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July 2010 papers

- A Cautious Note on the Design of Volatility Derivatives -- Abstract:This cautious note aims to point at the potential risks for the financial system caused by various increasingly popular volatility derivatives including variance swaps on futures of equity indices. It investigates the pricing of variance swaps under the 3/2 volatility model. Carr with Itkin and Sun have discussed the pricing of variance swaps under this type of model. This paper studies a special case of this model and observes an explosion of prices for squared volatility and variance swaps. It argues that such a price explosion may have deeper economic reasons, which should be taken into account when designing volatility derivatives.
- Are we building the foundations for the next crisis already? The case of central clearing -- Abstract: Counterparty risk has been at the heart of the recent crisis driven by the toxicity of over-the-counter (OTC) derivatives and failure of high profile financial institutions. This has led policymakers to propose laws that would require most standard OTC derivatives to be centrally cleared. Central clearing involves a central counterparty (CCP) intermediating a transaction and acting as an insurer of counterparty risk. This has advantages, potentially leading to enhanced transparency and liquidity in markets and smoothing major systemic problems. The idea is also popular since it represents a single and intuitively simple solution to the severe problem of counterparty risk. However, whilst CCPs may have a role to play in reducing counterparty risk, they can also be counterproductive to the stability of financial markets. In this paper, we argue that the introduction of CCPs should be carefully considered and that, far from reducing counterparty risk, they may actually allow it to breed and contribute to the next crisis.
- Basel III, the Banks, and the Economy -- By November, banking regulators are likely to complete an international agreement that will determine how strong banks must be. Tough new rules on capital and liquidity are being negotiated through the Basel Committee on Banking Supervision (Basel Committee). The agreement, which is known as “Basel III” because it will be the third version of these rules, will have a large effect on the world’s financial systems and economies. On the positive side, newly toughened capital and liquidity requirements should make national financial systems ‐‐ and indeed the global financial system ‐‐ safer. Unfortunately, enhanced safety will come at a cost, since it is expensive for banks to hold extra capital and to be more liquid. It is beyond serious dispute that loans and other banking services will become more expensive and harder to obtain. The real argument is about the degree, not the direction. The banking industry argues that Basel III will seriously harm the economy. For example, the Institute of International Finance (IIF) calculated that the economies of the US and Europe would be 3% smaller after five years than if Basel III were not adopted. My own analyses, and those of other disinterested parties, generally suggest a much smaller cost that would seem to be considerably outweighed by the safety benefits. As the recent crisis clearly attests, severe financial crises can cause permanent damage to the world’s economy, imposing economic loss and emotional pain on hundreds of millions, if not billions, of people. It is worthwhile to give up a little economic growth in the average year in order to avoid these major impacts, as my work suggests would be the case. On the other hand, if the industry is right, the additional safety is probably not worth the cost and a more modest regulatory revamp would be preferable. This paper explores the following questions about Basel III. What is Basel III and who is making the decisions? What is the timetable for Basel III? What are capital and liquidity? What are the current rules? What are the proposed changes from the current rules? What stays the same? What are the major areas of disagreement? Will the originally proposed changes or timetable be modified? What are the likely effects of Basel III?
- China’s Marriage Market and Upcoming Challenges for Elderly Men -- Abstract: Fertility decline has fueled a sharp increase in the proportion of ‘missing girls’ in China, so an increasing share of males will fail to marry, and will face old age without the support normally provided by wives and children. This paper shows that historically, China has had nearly-universal marriage for women and a very competitive market for men. Lower-educated men experience higher rates of bachelorhood while women favor men with better prospects, migrating if needed from poorer to wealthier areas. The authors examine the anticipated effects of this combination of bride shortage and hypergamy, for different regions of China. Their projections indicate that unmarried males will likely be concentrated in poorer provinces with low fiscal ability to provide social protection to their citizens. Such geographic concentration of unmarried males could be socially disruptive, and the paper’s findings suggest a need to expand the coverage of social protection programs financed substantially by the central government.
- Chronicle of Currency Collapses: Re-examining the Effects on Output -- Abstract: The impact of currency collapses (ie large nominal depreciations or devaluations) on real output remains unsettled in the empirical macroeconomic literature. This paper provides new empirical evidence on this relationship using a dataset for 108 emerging and developing economies for the period 1960-2006. We provide estimates of how these episodes affect growth and output trend. Our main finding is that currency collapses are associated with a permanent output loss relative to trend, which is estimated to range between 2% and 6% of GDP. However, we show that such losses tend to materialise before the drop in the value of the currency, which suggests that the costs of a currency crash largely stem from the factors leading to it. Taken on its own (ie ceteris paribus) we find that currency collapses tend to have a positive effect on output. More generally, we also find that the likelihood of a positive growth rate in the year of the collapse is over two times more likely than a contraction; and that positive growth rates in the years that follow such episodes are the norm. Finally, we show that the persistence of the crash matters, ie one-time events induce exchange rate and output dynamics that differ from consecutive episodes.
