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Thursday, December 9, 2010
In his April 2009 article for Vanity Fair (no longer fully available), Michael Lewis told the story about how Iceland's banking system basically imploded during the financial crisis. One of my favourite stories from the article is the one he tells about the fate of the country's many Land Rovers.
Presumably because they are a great tool for hauling fish across the Icelandic tundra, Land Rovers were a popular item for the small island nation. They were even more popular as the result of the availability of cheap financing during the pre-crisis boom in credit. The problem was, this cheap financing was provided in foreign currency; the interest rate for euros, pounds and dollars was far lower than that for the domestic currency, the krona. This is all fine and good if your salary is paid in euros, pounds and dollars, but in fact most people in Iceland are paid in krona.
When Iceland's economy went down the crapper, the value of the krona went with it. Since the value of their income had just plunged relative to the value of their debts, many civilized citizens of Iceland were forced to make one of two choices:
- Attempt to pay back their car loans in salted cod
- Do something crazy
"Icelandic Bank: Dear Mr. Ragnar Hjalrnarsson, the monthly payments on your Land Rover are 3 months overdue."
Mr. Hjalrnarsson: *panting furiously, having just run for cover*
"Iclelandic Bank: Mr. Hjalrnarsson?"
*KABOOOM*
"Mr. Hjalrnarsson: Land Rover? What is this Land Rover of which you speak?"
FIN
The fine folks in Iceland had resorted to blowing up their Land Rovers to avoid paying them back. Seriously. This is a country that, in 2008, still had a GDP-per-capita of over $52,000.
Why am I re-telling this story? Because the exploding Land Rover is a great metaphor for a currency mismatch: the situation wherein debts are denominated in a different currency than the income used to pay down those debts. Currency mismatches can exist not just for individuals, but for entire economies at the macro level. But since economies can't go around blowing up Land Rovers whenever it comes time to rollover their debts, the consequences can be quite severe.
The currency mismatch is not a problem specific to our most recent financial crisis, however; here is economist Morris Goldstein, speaking in 2007:
".... [S]erious currency mismatch has been a feature of every major emerging-market currency crisis of the past dozen years. It was there in Mexico in 1994–95, in the Asian crisis countries in 1997–98, in Russia in 1998, in Brazil in 1998–99 and 2001–02, in Turkey in 2001–02, and in Argentina in 2001–02.... [C]urrency mismatch provides the best explanation we have for why large exchange rate depreciations in emerging economies have had such costly growth effects. When financial liabilities are mostly denominated in dollars or in other reserve currencies while assets and revenues are mainly denominated in local currency, then a large depreciation of the local currency will result in balance sheet problems that ultimately cause economic growth to nosedive."
Here is Brad DeLong:
"The decade of the 1990s was marked by the sudden emergence of international financial crises. In a typical such crisis, a sudden loss of confidence in the value of a country’s currency by international currency speculators was followed by a rapid rise in the value of foreign currency—in the exchange rate—the threat of large-scale bankruptcies of banks and firms, financial panic, and a sharp severe recession. These crises hit in the Mexican peso crisis of 1994-1995. Then followed the far-reaching East Asian crisis of 1997-1998. The decade ended with crises in Brazil, Turkey, and Argentina."
The currency mismatch is not merely a modern creature - oh no. In the period of unfettered capitalism that characterized the late 19th and early 20th centuries, "hot money" was flowing into what we would now call emerging markets: Southeast Asia and South America. There were quite a few financial blow-ups involving currency and maturity mismatches - the Barings crisis of 1890 being the most famous.
In other words, we need to recognize that the risk of a currency mismatch contributing a major financial meltdown is present in just about every period in which we see capital flowing easily across borders. This leads me to ask one simple, juvenile, question:
Why why why why WHY?
With all this history, why hasn't anyone learned their bloody lesson? Why do we continue to see, to this very day, the potential for instability caused by currency mismatches present - and growing - in a variety of markets. I can think of several factors that play a role:
1) Access - pretty straightforward: you need easy access to international capital markets. This has been easier during certain periods of time (pre-1914, the Great Moderation of the 1990s-2000s, etc) and in certain regions (for instance, small EU members have direct access to foreign lending from other EU members due to the membership requirement for open capital accounts).
2) Import requirements - it is unlikely that many exporters or banks will accept the Papua New Guinea kina in an exchange for the sale of goods & services, for instance. Small economies with non-reserve currencies need to use foreign currencies to purchase the things they need, or borrow the funds they need. This can lead to debts in those same foreign currencies.
