The Crisis of Credit Visualized

An explanation of the credit crisis of 2008 quickly leads to the introduction of some terms and concepts that require extensive explanations. Acronyms are used such as CDOs and CDS that are very important to understanding of what happened yet rarely understood by someone the first time they are heard. It becomes understandable how even regulators at the time were not fully aware of what was going on around them and what securities they were rating.

It is refreshing to take a step back at times and look at the bigger picture of what transpired in terms that are simple to understand, starting from the very basics. A video titled “The Crisis of Credit Visualized” regards some of the most important issues to an understanding of the crisis in a very efficient manner. The links between banks, households and government are clearly outlined in ways that are visually appealing. 

For readers who find this valuable, be sure to have a look at the movie Inside Job directed by Charles Ferguson as well which tackles similar issues in style more of a documentary. Such videos may often leave one with a feeling of frustration, perhaps a feeling of being powerless against big institutions and banks that seem to have an impact on the daily lives of ordinary people. The key to affecting change however is to gain understanding of what is actually happening. This video and Inside Job serve as an excellent basis upon which to build such knowledge.

Further Reading:

http://www.investopedia.com/articles/basics/09/understanding-bailout-acronyms.asp#axzz1fNVHisJ3

"Emerging Markets" - Really?

The term “emerging markets” is conventionally used to describe nations in the world that are rapidly developing from a current less developed state. Depending on definition, this ranges from around 28 to 40 countries worldwide. When analyzed however, the term seems inappropriate.

The growth of “emerging” markets (in particular the BRIC nations) has been incredible. Over the past 25 years the world has grown at an average of 3.7%. In 2011, world GDP is expected to grow at 4.4% which is already above average. The BRIC economies however are poised to grow 7.9% on average after having already achieved similar rates so over the past couple of years. These economies are growing so strongly that 2009 is sometimes cited as the year in which emerging market consumption caught up with US consumption; it is the first time more cars were sold in China than in the USA. Apart from a new economic reality, this also carries a psychological impact for the car-loving nation of the USA.

A GDP per capita of $11,000 is often cited as the threshold for achieving developed status. Allan Conway, Head of Global Emerging Markets Equities of leading investment manager Schroders, mentions, “economies with a GDP per capita above about $11,000 are developed, between roughly $1,500 and $11,000 emerging“. Looking at the GDP per Capital of the BRIC nations reveals that only India is still truly in the midst of emerging status, lying at around $3,500 per capita. China is expected to cross the threshold in 5-7 years. Brazil and Russia already have. 

The world at night (click to enlarge), in which nowadays the BRIC nations (Brazil, Russia, India and China) are clearly visible. Source: NASA

Trade flows additionally highlight the changed world we live in from 10 years ago. 3 phases of trade in modern history can be identified, the first one being trade between developed markets, 48% of global trade for exampled occurred just between developed markets in 2008. The second phase is trade between developed and emerging markets which is still strongly increasing, China for example is forecasted to surpass France as Germany’s main exporting destination within two years. The third phase however is the most intriguing and its presence is becoming very apparent; trade amongst emerging markets. Examples include the Panama Railway in South America which is to be built by a Chinese firm (5% of world trade passes through the Panama Canal). Similarly, China is now the largest trading partner of Brazil, replacing the USA which held this position for the last 40 years.

Nevertheless, some issues remain that could hold these nations back if they are not dealt with properly. China’s one child policy will cause demographic pressure. Global imbalances (do the Chinese really believe in US repayment of debt?) persist and there is no mechanism to correct them. There is discussion about ‘overheating’ in several emerging markets, what growth level is sustainable (also from an environmental perspective)? Additionally, the BRIC members each have different interests, China and India being consumers of raw materials while Brazil and Russia are largely producers of such natural resources and this endowment powers their economies. Potential conflicts need to be avoided.

In conclusion, the rapid pace of development has catapulted these markets onto the world stage. They are no longer “emerging” but are a defining component of the world economy. Lets call them RDEs, Rapidly Developing Economies, and give their astounding achievements some recognition. Should they defy the challenges on the path ahead of them, they will join the exclusive “developed markets” club sooner than many are likely to predict today.