- Economic Security at Risk -- Executive Summary: Even before the current recession, economic security was a major concern of most Americans. This concern has only grown amid the deepest downturn in decades.Yet the discussion of economic security has been hampered by the lack of a simple, coherent measure that allows for the comparison of economic security over time and across Americans of different circumstances. The Economic Security Index (ESI), sponsored by the Rockefeller Foundation, was created to fill this gap. It provides a simple measure of the joint occurrence of three major risks to economic well-being:
Experiencing a major loss in income Incurring large out-of-pocket medical expenses Lacking adequate financial wealth to buffer the first two risks In brief, the ESI represents the share of Americans who experience at least a 25 percent decline in their inflation-adjusted “available household income” from one year to the next and who lack an adequate financial safety net to replace this lost income until it has returned to its original level. “Available household income” is income that is reduced by nondiscretionary spending, including, most substantially, the amount of a household’s out-of-pocket medical spending. Thus Americans may experience income losses of 25 percent or greater due to a decline in income or an increase in medical spending or a combination of the two. The ESI is the share of Americans who are counted as insecure by this standard. A higher ESI therefore indicates greater insecurity, much as a rising unemployment rate signals a faltering economy.
- Evaluating Conditions in Major Chinese Housing Markets -- Abstract: High and rising prices in Chinese housing markets have attracted global attention, as well as the interest of the Chinese government and its regulators. Housing markets look very risky based on the stylized facts we document. Price-to-rent ratios in Beijing and seven other large markets across the country have increased from 30% to 70% since the beginning of 2007. Current price-to-rent ratios imply very low user costs of no more than 2%-3% of house value. Very high expected capital gains appear necessary to justify such low user costs. Our calculations suggest that even modest declines in expected appreciation would lead to large price declines of over 40% in markets such as Beijing, absent offsetting rent increases or other countervailing factors. Price-to-income ratios also are at their highest levels ever in Beijing and select other markets. Much of the increase in prices is occurring in land values. Using data from the local land auction market in Beijing, we are able to produce a constant quality land price index for that city. Real, constant quality land values have increased by 900% since the first quarter of 2003, with half that rise occurring over the past two years. State-owned enterprises controlled by the central government have played an important role in this increase, as our analysis shows they paid 27% more than other bidders for an otherwise equivalent land parcel.
- Extraordinary measures in extraordinary times: Public measures in support of the financial sector in the EU and the United States -- Abstract:The extensive public support measures for the fi nancial sector have been key for the management of the current fi nancial crisis. This paper gives a detailed description of the measures taken by central banks and governments and attempts a preliminary assessment of the effectiveness of such measures. The geographical focus of the paper is on the European Union (EU) and the United States. The crisis response in both regions has been largely similar in terms of both tools and scope, and monetary policy actions and bank rescue measures have become increasingly intertwined. However, there are important differences, not only between the EU and the United States (e.g. with regard to the involvement of the central bank), but also within the EU (e.g. asset relief schemes).
- Fetters of Gold and Paper -- While we are lucky to have avoided another catastrophe like the Great Depression in 2008-9, mainly by virtue of our policy makers’ aggressive use of monetary and fiscal stimuli, the world economy still is experiencing many difficulties. As in the Great Depression, this second round of problems stems from the prevalence of fixed exchange rates. Fixed exchange rates facilitate business and communication in good times but intensify problems when times are bad. We argue that the gold standard and the euro share the attributes of the young lady described by Henry Wadsworth Longfellow (American, 1807-82):
There was a little girl, who had a little curl Right in the middle of her forehead, And when she was good, she was very, very good, But when she was bad she was horrid. We describe in this essay how fixed exchange rates share this dual personality, why the gold standard and the euro are extreme forms of fixed exchange rates, and how these policies had their most potent effects in the worst peaceful economic periods in modern times. We do not ask or attempt to answer whether the widespread adoption of the gold standard in the mid-1920s or the creation of the euro in 1999 were mistakes.1 Both decisions reflected deep-seated historical forces that developed over long periods of time: a set of gold standard conventions and a mentalit√© that flowered in the 19th century, allowing the gold standard to be seen as the normal basis for international monetary affairs, and a process of European integration with roots stretching back well before World War II which came into full flower in the fertile seedbed that was the second half of the 20th century, culminating in the emergence of the euro at the century’s end. We take these deep-seated circumstances as given and ask whether and how they could have been managed better. We ask, in particular, whether they could have been managed to prevent economic disaster.
- Fiscal stimulus and exit strategies in the EU: a model-based analysis -- Abstract: This paper uses a multi-region dynamic general equilibrium model with collateral
constrained households and residential investment to examine the effectiveness of fiscal policy. The presence of credit constrained households makes fiscal policy a more powerful tool for short run stabilisation and reinforces the effects from monetary accommodation at the zero lower bound. There exists an asymmetry between fiscal multipliers of temporary stimulus and multipliers of permanent fiscal consolidation, with the latter being smaller. Fiscal consolidations are likely to have short term negative output effects, but GDP will be higher in the medium and long run. Designing consolidations in such a way as to maximise the long term growth benefits from tax reforms could help to minimise the short term costs.
- Income Inequality in a Bubble Economy – The Case of Iceland 1992-2008 --Abstract: The paper outlines how the neoliberal experiment which was undertaken in Iceland, from the 1990s up to the financial collapse of 2008, affected the country’s income distribution. Increasing freedom for finance and extensive leveraging connected to an investment boom fed a speculation bubble and an expanding stock market, increasing greatly the flow of financial earnings. Financial earnings went disproportionally to the higher income groups, in particular the top 5%. At the same time government taxation policies were changed, in line with neoliberal prescriptions. Thus taxation on corporate incomes was reduced from 50% to 18% and a new tax on financial earnings was introduced in 1998, with the unusually low rate of 10%. There were also reductions of estate and inheritance tax rates. These measures greatly reduced the tax burden on high income earners and owners of larger assets. In conjunction with these developments the government greatly reduced the personal tax allowance for individual income tax payers, which greatly increased the tax burden of low income earners. Thus the government policies transfered tax burden from the higher end of the income scale to the lower end, adding to the growth of income inequality already emanating from the workings of the market. Together these developments increased income inequality at an unprecedented rate. This was particularly visible for the top 1% but affected the overall structure of inequality significantly. The paper outlines these developments and disaggregates the changing composition of earnings and changing equalization effects of taxes and transfers in the period.
