When did Austerity Become a 4 Letter Word? (Tchir)

Friday, April 27th, 2012

 

by Peter Tchir, TF Market Advisors

Suddenly, everywhere you look, “austerity” has become a 4 letter word. Clearly it wasn’t excessive spending that caused too much debt. Surely we didn’t hit a financial crisis in spite of excessive spending, nope, it is all the fault of austerity.

In the rush to avoid supporting anything that could be viewed as “austerity” we have lost sight of what austerity is, and how it can impact the economy.

Is pushing the retirement age from 55 to 57 “austerity”? I don’t see how making decisions like this is bad. It has very little impact on the economy today, yet is a crucial step to creating long term fiscal balance.

Is cutting retirement benefits, starting in 5 years “austerity”? Once again, the near term impact is minimal, and while painful, is a necessary step towards long term sustainability.

Is firing government employees “austerity”? While necessary in the long term, the immediate impact on the economy may not be worth it. Maybe bloated governments need to be dealt with, but over time.

Are programs designed to enforce the tax code “austerity”? Collecting these taxes will take money out of current spending, but the people holding this money by not following the tax laws don’t deserve to have it. It is necessary to create a culture of fairness. This is money that was supposed to be the government’s anyways. You might not like what the government does with the money (do any of us?), but programs that enforce existing tax codes should not be cancelled.

Are unemployment benefits “austerity”? This gets a lot trickier. The short term impact would be to take money out of the economy, as people are likely spending this money as they get it. Yet, if the benefits are too good, are people choosing unemployment with benefits over work?

Are cuts to health care “austerity”? A very touchy subject, yet the reality is this is an area that needs to be addressed. There has to be a balance between ensuring people can have access to great healthcare and that the system is sustainable and the cost/benefits don’t get out of control. In Greece, doctor’s were force to file things electronically or risk not getting paid. Funny how quickly doctor’s were able to computerize their offices, bringing costs lower, in spite of what looked like an “austerity” program.

So, let’s not let politicians get away with claiming everything that is “austerity” is bad. It isn’t. Some forms of “austerity” have minimal near term impact yet are crucial for the long run.

Then let’s look at the long run. Dr. Krugman had a piece today that highlighted the correlation between “austerity” and GDP growth. It showed that more “austerity” (however it was defined) meant slower growth. Doesn’t take a PhD to figure out that GDP is consumption based, and a cut in spending would reduce GDP.

What this chart, and so many other fails to do, is analyze what the impact is two years down the road. Countries were all busy spending throughout the 2000′s and here we are with a debt crisis. Too much debt is impeding the ability to grow. If a farmer planted a seed and the next day gave up in disgust because there were no crops to harvest, we wouldn’t have any food. Programs and policies take time. It is obvious that spending provides a bigger short term boost than cutting spending. It is far less obvious, that a year from now, the adjustments made to deal with the spending cuts won’t create a better future.

We too often confused “conjecture” with “fact”. Lately I have seen a lot written about how much better the job situation is today than it would have been without all the policies of Obama, Geithner, and Bernanke. It is treated as fact, yet it is merely conjecture. I will admit in the quarter the policies were applied, it made the situation in that quarter better than it was. We cannot know whether we are better off now than had we followed some alternative path. Maybe waiting to apply the policies would have created a bigger effect – the “wait until you see the white’s of their eyes” theory. Maybe allowing more banks to fail would have created a wave of new lending institutions that aren’t in competition with subsidized zombie banks. We don’t know. Economics is guess work. There are competing reasons in economics because with some data, some math, some simplifications, and some logic, both sides of a coin can sound good. The theories can’t be put to a proper test. There are no 3 identical economies where you can leave one alone (the control) and apply the competing theories to the other 2 economies and see which theory is correct.

We need to take a longer term view to determine the best solution and we need to critically analyze what has been done and not just assume alternative paths would have led to a worse current situation.