The Return of Manufacturing to the USA

For over 10 years now, outsourcing has been a dynamic, major force changing the structure of the world economy. Emerging markets offer what appears to be an endless supply of cheap labour, rapidly expanding domestic markets, attractive currency (low) valuations and governments warming up to the idea of foreign direct investment. China in particular has in recent history been a simple choice to make as a destination for companies seeking to produce abroad.

This trend continues in 2011. However, the rate of change is slowing. The management consultant firm Boston Consulting Group found that from 2001 to 2004, imports from China into the USA grew by around 20% per year. In the past few years this rate has slowed to around 4%. U.S. imports from other low-cost nations have largely flattened, and even declined in 2009. Last year, the “great sucking noise” (a term to describe the flow of manufacturing jobs out of the USA coined by presidential candidate H. Ross Perot in 1992), even went into reverse. For the first time since 1997, US manufacturing jobs increased, by around 1 per cent.

                                                                            Source: The Financial Times
Reasons for this developing trend are many. China’s wages are under strong pressure to rise, currently increasing by 15-20% per year. The Yuan is continuing to appreciate against the Dollar. Additionally, demographics (the one child policy having a major impact) are not in China’s favor; the population (in stark contrast with that of India for example) is ageing. Some observers go as far as to ask whether China will ‘grow old before it grows rich’. Reliability concerns, a lack of transparency regarding government policies and a strong political bias towards domestic firms including blatant theft of intellectual capital leaves Western firms worried how much quality is being sacrificed for lower and lower labour cost-gaps. The labour cost-gap between the USA and China is expected to shrink to just 40% by 2015.


When taking into account higher productivity of US employees, better quality and lack of transport costs, overall savings are predicted to become marginal. This is why the Boston Consulting Group, has coined 2015 the “tipping point” after which, in certain sectors, manufacturing will be as attractive in the USA as in China. The firm predicts this to have a dramatic impact, bringing 2 to 3 Million manufacturing jobs back to the US, mainly from seven industries including transportation goods (e.g. vehicles and parts), electrical equipment and furniture. Additionally, $100 Billion in output gains are expected, lowering the US non-oil trade deficit by 20 to 35%.


Clearly, other low-cost nations will also remain attractive, most notably Mexico in regard to US manufacturers. However, these are very often not capable of handling high-end manufacturing on the scale of China due to lack of infrastructure, scale, domestic supply networks, worker productivity and, in several cases, corruption (to various degrees relative to China). Evidence is starting to point in the US’s favour; Ford, NCR, Master Lock and several other companies are examples of firms that have recently shifted manufacturing from China to the US. It is difficult to predict where manufacturing will be focused in 10 years. However, The Boston Consulting Group has a bold answer: “We’re on record predicting a U.S. manufacturing renaissance starting by around 2015.”

Further reading: http://www.bcg.com/media/PressReleaseDetails.aspx?id=tcm:12-88775

https://www.bcgperspectives.com/content/commentary/manufacturing_supply_chain_management_made_in_the_usa_again/

https://www.bcgperspectives.com/content/articles/manufacturing_supply_chain_management_made_in_america_again/

https://www.bcgperspectives.com/content/commentary/sourcing_procurement_business_process_outsourcing_chinas_rising_costs/

Occupy Wall Street - To What End?

What many believed to be a one-off protest action has quickly taken on a different form; Occupy Wall Street is now a movement that has already been compared to the Arab Spring. However, while these revolutions had a clearly defined target, in the case of Egypt the overthrowing of Mubarak and in Libya Colonel Gaddafi, Occupy Wall Street lacks clearly defined goals. Ironically, this could not be better pointed out than by taking a look at the original poster gathering support for the protests.

The movement is threatening a bank run in which depositors would collaboratively rush to withdraw deposits from a bank. Should such a move really succeed to the highest degree as imagined by protestors, which is highly unlikely, a bank would be brought down. What would happen though when all the big banks are destroyed? Who will loan to businesses? It is unlikely that the “99%” of Americans the movement keeps mentioning it represents feel represented by the protests.