- Paying Attention: Overnight Returns and the Hidden Cost of Buying at the Open -- Abstract: Using 13 years of intraday data for U.S. stocks, we find a strong tendency for positive returns during the overnight period followed by reversals during the trading day. This behavior is driven by an opening price that is high relative to intraday prices. We find this temporary price inflation at the open is concentrated among stocks that have recently attracted the attention of retail investors, and these high attention stocks have high levels of net retail buying at the start of the trading day. In addition, we document that the sensitivity of opening prices to retail investor attention is more pronounced for stocks that are difficult to value and costly to arbitrage, and is greater during periods of high retail investor sentiment. The additional implicit transaction costs for retail traders who buy high attention stocks near the open frequently exceed the effective half spread.
- Placing the 2006/08 Commodity Price Boom into Perspective -- Abstract: The 2006-08 commodity price boom was one of the longest and broadest of the post-World War II period. Apart from strong and sustained economic growth, the recent boom was fueled by numerous factors, including low past investment in extractive commodities, weak dollar, fiscal expansion, and lax monetary policy in many countries, and investment fund activity. At the same time, the combination of adverse weather conditions, the diversion of some food commodities to the production of biofuels, and government policies (including export bans and prohibitive taxes) brought global stocks of many food commodities down to levels not seen since the early 1970s. This in turn accelerated the price increases that eventually led to the 2008 rally. The weakening and/or reversal of these factors coupled with the financial crisis that erupted in September 2008 and the subsequent global economic downturn, induced sharp price declines across most commodity sectors. Yet, the main price indices are still twice as high compared to their 2000 real levels, begging once more the question about the real factors affecting them. This paper concludes that a stronger link between energy and nonenergy commodity prices is likely to be the dominant influence on developments in commodity, and especially food, markets. Demand by emerging economies is unlikely to put additional pressure on the prices of food commodities. The paper also argues that the effect of biofuels on food prices has not been as large as originally thought, but that the use of commodities by financial investors (the so-called ”financialization of commodities”) may have been partly responsible for the 2007/08 spike. Finally, econometric analysis of the long-term evolution of commodity prices supports the thesis that price variability overwhelms price trends.
- Research on global financial stability: the use of BIS international financial statistics -- Introduction: One of the lessons of the global financial crisis which started in August 2007 is the crucial importance for policy makers and supervisors of having access to a wide range of reliable, timely and detailed financial statistics. In this regard the BIS has been playing a pioneering role in collecting and providing, since long ago, financial statistics which have been actively used to better understand the crisis and international financial trends and linkages. International financial statistics also may soon play an enhanced role as central banks and supervisors move towards a macroprudential approach to financial stability. The BIS financial statistics consist of three major groups. The first is represented by the international banking statistics, which provide data on stocks and flows, on the currency denomination and maturity structure of cross-border banking assets and liabilities, both on a locational and a nationality basis. The origins of the BIS international banking statistics go back to the mid-1960s and to the need to monitor the emergence of the so-called eurocurrency markets that had sprung up to circumvent domestic regulations. Throughout the current financial crisis, these data have inter alia been used to analyze cross-border sources of funding for banks, in particular the so called “dollar shortage”, whose role has been prominent in the early stage of the crisis, and channels for international transmission of disturbances. There is currently ongoing work to expand these statistics. Turning to the second group of statistics, in the mid-1980s, as a result of the increasing role of the international securities markets in global financial intermediation, the BIS was mandated to collect and publish international debt securities statistics on the basis of data from commercial databases and from central banks. In the early 1990s the BIS also started to collect domestic debt securities statistics. A third group of financial statistics which is collected and published by the BIS are data on derivatives. Data on OTC derivatives have been available, based on an ad hoc semi-annual survey, since 1998; in 2004 they have been supplemented with data on credit default swaps. Data for exchange traded derivatives, which are provided by the exchanges, are also published by the BIS, with a longer time series. Ongoing work is aiming at expanding these statistics with a view to better and more timely understand the transfer and ultimate distribution of credit risk. The second CGFS workshop on “Research on global financial stability: the use of BIS international financial statistics” was held on 4–5 December 2008 in Basel.2 The aim of the workshop was to take stock of how BIS international financial statistics have helped academic and central bank researchers to improve our understanding of global financial stability issues and, in particular, of the financial crisis which started in August 2007. In addition to BIS staff, the event was attended by economists and statisticians from thirteen central banks and from the IMF, together with eight academics. The workshop started with an overview of the new developments in the BIS statistics, followed by presentations and discussions of ten research papers. The presented papers can be broadly classified into three key areas. First, a number of contributions took advantage of the bilateral characteristics of BIS reporting bank claims vis-√†-vis other countries to construct quantitative measures of financial integration and to analyse the latter’s determinants. Second, other studies belong to the growing literature which combines BIS international banking with other international statistics to assess vulnerability of national balance sheets. In particular, the currency composition of the BIS data on international banking claims has proven to be a useful data source for analysing issues related to a country’s foreign currency exposures. Third, a few papers were part of a large literature on the lending channel and monetary transmission. Bank lending data allow researchers to examine the role of banks’ cross-border intra-bank lending on monetary transmission. This could improve the general understanding of the impact of bank globalisation on monetary transmission mechanism. The workshop concluded with a roundtable discussion on “What can we learn about the financial crisis from the BIS statistics”, chaired by Stephen Cecchetti. The roundtable discussion focused on two issues: what could be learned from the BIS statistics about the current financial crisis and what other data could improve the understanding of the crisis. It was acknowledged that the BIS statistics are one of the few sources that provide internationally comparable quantity data on international balance sheet data of banks, which has proved be useful in examining the transmission of the crisis. However, other participants noted that the lack of comparable data on fixed-income markets was a key obstacle to a more detailed analysis. In particular, volume data related to securitisation and other off balance sheet items would be valuable additions to the existing BIS data. Some participants pointed out that BIS consolidated banking data indeed contain very useful information on the asset side of reporting banks’ balance sheets. But as the recent crisis unfolded, it also became clear that more information on the composition of bank liabilities would be useful. As one example, in this crisis many international banks have experienced funding problems in both local and foreign currencies. In this context, the addition of currency split of banks’ consolidated liabilities would be extremely useful for tracking these funding difficulties. Some participants expressed interest in having the BIS explore which data already collected from constituent banks within BIS reporting countries might be useful to provide to the BIS for understanding past events and preparing for future ones. Overall researchers, especially those from academia, agreed that the workshop provided an excellent platform to share and exchange views on the use of these statistics. They appreciated the efforts by the BIS statisticians to clarify the conditions and other confidentiality matters for central bank and academic economists to use the data for research.
