19/10/2012: Tail Risk and Basic Investment Markets Models

For Investment Theory course: some additional slides on the topic of tail risks and applicability of the models we covered in class (note: these are just supplementary readings, so no exam-focused material):

Here are few of my slides from the 2009-2010 Advanced Quantitative Portfolio Management course. You can enlarge each slide by clicking on it.

18/10/2012: ARMs - compounded effects of austerity and banks deleveraging

As the Irish banks are hiking ARMs, it is worth reminding us as to why this is a bad news for Irish economy:

Now, here's the Catch22.

1. Irish banks funding costs are joined at a hip with the Sovereign funding costs, thus reducing these costs will require reducing Sovereign costs, which in turn means taking in more taxes and cutting back more Government spending.
2. The former part of (1) means that households on the ARMs will be bearing all of the burden of the high funding costs for the banks.
3. The latter part of (2) means that households on the ARMs are going to experience, alongside all other economic agents, the cost of Government deleveraging.

(2) + (3) means that in our 'fairness-concerned' society, ARMs holders will be paying twice the rate of the fiscal adjustment that any other group of agents.

Good luck, Michael Noonan, bankrupting the ARMs.

18/10/2012: Summit/Dinner+Dinner Commencing

With the start of the 2-day summit (cross-out: series of dinners) at the EU, here's what JPM research team we should expect from the meetings:

In brief: expect nothing much... With that, may I wish good 'news hunting' for the army of media folks besieging EU buildings...

14/10/2012: Shadow Economy

An interesting chart based on OECD data:

The above captures data for 2010 latest so we can expect the 'Latest' metric to come up as the crisis and rising tax burdens continue to push more and more activity into the Black Economy. Still, at ca 15% of GDP in Shadow economy, the problem of extra-legal economy is non-negligible. Another point to make is that since Shadow economy does not apply to the MNCs activities, Ireland figure should be adjusted for GNP/GDP gap. Which would put us right at Sweden's level. Performing the same for mid-1990s figure implies that Ireland's Shadow economy has declined over the period covered by lower percentage points than any other economy (save Austria's, US' and Germany's - where Shadow economy share rose).

13/10/2012: China's Property Bubble

Some interesting insights into China's economy dependency on property markets from the ECB Monthly Bulletin (link: http://www.ecb.int/pub/pdf/mobu/mb201210en.pdf). Italics are mine:

"Housing investment has been an increasingly important source of growth for China in recent years". Most notably:

• Real estate investment accounts for about 25% of total fixed asset investment, with the latter having driven 50% of GDP growth since 2006. So overall, over 12% of China's economic expansion is now due to property boom directly. Associated activities, e.g. construction, construction materials, banking services and planning & development services probably means that good 17-20% of the overall growth in China since 2006 has been due to the real estate investment boom.
• "In terms of its share in GDP, real estate investment rose from 10% in 2006 to 16% in 2011".
• "Construction and real estate services together employ over 10% of the workforce and contribute to 13% of total added value". 
• "Real estate investment also has strong linkages to other industries such as machinery and equipment".

"House prices in China have risen sharply in recent years and are high compared with incomes'. 'High'? Judge for yourselves:

• Average price per sqm of housing "across a sample of 35 large and mid-sized Chinese cities nearly tripled between 1999 and 2011, although this average masks great disparities." 
• "The price of a 100m2 house expressed in multiples of the annual disposable income of an average family of 3.3 persons also varies widely, from 4.4 times yearly income in peripheral cities (Hohhot, Inner Mongolia), to close to 16 in large, booming cities such as Beijing and Shenzhen (see Chart A)."

• "On average, the ratio fell between 1999 and 2011 as disposable income rose faster than the square metre price (11% compared with 9% annually – see the red dotted line in Chart B). However, when one considers the increase in the size of the average house, a different picture begins to emerge. Over recent years, living space has increased from an average of 19.4 m2 per capita in 1999 to 32.7 m2 in 2011,  while the average household size has decreased from 3.6 persons to 3.1, implying that the average house has grown from 70 m2 to 101 m2. As a result, the price of the average house (expressed in multiples of income) rose from 6.4 in 1999 to 8.6 in 2011 (see the blue line in Chart B)." 

13/10/2012: ECB study on fiscal (non)sustainability in OECD 1970-2010

An interesting study (ECB Working paper NO 1465 / AUGUST 2012) titled "REVISITING FISCAL SUSTAINABILITY: PANEL COINTEGRATION AND STRUCTURAL BREAKS IN OECD COUNTRIES" by António Afonso and João Tovar Jalles (link http://ssrn.com/abstract_id=2128484 ) attempts to identify if "fiscal imbalances in a number of OECD countries need to be curtailed before they become economically unsustainable, leading to insolvency situations". The study covered 18 OECD countries over the 1970-2010 period. Italics are mine, throughout.

Per authors: "In our empirical approach we perform a systematic analysis of the stationarity properties of the first-differenced stock of government debt as well as, on the one hand, the relation between government revenues and expenditures and, on the other hand, the relation between primary balances and debt. These approaches provide us with an indirect test on the solvency of public finances in these countries. We conduct this analysis on a country-by-country basis, …as well as for the country panel as a whole."

The study results show that "the first-differenced debt series for most countries is non-stationarity suggesting that the solvency condition would not be satisfied".

In addition, the authors find "the existence of one cointegrating relationship in only 6 countries between revenues and expenditures. However, the overall test results allow the rejection of the cointegration hypothesis in both relationships under scrutiny. In other words, government expenditures, in half of the countries, exhibited a higher growth rate than government revenues, challenging therefore the hypothesis of fiscal sustainability."

"... the cointegrating coefficients for the revenues-expenditures relationship are positive (but less than one) and statistically significant, meaning that for each percentage point of GDP increase in public expenditures, revenues increase by less than one percentage point of GDP."

In terms of causality, the study finds "...stronger effects running from revenues to expenditures and most countries are not able to generate the revenues required to finance the planned expenditures. We find Granger-causality from government debt to the primary balance, which can be seen as evidence of the existence of a Ricardian regime."

Finally, "panel data results corroborate time-series findings, and even though we find that long-run causality seems to run from lagged debt to the primary balance, on average the marginal long-run impact is zero."

Core conclusion: "All in all, we cannot say that fiscal policy has been sustainable for most countries in our sample."

In effect, there has been systemic, long term overspending by the states incapable of backing expenditure hikes with revenues. Living beyond their means is a long-term thing in the sample and is a prevalent modus operandi for the majority of the states over the period of 40 years.