E-mail: tchir@tfmarketadvisors.com

Twitter: @TFMkts

Tags: Austerity, Economy, Fairness, Financial Crisis, Fiscal Balance, Government Employees, Governments, Health Care, Letter Word, Nbsp, Necessary Step, Retirement Age, Retirement Benefits, Rush, Spite, Term Impact, Term Sustainability, Tf, Touchy Subject, Unemployment Benefits
Posted in Markets | Comments Off

Goldman Crashes To Earth: Reports 24% Trading Day Losses In Q2, Compared to 1% In Q1

Tuesday, August 9th, 2011

What a difference a quarter makes. Back in Q1, Goldman reported one (1) day in which it had a trading loss out of 62. It also reported 32 days on which it made over $100 million. Oh how the times have changed. According to the just released 10-Q, Lloyd Blankfein’s firm suffered an epic implosion, recording 15 trading day losses out of 63, or a stunning 24% loss rate. And far worse: only 4 days in which Goldman recorded profits of $100 million. And that’s why the stock is floundering. The only question is whether this was premeditated to shift the public anger away from Goldman which back in 2010 barely had any trading day losses in the entire year. And if not, what is the systemic change that caused this worst quarterly performance for Goldman in years?

Before (Q1)

and After (Q2)

As for the formal reason for the drop in profitability, here is the declining VaR. Of course, the real reason is anything but, but don’t hope on finding it in the official disclosure.

Goldman had some observations on the S&P downgrade of the US as well:

On August 5, 2011, Standard & Poor’s lowered the long-term sovereign credit rating of U.S. Government debt obligations from AAA to AA+. On August 8, 2011, S&P also downgraded the long-term credit ratings of U.S. government-sponsored enterprises. These actions initially have had an adverse effect on financial markets and although we are unable to predict the longer-term impact on such markets and the participants therein, it might be material and adverse.

Other legal disclosures from the 10-Q from Dow Jones:

Goldman also said in the filing it is in discussions with the Securities and Exchange Commission and the Financial Industry Regulatory Authority to resolve proposed charges concerning Goldman’s research communications.

In June, Goldman paid $10 million to the state of Massachusetts and agreed to make certain changes to settle an investigation that focused on Goldman’s so-called research huddles, and communications between analysts and top clients. Massachusetts alleged certain Goldman clients got special access to the firm’s stock analysts and allegedly got information and short-term tips that other clients didn’t get. The SEC and Finra have been investigating similar matters, Goldman said.

Also in the filing, Goldman disclosed it had lowered its “reasonable possible” loss estimate on legal charges above and beyond what it has already reserved to $2 billion, from $2.7 billion in the first quarter.

In expense disclosures, Goldman said it would take a charge of $130 million for a U.K. tax on certain financial services activities of large banks, including their subsidiaries, that operate in the region. Goldman said it would take three-fourths of the charge in the third quarter, with the remainder in the fourth quarter and warned that the final amount could vary from its estimate.

In a lengthy legal disclosure section, Goldman outlined the various ongoing legal actions facing the company, including a previously disclosed ongoing investigation by the Commodity Futures Trading Commission into Goldman’s role as a clearing broker for an SEC- registered broker dealer and the European Commission’s investigation of various firms, including Goldman, in connection with the supply of data related to credit default swaps and profit sharing and fee arrangements for clearing of credit default swaps.

The Department of Justice has been investigating the data supply issues as well, the firm said in the filing. It said it is cooperating with the investigations and reviews.

A new disclosure for the second quarter was Goldman’s ensnarement in a European Commission investigation begun in July raising allegations of an industry-wide conspiracy to fix prices for power cables including by an Italian cable company. Goldman owned a stake in the unnamed company in various of its investment funds from 2005 to 2009 and faces liability for part of any fine that may be levied.