- Shadow Banking -- Abstract: The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation in the United States profoundly. Within the market-based financial system, “shadow banks” are particularly important institutions. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds, money market mutual funds, securities lenders, and government-sponsored enterprises. Shadow banks are interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitization and secured funding techniques such as ABCP, asset-backed securities, collateralized debt obligations, and repo. This intermediation chain binds shadow banks into a network, which is the shadow banking system. The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses. Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed ignificantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis. We document that the shadow banking system became severely strained during the financial crisis because, like traditional banks, shadow banks conduct credit, maturity, and liquidity transformation, but unlike traditional financial intermediaries, they lack access to public sources of liquidity, such as the Federal Reserve’s discount window, or public sources of insurance, such as federal deposit insurance. The liquidity facilities of the Federal Reserve and other government agencies’ guarantee schemes were a direct response to the liquidity and capital shortfalls of shadow banks and, effectively, provided either a backstop to credit intermediation by the shadow banking system or to traditional banks for the exposure to shadow banks. Our paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relation to the traditional banking system.
- How the Great Recession Was Brought to an End -- The U.S. government’s response to the financial crisis and ensuing Great Recession included some of the most aggressive fiscal and monetary policies in history. The response was multifaceted and bipartisan, involving the Federal Reserve, Congress, and two administrations. Yet almost every one of these policy initiatives remain controversial to this day, with critics calling them misguided, ineffective or both. The debate over these policies is crucial because, with the economy still weak, more government support may be needed, as seen recently in both the extension of unemployment benefits and the Fed’s consideration of further easing. In this paper, we use the Moody’s Analytics model of the U.S. economy—adjusted to accommodate some recent financial-market policies—to simulate the macroeconomic effects of the government’s total policy response. We find that its effects on real GDP, jobs, and inflation are huge, and probably averted what could have been called Great Depression 2.0. For example, we estimate that, without the government’s response, GDP in 2010 would be about 11.5% lower, payroll employment would be less by some 8½ million jobs, and the nation would now be experiencing deflation. When we divide these effects into two components—one attributable to the fiscal stimulus and the other attributable to financial-market policies such as the TARP, the bank stress tests and the Fed’s quantitative easing— we estimate that the latter was substantially more powerful than the former. Nonetheless, the effects of the fiscal stimulus alone appear very substantial, raising 2010 real GDP by about 3.4%, holding the unemployment rate about 1½ percentage points lower, and adding almost 2.7 million jobs to U.S. payrolls. These estimates of the fiscal impact are broadly consistent with those made by the CBO and the Obama administration. 2 To our knowledge, however, our comprehensive estimates of the effects of the financial-market policies are the first of their kind.3 We welcome other efforts to estimate these effects.