What would aid the movement is having just one very clear demand, aim and message. One suggestion is: Reducing the role of money in politics. The connections between government and the financial services industry has become far too entangled to discern. People often point to the big names such as Goldman Sachs (Hank Paulson, Secretary Treasurer during the crisis in 2008 was formerly CEO at the firm), but it is hundreds of financial firms that are lobbying Washington and have a vested interest. The influence of money has become enormous. Leading up to the 2008 elections, Obama received more donations from investment banks and hedge funds than from any other sector. The biggest supporters were Lehman Brothers, Goldman Sachs and JP Morgan Chase. According to the New York Times, the 2008 presidential campaign tore through all records in terms of expenses, costing a staggering $5.3 Billion Dollars. 


This central demand of less money in politics should be supported by tangible ways of achieving this that could be used in negotiations with the government should protestors get to this stage. This should be in the form of regulation for party funding which could involve strict limits on corporate and private donations, controls placed on political spending and a legislative framework for providing transparency for both contributions and expenditures.

It is hard to imagine that 1% and 99% are currently being regarded equally by Washington. A government with the best interests of its people at heart would not give Wall Street the breaks they receive while simultaneously attempting to appeal to the average voter on social issues that will never be addressed in office. The movement has several noble intentions. However, the way protestors are going about achieving anything is naïve, too broad, and un-coordinated. Maybe the coming months will change this. This would allow the 99% to raise a louder voice towards Washington.

Further Reading -
http://www.ft.com/cms/s/0/cf49aa7a-34d7-11dc-8c78-0000779fd2ac.html#axzz1afNy5YS6
http://occupywallst.org/

A Greek Tragedy

It would likely happen on a most unexpected day. One turns on CNN only to find Breaking News coverage from Athens; Greece has left the Eurozone. Greek Prime Minister Girogos Papandreou holds a solemn speech stating Greek banks will be shut for a week and when re-opened, depositors will find their accounts in Greek Drachma, no more Euros. He states that all other options have at this point been exhausted; his country has yet again failed to meet deficit targets which were a condition for further aid. Europe declares it will stick to the agreed terms. No more help. Greece is bankrupt. What now?  

                                                                                                                                   Source: CNN

A positive effect would be that the competitiveness of Greece would instantly receive a massive boost. This is both for trade in goods but also services such as tourism. Chief Economist Buiter of Citigroup expects the Drachma would devalue 40% against the Euro, while UBS economists estimate up to 60%. Simultaneously however, import prices would rise significantly which could lead to demands for higher wages. The pressure to reform would be lessened after not being subject to Europe’s demands so wages could rise and the government could print money to finance the country. This inflation would be damaging and scare international lenders and yet again cut off Greece from crucial access to capital markets.

Internally for Greece, the banking sector would face the biggest problem. The devaluation of the Drachma would strongly let the value of debt payable internationally in Euros increase. The government would immediately be bankrupt. Greek banks hold government bonds of about 45 Billion Euros, which amounts to 160% of their own capital. If the Greek government defaults, the nation’s banking system would have no support and be wiped out. No economy can survive without a functioning banking system so the banks would have to be bailed out. The government would have no money to do this and it becomes conceivable that Europe would provide a massive capital injection for Greece’s banks as they exit the Euro to make their way into a new monetary system. Internationally, Europe’s banks would certainly be impacted, France’s institutions alone would have to write off 16 Billion Euros. However, they would survive. A haircut of 80% would hit German banks for example with a capital reduction of just 2.4%.

From the point of view of other countries, some natural discipline would be imposed as incentives are set right. Spain, Ireland, Italy and Portugal would see that the rules of the Eurozone are to be adhered to and targets met or a member must leave. However, if speculation on these countries ignites putting them into a similar position Greece finds itself in today, the EFSF would by a large margin be too small to save them. It is estimated by Commerzbank that the fund would have to increase from a current 528 Billion Euro capacity to 1.2 Trillion Euro, a political impossibility. The ECB could intervene and purchase debt in an attempt to calm markets and provide a much needed source of stability for the Eurozone. However, if this too becomes too onerous, further countries would be forced to quit the Euro. The monetary union would shrink back to something it was once supposed to be, a zone of similar and stable countries.