In other words, if the Gambino family was forced to release SEC filings, one would probably see comparable disclosures.

h/t London Dude

Tags: Adverse Effect, August 8, Debt Obligations, Dow Jones, Financial Industry Regulatory Authority, Financial Markets, Formal Reason, Goldman, Government Debt, Government Sponsored Enterprises, Legal Disclosures, Lloyd Blankfein, Public Anger, Quarterly Performance, Real Reason, Research Communications, Securities And Exchange Commission, State Of Massachusetts, Systemic Change, Term Impact
Posted in Markets | Comments Off

6 Huge Risks Threatening Everyone in Q2

Friday, April 1st, 2011

by Joe Wiesenthal, The Business Insider

Tags: 2q, Bofa, Business Insider, david bianco, Disruptions, Downgrades, Electronic Components, Euro Dollar, Financial Exposure, Folly, Government Shutdown, Market Dips, Municipal Budget, oil, Oil Prices, Recession, Record Highs, S David, Term Impact, Us Federal Government, Wiesenthal
Posted in Energy & Natural Resources, Markets, Oil and Gas | Comments Off

Jeremy Grantham: Investment Outlook (Fall 2010)

Thursday, October 28th, 2010

Jeremy Grantham, renowned chief of Boston’s $104-billion GMO, shares his investment outlook in his latest quarterly, aptly titled, “Night of the Living Fed.”

Among other things, Grantham says he likes being overweight high quality stocks and underweight low quality stocks. He feels investors should be moderately overweight emerging market equities, while moderately underweight the rest of the world. And, as for bonds, his thoughts are that while stocks in general are overpriced currently, bonds are even more so. Either way, Grantham’s letter always makes for enlightening reading.

In summary (Grantham elaborates on each of the summarized points in the letter):

1) Long-term data suggests that higher debt levels are not correlated with higher GDP growth rates.

2) Therefore, lowering rates to encourage more debt is useless at the second derivative level.

3) Lower rates, however, certainly do encourage speculation in markets and produce higher-priced and therefore less rewarding investments, which tilt markets toward the speculative end. Sustained higher prices mislead consumers and budgets alike.

4) Our new Presidential Cycle data also shows no measurable economic benefits in Year 3, yet point to a striking market and speculative stock effect. This effect goes back to FDR, and is felt all around the world.

5) It seems certain that the Fed is aware that low rates and moral hazard encourage higher asset prices and increased speculation, and that higher asset prices have a benefi cial short-term impact on the economy, mainly through the wealth effect. It is also probable that the Fed knows that the other direct effects of monetary policy on the economy are negligible.

6) It seems certain that the Fed uses this type of stimulus to help the recovery from even mild recessions, which might be healthier in the long-term for the economy to accept.

7) The Fed, both now and under Greenspan, expressed no concern with the later stages of investment bubbles. This sets up a much-increased probability of bubbles forming and breaking, always dangerous events. Even as much of the rest of the world expresses concern with asset bubbles, Bernanke expresses none. (Yellen to the rescue?)

8) The economic stimulus of higher asset prices, mild in the case of stocks and intense in the case of houses, is in any case all given back with interest as bubbles break and even overcorrect, causing intense financial and economic pain.

9) Persistently over-stimulated asset prices seduce states, municipalities, endowments, and pension funds into assuming unrealistic return assumptions, which can and have caused fi nancial crises as asset prices revert back to replacement cost or below.

10) Artifi cially high asset prices also encourage misallocation of resources, as epitomized in the dotcom and fi ber optic cable booms of 1999, and the overbuilding of houses from 2005 through 2007.

11) Housing is much more dangerous to mess with than stocks, as houses are more broadly owned, more easily borrowed against, and seen as a more stable asset. Consequently, the wealth effect is greater.

12) More importantly, house prices, unlike equities, have a direct effect on the economy by stimulating overbuilding. By 2007, overbuilding employed about 1 million additional, mostly lightly skilled, people, not counting the associated stimulus from housingrelated purchases.

13) This increment of employment probably masked a structural increase in unemployment between 2002 and 2007, which was likely caused by global trade developments. With the housing bust, construction fell below normal and revealed this large increment in structural unemployment. Since these particular jobs may not come back, even in 10 years, this problem may call for retraining or special incentives.

14) Housing busts also help to partly freeze the movement of labor; people are reluctant to move if they have negative house equity. The lesson here is: Do not mess with housing!

15) Lower rates always transfer wealth from retirees (debt owners) to corporations (debt for expansion, theoretically) and the fi nancial industry. This time, there are more retirees and the pain is greater, and corporations are notably avoiding capital spending and, therefore, the benefi ts are reduced. It is likely that there is no net benefi t to artificially low rates.