- Tackling inequalities in life expectancy in areas with the worst health and deprivation -- Summary:Inequalities in health outcomes between the most affluent and disadvantaged members of society are longstanding, deep-seated and have proved difficult to change. In the early 2000s, in England, people living in the poorest neighbourhoods, could on average expect to die seven years earlier than people living in the richest neighbourhoods and spend far more of their lives with ill health. In 1997, the Government announced that it would put reducing health inequalities at the heart of tackling the root causes of ill health to create a fairer society and to reduce the costs associated with ill health. The Government established the independent Acheson inquiry into inequalities in health to improve its understanding of the causes and how to tackle them. Such inequalities are due to a complex mix of social, economic, cultural and political reasons with unequal provision of healthcare responsible for only a proportion. The Department of Health (the Department) estimate that around 15 to 20 per cent of inequalities in mortality rates can be directly infl uenced by health interventions which prevent or reduce the risk of ill health, representing thousands of people dying earlier than might otherwise be the case.4 et a target for the Department to ‘narrow the health gap between socio-economic groups and between the most deprived areas and the rest of the country, in childhood and throughout life.’ In 2002, the Government refined this target to reduce inequality by 2010 by 10 per cent as measured by life expectancy at birth and infant mortality. Its intention was to provide a focus for short- and medium-term action. Lead responsibility for delivering the target was vested in the Department. A Treasury-led cross-cutting review in 2002 highlighted the importance of the NHS’ contribution to meeting the 2010 target and identifi ed that health interventions, such as reducing smoking in manual groups and preventing and managing other risk factors for coronary heart disease and cancer, were more likely than other actions to help deliver the target. The Department continued to develop its strategic approach to tackling health inequalities during the fi rst half of the decade. The Department’s cross-government health inequalities strategy, A Programme for Action, was published in 2003 and called on PCTs (PCTs) and strategic health authorities to ensure that tackling health inequalities was central to their planning and performance management systems. It included 12 cross-government headline indicators and 82 cross-government commitments. The following year the Department revised the health inequalities target to reduce by 2010, by at least 10 per cent, the gap in life expectancy between 70 ‘spearhead’ local authority areas – a fi xed group of areas with high levels of deprivation and poor health outcomes – and the population as a whole. The Department’s focus on fixed, spearhead areas from late 2004, was seen as a practical way of focusing activity and measuring progress. Under half (48 per cent) of local authority wards with the worst life expectancy are in a spearhead area. Since 2004, there have been a large number of policy documents on health inequalities alongside annual reviews of progress which show that although life expectancy overall has improved the gap between the better off and worse off has increased. Internationally, England is the only country with a broad, cross-government strategy to tackle health inequalities. In recognition of the need to develop a new post-2010 health inequalities strategy, the Department commissioned an independent review by Professor Sir Michael Marmot. His February 2010 report, Fair society, healthy lives – strategic review of health inequalities post-2010, focused on the impact of wider social determinants on health inequalities including education, employment and housing, and estimated that the additional NHS healthcare costs associated with inequalities are in excess of £5.5 billion a year. Our value for money investigation was carried out in parallel with the Marmot review, but focused on the strategic approach of the Department and the NHS in tackling health inequalities. It examines the impact of Departmental and NHS initiatives to reduce the gap in life expectancy between spearhead and non-spearhead areas and the cost-effectiveness of key health-specifi c interventions. It does not examine the Department’s wider health inequalities programme, for example, the delivery of the infant mortality element of the health inequalities Public Service Agreement (PSA) target or cross-government commitments.
- The Design of Government Guarantees for Bank Bonds: Lessons from the Recent Financial Crisis -- Executive Summary: Over the past few months, authorities have taken their first steps to end some of the public support measures put in place in response to the financial crisis; thus, the exit that the OECD’s Committee on Financial Markets discussed at its last few meetings has actually begun. The present article focuses on government guarantees for bond issues. Financial institutions have made extensive use of such bond issuance: in the period October 2008 to May 2010 close to 1400 guaranteed bonds have been issued by approximately 200 banks from 17 countries, for an amount equivalent to more than €1 trillion. In part reflecting the nature of the strains that the banking sector was exposed to and the specific structure of the banking system, the design of the guarantee schemes differed across jurisdictions. The guarantee schemes which were put in place, together with other measures, have been effective in resuming overall long term funding for banks and reducing their default risk. This type of public sector support for the banking system has, nonetheless, raised a number of concerns. First, the cost of issuing guaranteed bonds has mainly reflected the characteristics of the sovereign guarantor rather than those of the issuer: this situation has created distortions by favouring “weak” borrowers with a “strong” sovereign backing, which have been able to borrow more cheaply, even after accounting for the guarantee fee, than some “strong” banks with a “weak” sovereign guarantor. This phenomenon, which could have been prevented by choosing an appropriate fee determination mechanism, has become more acute with the increased differentiation of sovereign risk observed across advanced economies since early 2010. It tends to distort competition and create incentives for excessive risk taking. Secondly, the phasing out of guarantees has to be managed carefully and a balance has to be struck between two conflicting needs. While the possibility of renewed market tensions makes it important to dispose of a safety net, it is crucial to prevent further distortion to competition by providing the incentive to sound banks to exit from government-supported refunding and to weaker banks to address their weaknesses. The evidence identified here is not inconsistent with the suggestion that the continued availability into 2010 of guarantee schemes, even when the overall usage of guarantees is declining, may alleviate the pressure on some weak financial institutions to address their weaknesses. This suggestion is supported by the fact that, in some large advanced economies, the actual usage of guarantees was concentrated in a few recipient banks. In addition, the average credit rating of the banks that issued guaranteed bonds in the second half of 2009 and in the first half of 2010, when market conditions were much more favourable, is much lower than the average rating of banks that issued in the “turbulent” period (October 2008 to April 2009). Partly reflecting these concerns, the EU decided in May 2010 that, starting from July 2010, in countries that continue to make guarantees available those banks which continue to heavily rely on guarantees will have to undergo a review of their long-term viability.
- The financial market impact of quantitative easing -- Abstract: As part of its response to the global banking crisis and a sharp downturn in domestic economic prospects, the Bank of England’s Monetary Policy Committee (MPC) began a programme of large-scale asset purchases (commonly referred to as quantitative easing or QE) in March 2009, with the aim of injecting additional money into the economy and so increasing nominal spending growth to a rate consistent with meeting the CPI inflation target in the medium term. By February 2010, the MPC had made £200 billion of purchases, most of which had been of UK government securities (gilts). Based on analysis of the reaction of financial market prices and econometric estimates, this paper attempts to assess the impact of the Bank’s QE policy on asset prices. Our estimates of the reaction of gilt prices to the programme suggest that QE may have depressed gilt yields by about 100 basis points. On balance the evidence seems to suggest that the largest part of the impact of QE came through a portfolio rebalancing channel. The wider impact on other asset prices is more difficult to disentangle from other
influences: the initial impact was muted but the overall effects were potentially much larger, though subject to considerable uncertainty.
