28/10/17: Supplies of Monetary Methadone: ECB's Recalibration

My take on ECB's latest policy announcements for the Sunday Business Post: https://www.businesspost.ie/opinion/supplies-monetary-methadone-will-continue-401179.

25/12/2014: Unwinding Western Excesses, Squeezing Emerging Markets

Just in case you need a scary story for the holidays seasons, here's one from economics. Some time ago, we've learned that zero bound (extremely low) interest rates in the advanced economies spell quite a disaster for the emerging markets, where the economies are now suffering from triple pressures: declining commodities prices (on which many emerging markets economies often rely for exports, declining demand for their exports of goods, and declining investment inflows from the advanced economies.

But that's just the beginning. It seems that any unwinding of the QE deployed in the West is likely to hammer the emerging markets more.

Here's a World Bank paper from earlier this year on the topic: Burns, Andrew and Kida, Mizuho and Lim, Jamus Jerome and Mohapatra, Sanket and Stocker, Marc, Unconventional Monetary Policy Normalization in High-Income Countries: Implications for Emerging Market Capital Flows and Crisis Risks (April 1, 2014). World Bank Policy Research Working Paper No. 6830: http://ssrn.com/abstract=2419786

What the authors found is that as "the recovery in high-income countries firms amid a gradual withdrawal of extraordinary monetary stimulus, developing countries can expect stronger demand for their exports as global trade regains momentum, but also rising interest rates and potentially weaker capital inflows. …In the most likely scenario, a relatively orderly process of normalization would imply a slowdown in capital inflows amounting to 0.6 percent of developing-country GDP between 2013 and 2016, driven in particular by weaker portfolio investments. However, …abrupt changes in market expectations, resulting in global bond yields increasing by 100 to 200 basis points within a couple of quarters, could lead to a sharp reduction in capital inflows to developing countries by between 50 and 80 percent for several months."

Wait, we are witnessing this already, in part, as bond prices in a number of emerging economies are following oil prices down. And worse, if the above applies to corporate yields, the same will apply to government yields. Thus, 'normalisation' in the West can yield double shock to debt markets in the emerging economies.

World Bank paper has more on the subject: "Evidence from past banking crises suggests that countries having seen a substantial expansion of domestic credit over the past five years, deteriorating current account balances, high levels of foreign and short-term debt, and over-valued exchange rates could be more at risk in current circumstances. Countries with adequate policy buffers and investor confidence may be able to rely on market mechanisms and countercyclical macroeconomic and prudential policies to deal with a retrenchment of foreign capital. In other cases, where the scope for maneuver is more limited, countries may be forced to tighten fiscal and monetary policy to reduce financing needs and attract additional inflows."

So the best case scenario, sovereign wealth reserves (if any) will be exhausted on 'normalising' the US, UK, Euro Area and Japan, while if none are present, tough luck - the emerging economies are into a tailspin. They'll have to relieve the path of austerity-driven internal devaluations. Just because the West has ramped printing presses up so much, any 'normalisation' is going to be a disaster. If that is not a case of beggar thy poorer neighbour by enriching thy stock markets strategy, then do tell me what is?

And in another paper, "Tinker, Taper, QE, Bye? The Effect of Quantitative Easing on Financial Flows to Developing Countries" the same authors looked at gross financial inflows to developing countries over 2000-2013 (see: World Bank Policy Research Working Paper No. 6820: http://ssrn.com/abstract=2417518).

As above, authors found evidence "for potential transmission of quantitative easing along observable liquidity, portfolio balancing, and confidence channels. Moreover, quantitative easing had an additional effect over and above these observable channels, which the paper argues cannot be attributed to either market expectations or changes in the structural relationships between inflows and observable fundamentals. The baseline estimates place the lower bound of the effect of quantitative easing at around 5 percent of gross inflows (for the average developing economy), which suggests that of the 62 percent increase in inflows during 2009-13 related to changing global monetary conditions, at least 13 percent of this was attributable to quantitative easing. The paper also finds evidence of heterogeneity among different types of flows; portfolio (especially bond) flows tend to be more sensitive than foreign direct investment to our measured effects from quantitative easing."

So broadly-speaking, QE is impacting bond/debt flows and unwinding QE can be a costly proposition for the emerging markets.

10/1/2014: Top 5 Global Economic Risks of 2014: Sunday Times, January 5

This is an unedited version of my Sunday Times column for January 5, 2013.


2014 is the year of hope, arriving on foot of a renewed momentum in the economies of the U.S., U.K. and, since the beginning of the last quarter, the euro area. As welcome as these positive developments might be, any serious case for the economic fortunes revival in 2014 will have to stand against a rigorous analysis of risks and opportunities that are likely to emerge this year. Some are short-term; others are longer running themes signifying profound evolutionary transformations in the world of advanced economies.

Here are my top five picks for the economic risks and opportunities that are likely to mark 2014 the Year of Change.