A Greek default brings many inconveniencies and further hardship for the Greek people with advantages that seem negligible in the short-run. How many more Billion will be needed though, how much more evident must the disadvantages of a transfer union become before the all-members-inclusive-Eurozone reaches its breaking point? It should be kept in mind that a default does not mean end of Greece. The country has defaulted four times since its founding; in 1843, 1860, 1893 and 1931. Perhaps 2011 will be next.

Further Reading:
http://edition.cnn.com/2011/BUSINESS/06/19/europe.debt.explainer/index.html
http://www.ft.com/cms/s/0/d2d8b422-fb13-11e0-bebe-00144feab49a.html#axzz1bcrkHal2

The US Dollar – The World’s Main Reserve Currency Even in 2020

It is being mused and tentatively discussed amongst bystanders and participants of worldwide foreign exchange markets that the Chinese Yuan has the potential of soon replacing the US Dollar as the world’s reserve currency. For all the troubles two of the world’s leading currencies, the US Dollar (USD) and the Euro (EUR) are going through however, it is difficult to see how this could happen within the foreseeable future. 

What lends a currency strength and value is trust. It follows that the world’s leading currency needs to be the one with the most trust in it. China’s lack of transparency regarding its own currency, let alone its foreign reserve operations, will not provide a foundation for such trust. Trust would be undermined further from other areas, such as political stability and rule of law that have yet to develop before reaching the more sustainable state seen in parts of the developed world.


Additionally, the existing exchange controls China has in place is one reason, they are massive. Although some loosening up has taken place, a liquid and open market is unlikely to be achieved at any point in the next 10 years. The government seems to be in no rush of loosening up its fixed system. This is partly the reason why 74% of respondents recently said no when asked by the Economist if they believed the Yuan would be the world’s main reserve currency in 10 years (source below).

                                                                         Source: The Economist
One reason often cited as the reason for impending world’s reserve status is the size of the country’s economy. However, this is an abstract factor regarding currencies that has no direct impact. Switzerland's economy for example amounts to just 8% of Japan's, yet the Swiss franc (CHF), as a reserve currency, achieves a market share almost as big as that of the yen. What is far more important are sophisticated financial markets readily accessible for investors, such as liquid bond markets. This is currently not to be found in China.


Looking at America, the downgrade from AAA to AA (see blog post below) caused frightened investors to paradoxically seek out Treasury bills in search for safety. This shows the true extent to which the world still looks to and believes in the USD as the leading reserve currency. No downgrade of another nation would have investors fleeing for that country’s securities.

What China has achieved in the last 10 years is monumental and hard to put in words. Never before in human history have so many people been lifted out of poverty in such a short time. The developed world is often quick to judge and point fingers at some of the issues (such as human rights) in China when it is conveniently overlooked that it took the West hundreds of years to do what China is trying in 20-30. In many areas China will catch up and possibly pass the developed world. However, the world’s currency will not become Chinese. Simultaneously, it is unclear what the future holds for reserve currencies. Perhaps a trio of USD, Euro and Yuan as a leading reserve currency basket will be the next step, one or two decades down the line.

Further Reading:

http://www.economist.com/debate/overview/213

The United States of Europe

“The United States of Europe” is a concept that has recently gained traction as an idea. Prominent politicians such as Gerhard Schroeder (former German chancellor) have publicly called for such a creation. However, several problems present themselves with such a construct.

Hundreds of Millions of Euros and political efforts have not been enough to save the Euro. The framework in which the Euro was conceptualized is not right. In a common currency zone there should be a minimum in commonality or at least a trend towards more commonality. At present, it seems unlikely that Greece and Germany could ever be more apart economically, financially, socially and even politically. A common currency without commonality is by definition unsustainable. In difficult times such as these however, standing united to come out stronger in the end, uniting under a single name of “Europe” sounds tempting, even persuasive.

Does anyone really believe though that a common tax rate from Italy to Finland will be implemented? A common police force in Spain and Romania? The same levels of pensions and social benefits in France as in Bulgaria? Where would parliament sit and who would elect members? What will come of parliament in Paris, of the Reichstag in Berlin? Will they be turned into museums? Before any one of these decisions is reached the Euro will have at the current rate suffered a long and slow death.