- The Information Value of the Stress Test and Bank Opacity -- Abstract: We investigate whether the “stress test,” the extraordinary examination of the nineteen largest U.S. bank holding companies conducted by federal bank supervisors in 2009, produced information demanded by the market. Using standard event study techniques, we find that the market had largely deciphered on its own which banks would have capital gaps before the stress test results were revealed, but that the market was informed by the size of the gap; given our proxy for the expected gap, banks with larger capital gaps experienced more negative abnormal returns. Our findings suggest that the stress test helped quell the financial panic by producing vital information about banks. Our findings also contribute to the academic literature on bank opacity and the value of government monitoring of banks.
- The international role of the euro -- Introduction: This review presents and analyses developments in the international role of the euro during 2009. It provides information to the public on a broad set of timely indicators and statistics, covering various segments of markets for goods and services and fi nancial markets. It examines, in particular, the role of the euro in global markets as well as the use of the euro in individual countries outside the euro area, using available information up to December 2009. The main focus is on the relative importance of the euro in transactions and outstanding amounts in these various market segments. Compared with earlier issues, the review has been streamlined and some of the regular sections have been shortened to facilitate reading. At the same time, the review contains three special features that present analytical work on the international role of the euro. The main special feature focuses on the implications of international currency usage
and provides a detailed analysis of the returns on international assets and liabilities of issuers of international currencies. Two shorter special features discuss the construction of a summary indicator of the international role of the euro and review the degree of internationalisation of major currencies. The review promotes the dissemination of high-quality and timely data on the international role of the euro, for use by researchers and the broader public. It draws on available international statistics, complemented by data compiled by the ECB and the national central banks of the Eurosystem. To the extent possible, the data are harmonised and treated using a consistent methodology. For instance, in order to facilitate comparisons between currencies over time, the review consistently removes exchange rate-related valuation effects by presenting statistical time series at constant exchange rates. To ensure easy public access to the data, a statistical annex provides detailed information and time series for some key data. The review is structured as follows. Section 2 summarises the main findings. Section 3 examines the role of the euro in global markets, in particular debt securities markets, international loan and deposit markets, foreign exchange markets, and international trade. Section 4 focuses on the euro’s role in countries outside the euro area, covering both offi cial uses as anchor and reserve currency and private uses in cash holdings, bank deposits and bank loans. This section also contains the new results of the survey by the Oesterreichische Nationalbank on the use of the euro in central, eastern and south-eastern Europe. Finally, Section 5 contains the special features of this review.
- The Large Scale Asset Purchases Had Large International Effects -- Abstract: The Federal Reserve’s large scale asset purchases (LSAP) of agency debt, MBS and long-term U.S. Treasuries not only reduced long-term U.S. bond yields but also significantly reduced long-term foreign bond yields and the spot value of the dollar. These changes were much too large to have been generated by chance and they closely followed LSAP announcement times. These changes in U.S. and foreign bond yields are roughly consistent with a simple portfolio choice model. Likewise, the exchange rate responses to LSAP announcements are roughly consistent with a UIP-PPP based model. The success of the LSAP in reducing longterm
interest rates and the value of the dollar shows that central banks are not toothless when short rates hit the zero bound.
- The Realities and Relevance of Japan’s Great Recession: Neither Ran nor Rashomon -- Abstract: Japan’s Great Recession was the result of a series of macroeconomic and financial policy mistakes. Thus, it was largely avoidable once the initial shock from the bubble bursting had passed. The aberration in Japan’s recession was not the behaviour of growth, which is best seen as a series of recoveries aborted by policy errors. Rather, the surprise was the persistent steadiness of limited deflation, even after recovery took place. This is a more fundamental challenge to our basic macroeconomic understanding than is commonly recognized. The UK and US economies are at low risk of having recurrent recessions through macroeconomic policy mistakes—but deflation itself cannot be ruled out. The United Kingdom worryingly combines a couple of financial parallels to Japan with far less room for fiscal action to compensate for them than Japan had. Also, Japan did not face poor prospects for external demand and the need to reallocate productive resources across export sectors during its Great Recession. Many economies do now face this challenge simultaneously, which may limit the pace of, and their share in, the global recovery.
- The Value Added Tax: Too Costly for the United States -- Abstract: Most developed economies rely on a Value Added Tax (VAT) for a substantial share of their tax revenues, so it is natural that the United States would look toward the possibility of a VAT at a time when huge budget deficits are forecast as far out as the forecasts go. While one can debate the merits of a VAT in other countries, the tax is not a good fit for the United States. It taxes a base that has traditionally belonged to state governments, its introduction would bring with it intergenerational inequities, it has a cumbersome administrative structure that would impose large compliance and administrative costs, and it would slow economic growth. Because of slower economic growth, tax revenues from existing tax bases will fall if a VAT is introduced. This study projects that if a VAT were introduced in 2010, by 2030 the net effect on tax revenues would be small, because revenues collected by the VAT would be mostly offset by declines in revenues from other tax bases. Meanwhile, the introduction of a VAT would slow GDP growth, so government spending as a share of GDP would rise.