1. Growth Challenge in Advanced Economies:

Core challenge faced by Ireland over 2014 and beyond is delivering sustainable rates of growth in excess of those recorded over the last decade.

Looking at growth in the GDP per capita reveals several worrisome trends.

Irish growth rates from 2005-through 2013 are running below the levels observed during 1980-1994. With a period of structural catching up with the euro area standard of living well behind us, the task ahead for Ireland is finding new sources for long-term growth.

The above challenges are compounded by the fact that our core trading partners are experiencing structural slowdown in their own economies. We are witnessing continued structural decline in the longer-term rates of growth in real GDP per capita across the advanced economies of the euro area that started in 1995. More immediately, the US and UK economies' recovery in the wake of the latest recession is slow, compared to the recessions experienced in the early 1990s and 1980s. Thus, Ireland is also facing the challenges of opening up new geographies, beyond our traditional trading partners in advanced economies, for exports and shifting more indigenous firms to exporting.

Currently, Irish medium-term growth outlook (2014-2018) implies growth rates that are some 3 times lower than those recorded in 1990s. A sustainable recovery from the crisis will require us delivering economic growth rates closer to those attained in the 1990s. Meanwhile, we are struggling to reach growth levels of the 1980s.

2. Medium-term Changes in Employment and Skills Demand

Significant reshaping of the advanced economies' labour force expected in 2012-2022 reflects the shifts in growth toward more human capital-intensive growth.

Increasing specialisation is changing Manufacturing and challenging both the U.S. companies operating in Ireland and Irish indigenous producers. In addition, the ICT Services sector is increasing demand for narrowly-defined specialist capabilities, leading to accelerating depreciation of the ICT sector skills and potential for reduction in overall levels of employment in the sector. The resulting contraction in demand for older skills will be magnified by the widening gap between in-demand new workers and legacy ICT employees.

The downsizing of the state sector will continue. The first wave of reductions during the Great Recession was driven by organic attrition, implying little improvement in productivity amidst staff losses. In the December Gallup poll, 72 percent of U.S. respondents identified 'Big Government' as the biggest threat to the country future, up from 52 percent in 2009. In Ireland, per Edelman Trust Barometer, trust in Government has remained at 15 percent in 2012-2013, ranking the Government alongside the banks as the least trusted institutions. The next wave will see a push for improved productivity, resulting in gradual reduction in employment levels in the sector and simultaneous shift in demand toward higher-skilled public sector workers.

On the other hand, Ireland is likely to gain from the Leisure and Hospitality, and Healthcare sectors growth on foot of ageing population across the major economies. The latter presents both a challenge and a major opportunity. Capturing global demand growth for Healthcare and Social Assistance services will require greater deployment of e-Health, remote health and other data-intensive, ICT-reliant healthcare tools. We are also likely to gain from renewed capital investment in the wake of strengthening global economic recovery. Financial services (chiefly IFSC), and Professional and Business services (especially innovation-focused internationally traded services), will gear up for rising demand. Education will remain a core driver for skills development and human capital investment.

3. Governments' Leverage Up, Banks Leverage Down

With its banking sector deleveraging largely completed, the U.S. economy is enjoying a credit-driven recovery. Both, the U.S. banks and the Federal Government are also increasing their access to global funding markets.

In contrast to the U.S., euro area banks are continuing deleveraging, while financial fragmentation is pushing national banks into greater isolation. With credit on decline for nineteen consecutive months, euro area economies remain starved of working and investment capital and capital markets integration is rapidly collapsing.

All along, buildup in public debt continues unabated without delivering a meaningful uplift in domestic investment activities. While in the U.S. public debt increases are supporting public investment and private consumption, euro area government leveraging up is primarily funding unemployment supports, public pensions and banks, with share of investment spending in total Government expenditure declining. As the result, euro area gross investment as percentage of GDP has declined from 21 percent over 2000-2002 to less than 18 percent in 2013. In the advanced economies ex-euro area gross investment slightly rose from just under 24 percent of GDP in 2000-2002 to 24.2 percent in 2013.

These trends act to reduce Irish exports of capital goods and investment-related services and undercut availability of credit in the domestic economy. The risk for 2014 is that the forces of financial fragmentation will remain at play across the euro area. The opportunity is the market readiness for entry of new investment and lending intermediaries.

4. Irish Labour Income Trends

Between 2008 and 2013, labour income share of Irish GDP has declined from 48 percent to 41 percent, implying a loss of roughly EUR3.3 billion in the domestic economy. This decline was driven primarily by re-orientation of GDP growth away from labour-intensive domestic sectors to MNCs-led exports of ICT and financial services.

As the result, declines in labour income have outpaced declines in value added in the economy, implying a transfer of income from the employees to the corporate and state sectors.

Taxes increases have compounded this effect, leading to a significant decline in household investment and consumption.