16) Quantitative easing is likely to turn out to be an even more desperate maneuver than the typical low rate policy. Importantly, by increasing infl ation fears, this easing has sent the dollar down and commodity prices up.

17) Weakening the dollar and being seen as certain to do that increases the chances of currency friction, which could spiral out of control.

18) In almost every respect, adhering to a policy of low rates, employing quantitative easing, deliberately stimulating asset prices, ignoring the consequences of bubbles breaking, and displaying a complete refusal to learn from experience has left Fed policy as a large net negative to the production of a healthy, stable economy with strong employment.

Read the complete letter here in the slide deck, or download a copy (below slide deck)

–

You can download a .pdf copy here.

Hat Tip: MarketFolly.com

Tags: Asset Prices, Benefi, Debt Levels, Economic Benefits, Emerging Market, ETF, Fdr, Gdp Growth Rates, Greenspan, Investment Outlook, Jeremy Grantham, Letter 1, Low Quality, Moral Hazard, Quality Stocks, Recessions, Rewarding Investments, Speculative Stock, Stimulus, Term Impact, Wealth Effect
Posted in ETFs, Markets, Outlook | Comments Off

The Economy and Bond Market Diary (September 13, 2010)

Saturday, September 11th, 2010

The Economy and Bond Market Diary (September 13, 2010)

Treasury bond yields moved higher this week as recent economic data has been viewed more favorably as negative economic sentiment may have become overdone. The chart below shows the yield on the 10-year Treasury which is up about 30 basis points just this month.

Strengths

• Initial jobless claims fell to 451,000 which is considerably better than what has been reported in recent weeks.
• The trade balance improved in July as exports climbed while imports dropped. This is incrementally positive for third quarter GDP.
• The Labor Department reported that job openings rose 6.2 percent in June and hit the highest level since April.

Weaknesses

• The Fed’s Beige Book reported “widespread signs of deceleration” as the Fed prepares for its Federal Open Market Committee meeting on September 21.
• Home inventories rose for the 8th straight month in August as the housing market continues to struggle.
• Consumer credit fell for the 6th straight month as consumers pare down debt. While this is what needs to take place in the long run, the short term impact is sluggish growth.

Opportunities

• Inflation is unlikely to be a problem for some time and this gives central bankers and other policy makers around the world room for expansive policies.

Threats

• European financial concerns have intensified recently as the long-term solutions still appear elusive for many economies.

Tags: Basis Points, Beige Book, Bond Market, Deceleration, Economic Data, Economic Sentiment, Federal Open Market Committee, Financial Concerns, Growth Opportunities, Housing Market, Initial Jobless Claims, Labor Department, Long Term Solutions, Market Diary, Open Market Committee, Quarter Gdp, Sluggish Growth, Term Impact, Trade Balance, Treasury Bond Yields
Posted in Markets | Comments Off

Strengthening the financial system: The benefits outweigh the costs

Monday, August 23rd, 2010

Just like an overweight victim recovering from a severe heart attack, the financial system must change its ways. After working tirelessly – and in the end successfully – to stabilise the patient, the world’s central bankers and supervisors are developing a rigorous diet and exercise programme to help avoid a relapse. Yet, now that the immediate danger has passed, a natural scepticism has set in. Does the financial system really need to change its ways? Why bother with all this unpleasant exercise? Are the benefits of more stringent regulation and supervision really worth the cost?

Two papers released this week by the Financial Stability Board and the Basel Committee on Banking Supervision give a clear answer. Stronger capital and liquidity requirements bring substantial benefits – and only with modest costs. The first study (Basel Committee on Banking Supervision 2010) looks at the long-term impact of stronger capital and liquidity requirements, while the other (Macroeconomic Assessment Group 2010) examines the transitional economic impact as the new standards are phased in. Taken together, these two reports show that the benefits will be significant, while the costs are likely to be very modest.

The Basel Committee on Banking Supervision and The Financial Stability Board are well advanced in the preparation of detailed internationally agreed financial reforms. Improved capital and liquidity standards form the core of these reforms. They outline that banks should:

• increase and improve their capital base;
• set a simple leverage ratio as a supplementary backstop to the risk-based capital framework;
• adopt capital conservation measures to generate buffers that can be drawn down in periods of stress;
• and – in contrast to their behaviour before the financial crisis – manage their maturity and currency mismatches in a prudent manner.

