here are well outside the norm, and we should at least allow for valuation extremes that are similarly outside of the norm. [More here]

Proposals for a new global reserve currency

China’s central bank governor posted a note on the web site of the People’s Bank of China proposing a new global reserve currency. The key points are here:

They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand.

The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists.

 When a national currency is used in pricing primary commodities, trade settlements and is adopted as a reserve currency globally, efforts of the monetary authority issuing such a currency to address its economic imbalances by adjusting exchange rate would be made in vain, as its currency serves as a benchmark for many other currencies.

The frequency and increasing intensity of financial crises following the collapse of the Bretton Woods system suggests the costs of such a system to the world may have exceeded its benefits. The price is becoming increasingly higher, not only for the users, but also for the issuers of the reserve currencies.

Although crisis may not necessarily be an intended result of the issuing authorities, it is an inevitable outcome of the institutional flaws.

The proposal has met with predictable response from the West. After some confusion, m/s Geithner and Bernanke have rejected the proposal as did Mr. Gordon Brown. ‘Economist’ struck a cautious tone while Brad Setser sounded unsure.

China has tended to argue that it had no choice but to build up dollar reserves so long as the dollar occupied a central place in the global financial system. Analytically, I don’t think this is true — China didn’t have to peg to the dollar, it didn’t have to keep its peg to the dollar at the same rate as the dollar fell from 2002 to 2005 and it didn’t have to limit the pace of RMB appreciation against the dollar in 2005 and 2006. A different set of choices would have produced smaller Chinese current account surpluses and a smaller Chinese reserve portfolio.

He is bang on target on this one. This proposal should be delinked from the question of China’s foreign exchange reserves. China’s foreign exchange reserve accumulation to keep its currency lower or prevent it from appreciating, has created a lot of domestic and external imbalances. More importantly, China’s growth has come at the expense of growth in other smaller Asian exporters whose currencies too suffered from excessive appreciation up to 2007 and then from excessive depreciation, partly because ironically, the banks and the exporters were resigned to and were too prepared for a steadily appreciating currency (e.g., Korean won).

The United States shouldn’t — in my view — be opposed to the development of an Asian reserve currency, or a set of Asian reserve currencies, that generally float against the dollar and the euro. After World War 2, the DM — and then the euro — emerged as Europe’s reserve currency. And European countries moved from pegging to the dollar to managing their currencies against the DM and then to the euro. That hasn’t been bad for the US.

Exactly. The United States can and should accept a multiple reserve currency world.  The key point that the PBoC governor makes is that it imposes costs on the reserve-currency country itself. We have seen that now. That point is ignored because it is being made by China and hence perceived to be in its self-interest only. That is unfortunate. The point made by the PBoC governor and reproduced below again deserves to be heeded by the US but also pressed upon it by other nations:

The frequency and increasing intensity of financial crises following the collapse of the Bretton Woods system suggests the costs of such a system to the world may have exceeded its benefits. The price is becoming increasingly higher, not only for the users, but also for the issuers of the reserve currencies.

Brad: Shifting too a more balanced world economy may not require something as ambitious as an international reserve currency; a bit more exchange rate adjustment, a bit more floating and a bit less reserve growth might do the trick.

Zhou is right: Excessive reserve growth poses problems for the US as well as the countries adding to their reserves.

After acknowledging that the governor was right, Brad backpedals. I doubt if exchange rate adjustment on the part of China, bit more floating and bit less reserve accumulation would persuade the United States to learn to live with its means and not consume beyond what it produces.

The key point that the PBoC governor makes is that the costs of the current system have exceeded the benefits and that has nothing to do with the size of their foreign exchange reserves. If the global reserve and transaction currency country engages in solely national-interest driven monetary and fiscal policies, it gives rise to more frequent asset price booms and busts and emerging market currency crises, with little time for them to adjust. That is the experience of the world in the last 35 years of fiat currency global dollar standard.

Finally, Brad manages to end on the right note:

Zhou’s proposals lead naturally to a discussion not just of reserve currencies, but exchange rates, exchange rate regime and reserve growth. That is a discussion that the G-20 ultimately needs to have.

One point that Economist makes is worth reflecting upon: 

America would resist, because losing its reserve-currency status would raise the cost of financing its budget and current-account deficits

Many other countries – Japan, Germany and Switzerland to name a few –  have not enjoyed global reserve currency status but managed to have low cost of funding because their central banks were more particular about preserving the purchasing power of their currencies, were stridently anti-inflation and their households saved while borrowing within limits, if at all.