- Understanding Public Opinion On Deficits and Social Security -- Abstract:
Government budget deficits have suddenly become a hot topic. The Peter G. Peterson Foundation has funded the private organization “AmericaSpeaks” to conduct “town hall meetings” and report to the new, presidentially appointed National Commission on Fiscal Responsibility and Reform concerning what the American public thinks about various deficit-reduction proposals. We urge Commission members and others to consider the full range of evidence about public opinion concerning deficits and Social Security. Deliberative forums – including the “America Speaks” format the Commission appears to be embracing – are subject to serious pitfalls that make them unreliable as measures of “true” public opinion or as guides to future opinion. Expert analysis of evidence from many sources makes clear that large majorities of Americans strongly support Social Security, oppose benefit cuts (even for the sake of deficit reduction), and prefer to strengthen Social Security finances by raising the payroll tax “cap” or otherwise using progressive taxes. Officials who ignore these views will do so at their peril.
- What determines government spending multipliers? -- Abstract: Theory predicts that the effect of fiscal expansion varies with the economic environment, notably the monetary and exchange rate regime, the state of public finances, and the health of the financial system. Using a panel of OECD countries, we evaluate the issue empirically, focusing on the macroeconomic effects of government consumption. Fiscal shocks are identified as residuals from an estimated government spending rule. These shocks are then interacted with conditioning variables in order to explain macroeconomic outcomes across a range of economic environments. The unconditional responses to a spending shock are in line with earlier results, featuring a positive, if relatively small output multiplier, no significant movement in consumption, and a fall in investment and the trade balance. Yet, these average results mask important differences across environments. In particular, the responses of the real exchange rate and net exports vary systematically across exchange rate regimes, with real appreciation and external deficits emerging mainly under a currency peg. Output and consumption multipliers, in turn, become quite sizeable during times of financial crisis.
- Implementation of Monetary Policy: How Do Central Banks Set Interest Rates? -- Abstract: Central banks no longer set the short-term interest rates that they use for monetary policy purposes by manipulating the supply of banking system reserves, as in conventional economics textbooks; today this process involves little or no variation in the supply of central bank liabilities. In effect, the announcement effect has displaced the liquidity effect as the fulcrum of monetary policy implementation. The chapter begins with an exposition of the traditional view of the implementation of monetary policy, and an assessment of the relationship between the quantity of reserves, appropriately defined, and the level of short-term interest rates. Event studies show no relationship between the two for the United States, the Euro-system, or Japan. Structural estimates of banks’ reserve demand, at a frequency corresponding to the required reserve maintenance period, show no interest elasticity for the U.S. or the Euro-system (but some elasticity for Japan). The chapter next develops a model of the overnight interest rate setting process incorporating several key features of current monetary policy practice, including in particular reserve averaging procedures and a commitment, either explicit or implicit, by the central bank to lend or absorb reserves in response to differences between the policy interest rate and the corresponding target. A key implication is that if reserve demand depends on the difference between current and expected future interest rates, but not on the current level per se, then the central bank can alter the market-clearing interest rate with no change in reserve supply. This implication is borne out in structural estimates of daily reserve demand and supply in the U.S.: expected future interest rates shift banks’ reserve demand, while changes in the interest rate target are associated with no discernable change in reserve supply. The chapter concludes with a discussion of the implementation of monetary policy during the recent financial crisis, and the conditions under which the interest rate and the size of the central bank’s balance sheet could function as two independent policy instruments.

Readings

John Stewart Mill vs. the European Central Bank - Project Syndicate
The money-inflation connection: It's baaaack! - Macroblog
Foreclosures Rise in Three-Fourths of U.S. Cities in 2010 - Housing Wire
The PBoC can’t easily raise interest rates - China Financial Markets
Chinese Banks At Risk, Part 1 - Patrick Chovanec
Chinese Banks at Risk, Part 2 - Patrick Chovanec
Japanese Monetary Policy (Wonkish) - Paul Krugman
Global imbalances: Origins and prospects - Voxeu

Greater China Chartbook: Q2-2010

- Growth "China’s investment-led recovery is slowing, but wage and consumer growth still look very strong. Activity levels in the real-estate sector still look reasonably strong. We look for a mild loosening of policy in Q4 or Q1 2011, depending on the Q3 data. We look for 10% real growth in 2010, 8.5% in 2011."
- Investment "Growth in government approvals of infrastructure projects has slowed, and the rationing of bank credit has also had an effect. However, activity levels remain elevated."
- Consumption "Incomes are rising across China in real terms, and that is supporting strong consumption growth countrywide. Incomes seem to be rising for everyone, even if the rich are benefiting the most."
- Money "Credit growth has slowed to a less worrying rate, but there is still a lot of liquidity around, and real interest rates are still negative. This creates an environment where asset bubbles grow easily."
- Trade "We expect exports to rise by 30% this year, though the trade surplus will fall moderately, to around USD 180bn. China’s share of world exports continues to grind higher. We reduce our forecast for the 2010 current account surplus to 4.8% of GDP from 5.2%. We look for the C/A surplus to trend mildly up again in 2011-12."
- Inflation "Price pressures appear to be moderating, though we could still have a pork price shock in H2. Stable commodity prices will help a lot over the next 12 months. We revise down our CPI inflation forecast for 2010 to 2.5% from 3.5%, and raise our 2011 forecast to 3.5% from 3.0% to take account of increased food-price inflation."
- CNY "The Chinese yuan (CNY) has de-pegged, again, and we look for a 3-4% appreciation against the US dollar over the next 12 months, to 6.35 by end-2011. China remains a buyer of US Treasuries but has been actively buying other countries’ bonds too."