The motive for these specific reforms – as well as capital regulation in general – is that if banks are left to their own devices, they will hold too little capital and liquidity. While a lower level of capital may result in higher returns to equity holders, it will also mean a smaller buffer to weather loan defaults and investment losses. Less liquidity meanwhile, implies not only a higher fraction of long-term assets funded with short-term debt that raises interest rate margins and profits, it also makes banks more exposed to sudden withdrawals and difficulties in rolling over debt. As we have learned at no small cost, the upside of these risks belong to banks’ shareholders and managers, while the size of capital and liquidity cushions determines how much of the downside risk is borne by all of us.

Serious financial crises occur every 20 to 25 years; the average annual probability of a crisis is of the order of 4-5%. When they do occur, banking crises are often quite costly, bringing with them deep recessions and a permanently lower GDP. Estimates of the cumulative (discounted) output losses range from a minimum of 20% to well in excess of 100% of pre-crisis output, depending primarily on how long-lasting the effects are estimated to be. A study by the Basel Committee on Banking Supervision (2010) using the median estimate of the costs of crises across all comparable studies – around 60% – finds that each percentage point reduction in the annual probability of a crisis yields an expected benefit per year equal to 0.6% of output. While individual country experiences obviously vary, on balance the frequency of crises does not differ much between industrial and emerging economies and, if anything, costs appear somewhat higher in industrial economies.

The ups and downs of a better diet

Although there is considerable uncertainty about the exact magnitude of the effect, the evidence indicates that higher capital and liquidity requirements can significantly reduce the probability of banking crises, though with declining marginal benefits. Furthermore, the stronger the banking system the less severe a banking crisis is likely to be, should it come. Higher aggregate levels of capital and liquidity should help insulate stronger banks from the strains faced by weaker ones. It is with the aim of reducing the frequency, severity, and public costs of financial crises that the G20 leaders are committed to significantly increasing the levels of capital and liquidity in their national banking systems.

While a better diet and more exercise will increase life expectancy, what about the hunger and soreness the patient experiences as he starts the new programme? Even if the long-term benefits are recognised, what about the short-term costs of implementing a strong regulatory system?

This is the question addressed by the Macroeconomic Assessment Group, a group that draws together the modelling expertise of two dozen national authorities and international organisations. The report concludes that, for each percentage point increase in required capital implemented over a four year horizon, the level of GDP relative to the baseline path declines by a maximum of about 0.19%. This maximum GDP loss occurs four and a half years after the start of implementation; after which GDP recovers towards its baseline level. The 0.19% figure is the sum of 0.16%, the median GDP decline estimated for specific countries by national authorities, and 0.03%, which is the potential impact of international spillovers (reflecting exchange rates, commodity prices and shifts in global demand) as estimated by the IMF.

Putting this into a more commonly used terminology, we can translate the decline of 0.19% and the subsequent recovery into implied changes in the average annual growth rate during the transition. First, note that with a four year implementation period, the maximum deviation from the baseline occurs after 4½ years. In order to reach a cumulative 0.19% fall in the level of output in this time period, growth would have to be roughly 0.04% below trend. Following this, the economy slowly recovers with growth 0.02% above trend.

No pain no gain?

These results are for every one percentage point increase in target capital ratios, whether the source of this increase be higher regulatory minima, required buffers, changes in the definition of capital, the application of a leverage ratio, or some other change in standards. And, importantly, the numbers are scalable. So, the report’s results imply that a two percentage point increase in target capital ratios would bring with it a fall in growth of 0.08% at an annual rate relative to trend for 4½ years, followed by annual growth of 0.04% above trend as the recovery ensues.

As with any policy simulation or forecast, the conclusions of the analysis depend on a variety of assumptions about behaviour. For example, most of the effects reflect the presumption that higher capital levels will increase bank funding costs, and these will be passed on to borrowers in the form of higher loan rates. But, instead of (or in addition to) raising loan rates, banks may choose to shrink their balance sheets, cutting back on lending – rationing credit – in ways that wouldn’t be reflected in lending rates. When some modellers in the Macroeconomic Assessment Group studied this possibility, their work suggested more substantial output effects.