It is significant to note that two countries that almost always had weakening currencies, low savings and higher interest rates than these three were the UK and the US both of whom had gotten accustomed to low cost of debt and seigniorage benefits of being reserve and global transaction currencies.

Therefore, it is in the interest of the United States to accept higher interest rates that come with the loss of the polar reserve currency status. It is an incentive to savers and disincentive for borrowers – exactly the long-term adjustment that America needs. 

That is why when commentators (e.g., Paul Krugman) question Europe  and China’s fiscal stimulus sizes compared to that of the US or the UK, it is not clear to us whether the former are too tight-fisted and the latter are too profligate because of habit and because of low funding costs now (e.g., U.S).

From Table-2 of the note prepared by IMF (Global Economic Policies and Prospects, Note by the Staff of the International Monetary Fund for Group of Twenty Meeting of the Ministers and Central Bank Governors March 13–14, 2009, London, U.K.), the combined projected average annual change in 2008-10 over 2007 in the overall budget balance including automatic stabilizers and discretionary measures (as % of GDP) is 6.1 for China, 6.3 for the EU, 6.6 for Japan, 7.8 for the US and 9.0 for the UK.

I am not sure if these are average annual change. If so, the cumulative change during the period is unusually (or, unacceptably) large. The other explanation is that I do not understand the table. 

(p.s: Russia has made a similar suggestion as part of a comprehensive eight-point proposal. That got some attention. But not this much. The good thing about Russia’s proposal is that included financial literacy).

The Swiss franc devaluation

‘Economist’ has  a story on the Swiss National Bank (SNB) deciding to buy foreign currencies aggressively. It ends the story with these two paragraphs:

Back in the 1930s many countries had to choose whether or not to abandon the gold standard. Those that did so soonest tended to suffer least during the Depression. In these days of floating currencies, it is no longer necessary to announce a formal devaluation; benign neglect can allow the currency to fall. Some Europeans suspect this has been happening with the British pound.

But it is still a form of subtle protectionism, relying on someone else to take the strain. To raise the most worrying example, Chinese exports are down by more than a quarter from a year ago. What if the Beijing authorities decided that, in order to generate their targeted 8% economic growth, a bit of depreciation was required? After all, what’s good for the Swiss… [More here]

It is easy to answer the question they have posed. China has two trillion dollars worth of foreign exchange reserves accumulated over the years by intervening to smooth or hold down the value of the Chinese yuan against other currencies in the world. Switzerland has very little foreign exchange reserves, if at all. Hence, the starting points are very different.

Swiss banks have a lot of foreign currency assets. This move would raise the value of such assets. Second, it also mitigates the loan burden held by some of the residents of some C&EE countries in Swiss francs. This move on the part of the SNB has other positive pay-offs as well, thus.

Should the Indian government borrow abroad?

T. K. Arun makes a suggestion that Indian government should borrow abroad. He mentions a sizable sum of USD 20 billion.
The government should meet a part of its huge borrowing programme by issuing bonds abroad. Non-resident Indians would lap it up. So would a number of invitees to the forthcoming G20 summit: it shouldn’t take all that much of diplomacy to persuade them to park a tiny fraction of their multi-trillion dollar forex reserves in Indian bonds.
 
India can choose to be a little aggressive on interest rates, too. The rupee would appreciate from the present panicky levels, and soften the cost of external borrowings. Even $20 billion of such inflows would increase domestic credit flows, bring down yields and shore up the rupee. [More here]
I shall ignore his opening paragraph about whether we are too downbeat or too upbeat. He tones down and says that things are not wrong but not desperately wrong. Let us not quibble and leave the quibbling to him.
 
To the extent that India is interconnected with the world more than before via capital flows (incl. remittances which have multiplier effects), caution on the world economy does translate into caution for India. of course, it applies to many other developing countries too, including China.
 
But, his proposal for external commercial borrowing (ECB) by Government of India (GoI) is not a bad one. GoI can check out the likely market reaction by talking to potential lead managers. After all, Indonesia completed a USD 3 billion borrowing programme rather well just a month ago. The bonds are trading well above par.
 
As for his conclusions/forecasts in the last paragraph, he races into them too fast and without a proper framework. They too are best ignored.
 
Any thoughts on his suggestion?

De-coupling skeptics have to explain this

Nearly a month ago, Indonesia successfully placed two sovereign bond issues successfully for a sum totaling USD 3 billion. The news article is here. Earlier this week, a British gilt auction failed to receive 100% response. A German five-year bond auction narrowly missed the same fate. Here is a FT news report on these two matters.