No, Europe is far from a state in which this can be implemented. A common standard for the security of nuclear power plants could not be passed, let alone a common approach towards highway tolls or maximum speeds on highways across Europe.  Europe is even headed towards breaking its own rules in any mention about the possibility of Greece leaving the Eurozone, the constitution at present does not allow a member to leave.  

In contrast, one vision, more sustainable than that of a USE, is that of a Euro 2.0. A common currency zone, a sort of club, in which members join after being examined and must adhere to the rules or be kicked out. Greece joined the Eurozone after providing data below any form of acceptable accounting and is now treated as an equal. If a young man enters a pub and is found to have provided a fake I.D., he will be kicked out. Such an approach would be helpful for what is to come should the current Euro not survive the current crisis.

In extraordinarily uncertain times such as these, populist moves may come to resonate well with an audience. Take a step back however and the United States of Europe as a concept is exposed for what it really is: European populism in XXL.

Further reading:

http://www.reuters.com/article/2011/09/04/us-germany-europe-idUSTRE7831IE20110904

Swiss Franc (CHF) Devaluation – A Swiss perspective

On September 6^th, 2011, the Swiss National Bank (SNB) shocked markets by announcing that the Swiss Franc was to be pegged to the Euro at an exchange rate of 1.20 (EUR/CHF). This was a move announced in the, “strongest language from a central bank in the modern era”. To further highlight the severity of what this meant, the Swiss Franc dove 9.32 percent to 1.212 francs per Euro just after the announcement in what Chief Economist at World First (a foreign exchange broker) Jeremy Cook called, “the single largest foreign exchange move I have ever seen (…) This dwarfs moves seen post Lehman Brothers, 7/7, and other major geopolitical events in the past decade".

                                                                                                    Source: Financial Times

Critics were quick to point out that this would have repercussions in the form of intensified currency wars, with the Japanese for example likely to implement similar measures to slow the Yen’s appreciation in future. The Swiss Franc’s image as a safe haven currency immediately took a hit. With the world’s other major currencies all in trouble (especially USD and EUR), gold, already overvalued, appeared as one of very few alternatives left for market participants seeking safety (it reached an all-time high on the day of the SNB announcement of over $1920). The SNB decision was flagged as an uncooperative and drastic move, only further destabilizing the developed world in uncertain times.

However, people analyzing this from a global macro perspective are quick to overlook what a dramatic impact the currency appreciation was having on Switzerland. It was regarded as an, 'acute' threat to the economy and labour market. It was estimated to be a risk factor that could lead to recession and deflation. To display the extent this affected the economy, consider food maker Nestle whose first-half sales in 2011 were down 13%, although they rose 7.5% on an absolute, currency adjusted basis. Credit Suisse announced losses of even greater magnitude where revenues would have been 37.7% higher without Franc appreciation. Efficient companies performing well are suffering. All sectors are affected, hotels expecting 3 to 5% less guests, workers are having to accept increased working hours to make up for lost competitiveness and major retailers are taking dozens of products off shelves after failed price cut negotiations with manufacturers. Ironically, the entire economy, which fundamentally is doing very well and is stable, is under immense pressure because of this reason (such strength being the cause for many investors to invest in the Franc).

Additionally, two factors worsened fears. Firstly, any previous attempts by the SNB to intervene and cool the franc had failed, prominently displayed in the loss of SFr14.3 billion ($14.8billion) generated by the SNB after massive Euro purchases between March 2009 and June 2011 which did close to nothing to stop the currency’s rise. Secondly, the breakneck speed of appreciation was something that had an effect as companies were not having time to react or implement safety measures before it was too late.  

                                                                                                              Source: Financial Times

This reveals how, from a Swiss person’s perspective, the currency intervention was an impressive and successful development. It reminds many of the move taken in a similar environment in the 70s when Switzerland implemented negative real interest rates to prevent excess capital flows due to similar reasons people are seeking out the Franc today, an unheard of move at the time. As a whole, the Swiss feel delight and are comforted by the fact that their central bank, as well as politicians, are able to act quickly when they need to in the interest of their people, even if this means internationally unpopular and/or dramatic unprecedented moves such as this one. This is comforting especially in light of the relatively slow political progress of many other countries in the western world in 2011.