Over 2014-2016, Ireland faces a major challenge in rebuilding household financial positions and income to achieve sustainable levels of household debt, private investment and consumption. This can only be delivered by reducing the burden of taxation faced by the households, which puts us straight on the collision path between our corporate and wealth taxation policies, and the income tax policies reforms needed to restart the domestic economy.

Good news: by taking radical approach to rebalancing our tax system, we can do both – deliver sustainability-focused reforms and reboot the domestic economy. Bad news: our political and economic elites are too reliant on the status quo to secure their power to be able to structure and implement such reforms.

5. Monetary Policy Unraveling

2014 will mark the beginning of the end to unorthodox monetary policies deployed during the crisis.

This month, the U.S. Fed will begin gradual tapering of its purchases of the Government bonds. In advance of this, futures on 3 months Treasuries have been losing value since November. Meanwhile, euribor - the interest rate charged by top euro area banks for loans to each other - has been moving up relative to the ECB policy rate.

The ECB rates have now been in divergence from their historical mean for record 60 months. For now, Frankfurt is concerned with deflationary risks in the economy. Short-term eurodollar 3 month forward curve is pricing in euro devaluation in the short term and higher yields in the U.S. However, the return to historical norms for the ECB is only a matter of time. This will see rates rising over time toward the pre-crisis average of 3 percent from the current 0.25 percent.

For Ireland, normalisation of monetary policies presents significant risks. Rising interest rates, especially if compounded by the banks' drive to increase their lending margins, can derail nascent recovery, depress investment and destabilise once again the residential mortgages, including many that are deemed to have been ‘sustainably restructured’ prior to interest rates rises. In addition, higher yields on Government bonds will take a huge toll on Exchequer finances.

Unless this re-pricing in the bonds markets comes at the time of high growth in the Irish economy, the process of unwinding of global accommodative monetary policies can put us through a severe test, possibly as early as late 2014.

16/9/2013: Some scary charts from BIS: Yields Blowing Up & Leverage Climbs

BIS Quarterly (http://www.bis.org/publ/qtrpdf/r_qt1309a.pdf) has some interesting analysis of the US yields:

"An examination of the rise in US bond yields between May and July reveals as a key  driver the uncertainty about the future stance of monetary policy. The sell-off mainly shifted bond yields at long maturities, while the short end of the yield curve remained anchored by the Federal Reserve’s continued low interest rate policy."

"In addition, the federal funds futures curve also shifted upwards, signalling market perceptions that a policy rate exit from the current 0–0.25% band had become quite likely to occur as early as in the second quarter of 2014."

"A model-based decomposition of the  10-year US Treasury yield, which sheds light on the various drivers of these shifts,  indicates that the recent yield spike was largely the result of a rising term premium. This is consistent with markets reacting to uncertainty about the extent to which an improving economic outlook would affect future policy rates. It is also consistent with uncertainty as regards the impact that a reduction in the Federal Reserve’s purchases of long-term Treasuries would have on these securities’ prices."

"In comparison, the bond market sell-offs in 1994 and 2003–04 were different in  nature. During those episodes, long-term nominal yields rose together with policy rates or on the back of expected increases in future real interest rates and inflation. By contrast, inflation expectations were largely unchanged in the second and third quarters of 2013."

Basically, as we all know  by now, current yields have nothing to do with inflation and are solely priced by reference to expected liquidity conditions. Or put differently, nothing but printing press matters. So much for monetary policy-real growth links...


And BIS does deliver a nicely focused warning: "Their recent spike notwithstanding, bond yields in mature markets remained low by historical standards. For one, the yields on sovereign bonds in the largest world economies had been on a downward trend since 2007. And investment grade spreads in the United States, the euro area and the United Kingdom declined respectively by 75, 110 and 190 basis points between May 2012 and early September 2013, falling past their earlier troughs in 2010 and reaching levels last seen at end-2007. The evolution of the corresponding high-yield bond indices was similar, with spreads declining by 230 to 470 basis points over the same period."

Go no further than the second chart above: reversion to the mean is going to be brutal. And this brutality will only be reinforced by the fact that quietly, unnoticed by most, leverage has returned: overall share of leveraged and highly leveraged loans in total syndicated loan signings is now at all-time high.

Starting with page 6 (above link), the quarterly is a must-read as it exposes growing problem with high risk debt accumulation by investors and that amidst the historically low rates. The system is back at end-of-2007 levels of credit underpricing. The big difference today in contrast with 2007 is that no one has any bullets left to fight the bear, should one appear on the horizon.

2/8/2013: The Impossible Monetary Dilemma: July update

Two charts updating the Impossible Monetary Dilemma through July:

Good luck to all believing tapering will be enough to get monetary policy to mean-revert. Oh, and in case you wonder, mean reverting refers to historical mean - which is skewed downward by the period of historical lows of 2001-2005 and H2 2008- present. Even that historical mean is out of reach for any ordinary tightening.