The FT wrote thus on March 26th:

Yesterday was the fourth time a gilt auction has failed since they were introduced to raise public debt in May 1986.

Now, to further drive the point home, Indonesia’s bonds are trading well above par one month later. May 2014 paper with coupon of 10.375% is being quoted at 106-107.00. March 2019 11.625% paper is quoted at 109.5-110.50.

I guess it is time for people to start re-examining standard definitions of Emerging markets, sovereign risks

Now, that is a classic

Received from a friend:  

——————————————————————–

March 24, 2009

The Editor

Financial Times

Sir: Structured investment vehicles to invest in tranched mortgage-backed securities with plenty of leverage have been duly condemned for the huge problems and losses they caused.  So to solve the problems the United States Treasury now brings us structured investment vehicles to invest in tranched mortgage-backed securities with plenty of leverage provided by the taxpayers.  Hair of the dog?

Yours faithfully,

Alex J. Pollock, Resident Fellow, American Enterprise Institute, Washington, DC

———————————————————-

My friend who sent me this letter adds that if we went to http://www.ft.com and searched for all of Alex’s letters over the past two years, we would find some of the most erudite commentary on this crisis.

One heck of a punch-line for Wall Street

From Chrystia Freeland in FT on the denial among top financial types on public anger:

… in the days after the Bolshevik revolution, Russia’s bourgeoisie didn’t think much had happened, either, and stock prices held steady on the Petrograd exchange. 

The full article makes a lot of sense. The denial about public anger is due to denial over one’s culpability arising out of the belief that they did nothing wrong or that they would not have done anything different. I have some thoughts on this that I hope to flesh out in my MINT column, coming Tuesday.

Does Europe really need a big stimulus?

Paul Krugman has been hammering away at the absence of co-operation from European nations on stimulating their economies. Perhaps, if he had seen this news item in FT, he would have had second thoughts. The article header, ‘Eurozone consumers defy gloom‘ leaves no one in doubt as to the content.

Again, thanks to Paul Kedrosky, I was directed to this excellent piece: ‘Inflation and the collapse of democracies‘. This observation is insightful and makes a lot of sense:

Friedman’s famous conclusion that inflation is “always and everywhere a monetary phenomenon” isn’t entirely true, for where does the pressure to run the printing presses come from if not government?The work in Peter Bernholz’s book “Monetary Regimes and Inflation” suggests that inflation is in fact always and everywhere a fiscal phenomenon. In it, there is a very telling table (Table 5.1) showing fiscal deficits were greater than 20% of GDP before 24 of the 29 hyperinflations he studied. I’ve tried to get a hold of it to publish here but can’t find on the net and since I can’t be bothered scanning it you’ll just have to take my word for it and/or buy/borrow/steal the book to read it yourself. [more here]

The blogger recommends reading the latest market comment of John Hussman. That one is in response to the PPIP. I would go one step further. I would recommend that you make John Hussman regular weekly reading. Very organised and methodical.

Had the US been an emerging economy…

Among the various blogs I visit, if I were to pick my top favourite, I would pick Paul Kedrosky’s Infectious Greed as the most valuable resource. A visit to his blog today introduced me to this long but very worthwhile piece by Simon Johnson, former Chief Economist of the IMF in ‘The Atlantic’.  Some of his observations are very insightful. Overall, worth ploughing through. I did that. Some interesting excerpts to whet your appetite

Many IMF programs “go off track” (a euphemism) precisely because the government can’t stay tough on erstwhile cronies, and the consequences are massive inflation or other disasters. A program “goes back on track” once the government prevails or powerful oligarchs sort out among themselves who will govern—and thus win or lose—under the IMF-supported plan. The real fight in Thailand and Indonesia in 1997 was about which powerful families would lose their banks. In Thailand, it was handled relatively smoothly. In Indonesia, it led to the fall of President Suharto and economic chaos.

In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again).

But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true. Alan Greenspan’s pronouncements in favor of unregulated financial markets are well known. Yet Greenspan was hardly alone. This is what Ben Bernanke, the man who succeeded him, said in 2006: “The management of market risk and credit risk has become increasingly sophisticated. … Banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.”

To paraphrase Joseph Schumpeter, the early-20th-century economist, everyone has elites; the important thing is to change them from time to time.

While you are at it, you may want to stop by at Rolling Stone and take a look at this piece. It has been doing the rounds for quite some time. But , I happened to read it yesterday and I was glad I did so. It makes two important points:

One is that it offers a clue as to why democrats took to financial liberalization with gusto in the 1990s.