An easing of monetary policy reduces the estimated output losses. When it is assumed that the central bank responds to the incipient aggregate demand fall and reduced inflationary pressures precipitated by the regulatory changes, the central estimate of the maximum output loss shrinks significantly. Such offsets are especially pronounced in models that incorporate credit supply constraints, for which the GDP loss at the four-and-a-half year point falls from 0.32% to 0.17%.

The adjustment costs of implementing higher capital requirements arise from the fact that equity investors – suppliers of the bank’s risk capital – require higher returns than depositors. So, higher capital requirements mean higher funding costs; costs that banks will try to recover by raising loan rates they charge borrowers or shrinking their balance sheets.

But banks can also meet the new requirements by some combination of retaining more earnings (reducing dividends), decreasing remuneration rates on deposits and other liabilities, or reducing other costs of doing business (including managerial compensation). It is also possible that, as banks become safer, markets will require a lower return on equity, tempering the pressure on funding costs. Any of these would reduce the degree to which lending rates would need to rise and loan volumes fall, attenuating the macroeconomic impact.

Indeed, Elliott (2009), who estimated that each percentage point increase in capital ratios would lead to a 19 basis point widening in lending spreads if other factors were kept constant, concluded that the widening of spreads could be as low as 4.5 basis points if banks’ return on equity, asset mix and other variables are allowed to change. Hanson et al. (forthcoming) arrive at a similar estimate for the likely widening of lending spreads. They suggest that the only impact of capital and liquidity requirements would be due to effects that are not encompassed in Modigliani and Miller’s (1958) idealised framework, notably the tax advantages of debt and the premium that banks would need to pay investors to hold longer-term, less-liquid debt instruments.

While acknowledging the potential importance of these factors, the Macroeconomic Assessment Group implemented a conservative approach by assuming banks could not make these adjustments. Focusing on the implications for borrowing costs, Macroeconomic Assessment Group researchers estimated that banks’ lending rates would need to rise by about 15 basis points for each percentage point increase in capital¹. With companies needing to pay more to borrow, they will start fewer new investment projects, slowing the level of overall economic activity. Yet, as the financial system adjusts during and after the phase-in, these costs will slowly dissipate, returning GDP to the path it would have followed in the absence of the changes.

This analysis assumes the higher capital requirement will be phased in over a four year period. If the implementation is faster, say two years rather than four, then the estimated impact on GDP is likely to be both larger and earlier. The estimated maximum decline in GDP is 0.22% rather than 0.19% and comes two years earlier. In terms of growth rates, a two-year implementation implies that (per percentage point increase in target capital ratios) growth will be 0.09% lower for 2½ years rather than 0.04% lower for 4½ years.

By contrast, the report concludes that lengthening the implementation period from four to six year makes little difference in the maximum decline. (Of course, if a similar sized cumulative loss is spread over a longer implementation period means a smaller decline in annual growth, relatively to trend, during the transition.) In any event, most of the factors not considered by the modelling group, like limits to the market’s capacity to quickly absorb large volumes of new bank equity issuance, would argue for a longer rather than a shorter transition period.

Separate analyses looking at the impact of stronger liquidity standards (which would oblige banks to hold more liquid assets and rely less on short-term wholesale funding) show that these, too, are likely to have only mild transitional effects. This is at least in part because of the complementarity of capital and liquidity requirements. That is, they call for similar changes to banks’ asset and liability structures – so, as one rises, the required level of the other falls.

Studies published by banks come to different conclusions. For example, in June the Institute of International Finance (2010) issued a report concluding that phasing in an increase in capital requirements of as little as two percentage points will lead to a drop of GDP of 3% in the G3 economies. Why such a big difference? One reason is that the industry studies assume a much larger increase in the lending rate, largely reflecting the withdrawal of implicit government support. But as the industry studies also acknowledge, they have assumed no changes in dividends, compensation policies and operational efficiency, nor have they taken account of the benefits coming from a more resilient financial system, including the lower funding premia that safer banks need to pay.