- Housing "After the April market-cooling measures by the State Council, land prices and transaction volumes have corrected downwards, but apartment prices have generally not budged. We expect home prices to fall moderately in H2, but do not foresee a rout."
- Fiscal policy "The government has been withdrawing stimulus over the last three quarters. Fiscal revenues are now booming again. Central government debt is not a concern, but local government debt is. The government appears to be preparing to boost central funding of education, health care and low-income housing construction."
- Energy "China’s coal consumption has plateaued, while its thirst for oil continues to grow; oil consumption is on track to reach our estimate of 9.2 mn barrels/day for 2010, up 7.6% on 2009. The filling of stage two of the Strategic Petroleum Reserve is underway."
- Metals and food "The infrastructure slowdown has impacted iron ore imports and steel prices. Less home-building will hit copper demand. Soy demand still looks super-strong, on the back of strong meat and oil consumption growth."
- Hong Kong "Strong consumption underpins our GDP growth call of 5.4% for 2010. Inflation is not a big concern – and we do not think there is a property bubble. The CNY market appears to be on the verge of significant development."
- Taiwan "Consumption is strong, unemployment is falling, and the central bank is normalising rates. Even so, we do not think inflation is much of a risk."
StandChart Greater China Chartbook 2010Q2

Looking into the Second Half

- "In our final weekly before a brief summer break, we look back over the year so far and
forward to the second half of the year and the market themes and questions that we think will dominate there. While the year has proceeded in distinct phases – from US growth upgrade to European sovereign risk to US slowdown worry – many assets are not far from where they begun 2010."
- "In thinking about this evolution and the path forward, we find it helpful to think about three sources of risk exposure. The first is US growth risk and the issue of whether the market has priced enough of a slowing. The second is non-US growth risk broadly speaking and whether the market is too optimistic or too pessimistic there. Running around this issue is whether it is possible to see slowing in the US without seeing more serious slowing elsewhere (the ‘decoupling’ debate returns!). The third is the kind of systemic risk that has reappeared with
worries about sovereign exposures and the banking system."
- "We think the second half of the year will be dominated by a set of judgments that relate to these three areas. First, how deep a US slowing and what kind of policy response might be forthcoming? Second, how much decoupling is possible (and will China’s policy shift meaningfully)? Third, will sovereign and systemic risks intensify again or settle? Our own forecasts envisage a period of some muddiness in the near-term that ultimately resolves towards a more positive global view. But given the fragilities in the system, we will be watching our various proprietary tools (GLI, FSI, FCIs) and trying to stay open-minded."
GoldmanSachs Global Economics Weekly 20100728

India’s Rising Labour Force

- "India will likely provide the largest increase to the global labour force over the next decade—we estimate an additional 110 million by 2020."
- "Key demographic trends driving the labour force are urbanization, more women in the work-force, and a large increase in the 30-49 age group."
- "Demographics alone may contribute about 4 percentage points of annual GDP growth over the next decade."
- "Demographics will affect consumer spending patterns. Spending on services such as health and education may increase five-fold by 2020."
- "The age structure of the population is favourable for flows into equities and bonds, and less favourable for bank deposits."
- "India’s manufacturing sector has the potential to create the necessary jobs due to recent policy changes, low unit labour costs, infrastructure build-out, prospective lowering of effective tax rates, and rising productivity trends."
- "For potential to meet reality, however, India would need to reform its archaic labour laws and invest heavily in education and skills training."
GoldmanSachs Global Economics Paper 20100728

Turbulence in the steel market

- "Radical changes in the iron ore market: shortening of contract periods and orientation to spot price as benchmark."
- "The changes will result in greater planning uncertainty and increased volatility for all industries along the value chain."
- "The steel industry feels it has no choice but to pass on the higher cost of raw materials to users and is seeking to boost steel prices."
- "The order upswing in steel-processing industries will be curbed by the rising price of steel."
- "Higher steel prices will be passed on to the end consumers of steel products."
- "While the related raw material prices have already peaked, steel price hikes will hinge on the development of the global economy."
DeutscheBank Research Briefing 20100729

Slowing global momentum: “minor” risks to Asian earnings

- Earnings outlook and context "Our regional earnings analysis supports our view that Asian earnings may be only modestly impacted by a slowdown in global, largely G3, growth. The 2Q reporting season has started well and sensitivity to the US/Europe is less than most believe. However, we are less confident about what the market will pay for those earnings, if concerns about G3 growth persist and global valuations remain under pressure."
Stressing regional earnings reveals moderate downside "Looking at the relationship between our GLI and Asian earnings, as well as the US/European exposure of Asian corporates, we feel a modest revision on the order of -2% might be necessary. Areas where
we have concerns vs consensus include metals/mining, bulk shipping, India IT and Korea autos."
Separating “minor” setbacks from “major” pullbacks "We look at major and minor index setbacks in the last 15 years and ensuing EPS change. We believe this episode will be ‘minor’ in terms of index risk and profit revisions, largely because starting valuations and EPS growth expectations were not elevated. That said, the ytd valuation decline may not be discounting specific Asian earnings risks, but concerns about medium term global growth, implying less room for valuations to rebound."
2Q has started on track; we look for potential surprises "10% of index cap has reported so far, and numbers are tracking 52% of full year estimates. We highlight potential upside and downside surprises based on margin and sales analysis, and our bottoms-up
analyst estimates."
GoldmanSachs Asia Pacific Portfolio Strategy 20100728