Second, it explains how institutions can pick and choose their regulators in the US and then turn around and tell European regulators to lay off because they are being regulated in the US (by a regulator of their choice). That partially explains how Europe got dragged into it.

Good and fast-paced writing. It just flows.

Geithner’s PPIP

A good friend did a google search on PPIP and it came up with Pain Put In Perspective. Interesting.  Here is some perspective.

Useful to start with three resources:

(1) Tim Geithner’s piece in WSJ yesterday

(2) The Treasury of the US Government page on facts of the Treasury plan:
(3) Tracy Alloway in FT.com does some early math on the proposal:  

We shall start with (3):
 
(1) Is it a backdoor taxpayer subsidy for banks by overpaying for bad assets: YES and NO. But, YES in the end
 
Tracy is right that the Treasury plan does not incentivise the private sector to overpay for the bad assets. Simply put, the Treasury does not increase the subsidy if the private sector if they overbid for the bank bad assets. The subsidy stays at 7%. BTW, this is under the ‘Legacy loan programme’.
 
That is one good reason why this plan is not a backdoor attempt to recapitalise banks at the taxpayer expense. However, at the same time, there is already a heavy taxpayer subsidy involved since 93% of the capital (equity + loans) come from the government (i.e., taxpayer).
 
One observation I read either in Geithner’s article (or elsewhere?)  suggests that the private sector needed to be incentivised with low financing costs (hence the ability of the proposed asset management companies to issue FDIC guaranteed debt) to induce them to buy the bad assets from banks. That is troubling.
 
If the price is right, they should be willing to buy. After all, don’t we keep reading that fund managers are sitting on ‘mountains of cash’? the opportunity returns foregone by investing in cash is close to zero percent today. So, do they really need to be incentivised with low cost of finance? If so, then is it to induce them to pay more for the bad assets? If so, it is a tax-payer subsidy to banks.
 
(2) This last sentence from Geithner’s WSJ article too is troubling:
 
“Our goal must be a stronger system that can provide the credit necessary for recovery.”
 
When it comes to economic growth,  America is still thinkng in terms of credit. Not savings, investment and returns. Low interest rates incentivise debt creation, not savings. I thought lending, loans and low interest rates created this crisis?
 
(3) Lingering concerns:
 
(a) Why cannot Treasury set a price and buy the assets? Make the price-setting transparent. Show the models used to arrive at the prices. Determine which banks are solvent under these prices for bank assets, let the insolvent ones go under liquidation, protect depositors (FDIC insurance is there) and senior debt holders (with some appropriate hair-cuts) and let junior debt holders and equity holders get nothing.
 
(b) why is it that private investors have not come forward to buy bank stocks or buy bad bank assets on their own? is it because banks are carrying these assets at high prices in their books? If so, will they come forward to offload these assets to the new Public-Private Investment Management companies?
 
(c) This approach does not think the solutions through to their logical conclusions. The key to the success of all these initiatives is the ability and willingness of corporations and US households to borrow. Households, especially, are still over-leveraged. The solution to that is to save more out of current income and use the savings to repay debt. But, lower interest rates incentivise borrowings and not savings. If they do not choose to fall for the bait of lower interest rates, what would the Federal Reserve and US Treasury do next?

(d) Let us think of the other scenario: that banks begin to lend and that US households refinance their old debt at lower interest rates that the US government and the Federal Reserve are engineering now. Their stock of debt would remain but would have lower financing costs temporarily. This is exactly what happened in 2001-2004. But, when interest rates began to rise ever so gradually from 2004 onwards, they did not change their behaviour but misunderstood the transparency and the advance flagging of policy moves to take on more debt.

(e) The refinancing of the debt at lower interest rates for the household sector means that some of the debt burden is being transferred to the public sector. Hence, the overall stock of national debt at best remains the same but, at worst, is substantially higher, after all the stimuluses are accounted for. Effectively, there is no restructuring.

(f) The external consequences of boosting borrowing and consumption on imbalances, on the appropriation of global savings to finance them, the impact on commodity prices and their impact, in turn, on the global poor, the impact on global environment have become less relevant considerations for policymakers but they remain crucial for the rest of the world. After all, just about a year ago, these issues loomed large on every one’s minds. The proposed remedies for the US banking system risk bringing them back.

Update: In fairness, I should have added that even before judging the success of the initiative on the basis of whether it persuades corporations and hosueholds to borrow (if it is appropriate at all), the good thing it does is to bring forward the moment of reckoning for banks.  They have to reveal their balance sheets, their asset valuations now and accept the consequences that flow from them.  Perhaps, some exciting times lie ahead of us.