A clear lesson of this financial crisis is that the safeguards that were place were too weak. But reinforcement is not free. Fortunately, the short-term costs are likely to be small and transitory, while the benefits of a stronger and healthier financial system will be around for years to come.

References

Basel Committee on Banking Supervision (2010), An assessment of the long-term economic impact of the new regulatory framework, August.

Elliott, D (2009), “Quantifying the effects on lending of increased capital requirements”, Pew Financial Reform Project Briefing Paper 7.

Institute of International Finance (2010), Interim Report on the Cumulative Impact on the Global Economy of Proposed Changes in the Banking Regulatory Framework, June.

S Hanson, A Kashyap, and J Stein (forthcoming): “A Macroprudential Approach to Financial Regulation”, Journal of Economic Perspectives.

Macroeconomic Assessment Group of the Financial Stability Board and Basel Committee on Banking Supervision (2010), Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements, Bank for International Settlements, August.

Modigliani, F and M Miller (1958), “The cost of capital, corporation finance and the theory of investment”, American Economic Review, 48:261–297.

---

1 To understand where a number like this may come from, imagine a stylised bank with a balance sheet (where total assets equal risk-weighted assets) that has the following composition. On the liabilities side, there are deposits and debt, for which the bank pays an average of 5%, and capital, with a return of 15%. Assets are composed of two thirds loans and one third a combination of securities and cash (reserves). Now consider an increase in the capital ratio of 1 percentage point. This raises the cost of funds (the weighted average cost of capital plus deposits and debt) by 10 basis points. To maintain return on equity at 15%, the bank must recover this cost increase by raising the return on its assets. If this is done solely by raising rates charged to borrowers, since loans are two thirds of assets, it must raise lending rates by 15 basis points – a number close to that in the MAG report and obtained by Elliott (2009).

Copyright (c) VoxEU.org

Tags: Assessment Group, Basel Committee On Banking Supervision, Capita, Economic Impact, Exercise Benefits, Exercise Programme, Extent, Financial Reforms, Financial Stability, Global Crisis, H Cohen, Heart Attack, Liquidity Requirements, Relapse, S Central, Scepticism, Stephen Cecchetti, Stringent Regulation, Substantial Benefits, Term Impact
Posted in Markets | 1 Comment »

Chart of the Week – Yuan Winners

Thursday, July 1st, 2010

A stronger Chinese yuan makes exports into China cheaper and imports from China more expensive.

The U.S. stands to benefit both ways – Chinese consumers get more purchasing power for high-end American exports, and domestic manufacturers will be better able to compete against Chinese producers and help America chip away at its massive trade deficit with China.

Other countries stand to benefit as well, perhaps none so much as Indonesia and India.

The chart below from our Weekly Investor Alert shows how stock markets performed in the Asia region from mid-2005 to mid-2008, the last period when the yuan was not tightly pegged to the U.S. dollar.

The top performer was China itself, but then came Indonesia’s stock market at 104 percent and India at 83 percent.

Indonesia is a major natural resource producer, and China is one of the main markets for its liquefied natural gas, palm oil, wood pulp and rubber. India competes with China in a range of manufactured products, including textiles and electric components. A stronger yuan could make Indonesian and Indian products more attractive to Chinese buyers (assuming the rupiah or the rupee is not appreciating at the same pace).

China, Indonesia and India are all countries we watch as part of our “E-7” group of the world’s most populous emerging economies, and we will be watching as well to see the short-term and longer-term impact of yuan appreciation on the relationships among these nations.

Tags: American Exports, Asia Region, China Indonesia, Chinese Consumers, Chinese Yuan, Commodities, Domestic Manufacturers, Electric Components, Emerging Economies, energy, India, Investor Alert, Last Period, Liquefied Natural Gas, Natural Gas, Natural Resources, Palm Oil, Rsquo, Rubber India, Rupiah, Stock Markets, Term Impact, Top Performer, Trade Deficit With China, Wood Pulp
Posted in China, Energy & Natural Resources, India, Oil and Gas | Comments Off