Further Reading:

http://www.reuters.com/article/2011/09/06/us-swiss-snb-idUSTRE7851LV20110906?

http://www.thelocal.ch/1068/20110906/

http://online.wsj.com/article/SB10001424053111904006104576499430671400702.html

http://online.wsj.com/article/SB10001424052748704187604576288201648772590.html

http://www.ft.com/cms/s/0/587765d6-beb7-11e0-a36b-00144feabdc0.html#axzz1ZF6AS5rk

http://www.swissinfo.ch/eng/specials/swiss_franc/Switzerland_hit_by_currency_devaluation_race.html?cid=28504670

Dangerous Letters Game

1-3 letters is all it takes to rate a country, a company and/or its financial securities. To indicate, for better or worse, the health of the entity as it stands now and is likely to in the foreseeable future. The ratings are said to affect borrowing costs, the capital flows in an out of the country or firm, asset pricing, forecasts and opinions. Investment grade ratings range from (for S&P) AAA (no risk of default) to BBB after which a security is classified as 'high yield' or 'junk' down to C (highest risk of default). They are significant and are monitored closely by analysts across the globe. Hence in essence, a rating identifies the risk associated with investing into the entity in question. Or does it?

The USA downgrade from AAA rating to AA+ on the 5^th of August 2011 was predicted by many to cause calamity in the markets. Leading editors of the world’s prominent financial publications voiced their concerns on the impact the downgrade could have once markets would open the following Monday, August 8^th. However, widespread panic never occurred and the most important indicators reveal what little real impact the downgrade has had. American Treasury yields, which many experts were certain would increase to compensate for the higher risk, remain at near 2%, even falling to 1.875% on September 21^st, the lowest point since figures dating back to 1953. US debt is still regarded as the safest in the world by the markets, with or without AAA.

Mortgage Backed Securities (MBS) leading up to the financial crisis were complex constructs of mortgages that when packaged by financial engineers at the most prominent of investment banks often received high (investment grade) ratings by leading agencies. However, apart from the handful of people that designed them, nobody knew how they were constructed and what constituted an MBS (often loans from overexposed borrowers with little chance of paying back when house prices stopped rising). Least of all the rating agencies that rated these securities as safe and upon whose judgement of A or AA vast fortunes were invested up until 2008. The subprime mortgage crisis eventually took its toll, wiping out Billions of Dollars that may never have gone lost had the rating agencies been able to calculate the true risk they labelled as safe. This is another case in which ratings turned out to be near meaningless.

Example of the construct of a MBS, little understood by ratings agencies

                                                                                                                                            Source: Wikipedia

Additionally to not always having an impact, the process of rating a country or firm may be risky in itself. The highly publicized downgrading of the USA by S&P could have easily led to a downgrade war amongst rating agencies (S&P, Moody’s, Fitch) as these private companies vie for attention and may not have wanted to feel ‘left behind’ in any bold moves that give their competitors an advantage. Thankfully, a downgrade war with real impact and amplification of market fears has not taken hold.  Similarly, there is an incentive problem as rating agencies are paid to rate the securities of firms by the very firms that issue them. If you are given money to rate someone’s merchandise you do not want to tell them it is highly dangerous as this will prompt them to go to your competitor that may be less harsh, leaving you empty handed.

Ratings agencies should be nationalised. This would mitigate the possibility of downgrade wars and incentive issues, both aspects coming naturally in privatised, open-market competitive moves that can serve a firm well but are in this context out of place. A rating needs to reflect risk as it most accurately can be, not as it most favourably can be to serve the interests of the rating agency.  

Make no mistake, ratings do remain important, especially to value for example countries investors have little knowledge about (frontier economies come to mind such as Colombia which is investment grade rated which will likely be important to it and help it gain FDI). However, ratings are not the end-all “stamp of approval” to determine the standing of the rated entity.  Investment professionals and the media need to regard ratings as nothing more than a support to an argument, not as the source of an argument.

Comments?

Further Reading:

http://www.bloomberg.com/news/2011-04-13/moody-s-s-p-caved-to-mortgage-pressure-by-goldman-ubs-levin-report-says.html
http://news.yahoo.com/geithner-u-treasuries-still-safe-downgrade-225436759.html