3) Lack of trust in the local currency - often domestic borrowers will seek outside financing if the local currency has a history of high inflation, political meddling, or exchange rate volatility.
4) weak domestic capital markets - sometimes domestic borrowers simply cannot raise money domestically. There are any number of elements to this, including: restrictive local banking regulations, lack of expertise, or lack of appetite (see #3).
5) Behavioural/psychological element - it is hard to resist cheap money. Look at the subprime real estate crisis in the United States and you can see how difficult it is for people to resist borrowing irresponsibly (often from irresponsible lenders). The people in Iceland basically did the same thing, and got burned when interest rate on the loans shot up. People tend to overestimate their ability to predict future events.
6) ...what have I missed?
One argument I'm not buying is lack of awareness. As illustrated above, the challenge of currency and maturity mismatches is not new. Policymakers know and appreciate the dangers associated with a country (or many of its citizens) borrowing in foreign currency, particularly for the short-term. But sometimes the problem is an inability to stop hot money inflows & outflows - see the point about access above - and the costs associated with markets who are perceived to have overly-restrictive measures in place for investments.
Why am I bothering with all of this? It is because, even though the crises I've mentioned above are mostly old news, the challenge posed by hot money inflows is as topical as ever. This is part due to the expansionary monetary policies adopted by the United States and other large developed economies to stimulate recovery. I discussed this back in April with this atrociously-titled post, but if anything the trend has become more pronounced in the period since then.
The recent IMF global markets monitor suggests that capital inflows to emerging markets continues to surge, led primarily by portfolio flows to liquid debt and equity markets. In many parts of the world (including parts of Latin America and Asia), the levels of inflows are reaching pre-Lehman levels. It is important to emphasize that this is not foreign direct investment (i.e. the money isn't there for the long-haul).
India is seeing heavy capital market inflows, again mostly in equities and mostly portfolio inflows. China is also trying to keep a lid on domestic credit growth and just recently capped the amount of lending by domestic banks.
In fact, many emerging markets are toying with capital controls as a way to limit volatility. Brazil has done so, and there is speculation (so far un-founded) that Malaysia will follow suit. Brazil was even somewhat successful in getting pro-capital control language in the G20 communique from Korea ("practical tools to overcome sudden reversals of flows," anyone?). The large exporters will also continue to keep large foreign exchange reserves as a buffer - a policy that turned out to be rather justified in recent years, despite the distorting effects it has on global imbalances and the huge opportunity cost.
All of this suggests that the dangers associated with currency mismatches and rapid capital inflows have not gone away. Quite the opposite. Large inflows may be justified in the current environment of strong emerging market performance, but our ability peer into the future is limited. We do not know what is coming next.
We do not know who will be blowing up their Land Rovers next.
Thursday, May 6, 2010
Rory Doyle writes in a personal capacity. The views expressed are his own and do not necessarily represent those of AIM or its investors.
And then it came...today was the most volatile day in the financial markets since the height of the financial crisis, and as the Dow dropped 1000bps someone turned to me and said the following: Greece is to the sovereign crisis what Bear Stearns was to the financial crisis, with Spain or the UK to become the Lehman Brothers that plunges the global financial system back into the abyss.
Maybe...but at the very least we've turned a very dark and volatile corner. Forget the fact that technical glitches and erroneous trading caused the Dow to shed over 700bps in just 15 minutes this afternoon, which between 2-3pm made it feel like it was September 2008 all over again. The markets are telling us something, and Europe better wake the hell up and finally listen.
The panic is back.
Blood runs through the streets of Athens while EU policymakers dither. The ECB is disturbingly absent and elections in the UK and Germany hang over Europe like a proverbial sword of Damocles. How ironic it is that a German Chancellor may be the one to doom the Euro as we know it. Angela Merkel's shameful electioneering while Greece moved closer to default and Spanish and Portuguese spreads widened by multiples should be held in contempt. She should lose her job for failing Europe and, ultimately, failing Germany as well. The cost to Germans has risen exponentially over the past three months.
At the moment I'm less interested in hearing about Greece's dismal and fraudulent track record and more interested in seeing Europe act decisively. How cute that those same European leaders who leveled smug cheap shots at the US and 'Anglo-Saxon Capitalism' in recent years should so suddenly find themselves on the other end of the microscope. The eurozone's structural deficiencies have been laid bare and a decade of turning a blind eye to the blatant flaunting of the eurozone's fiscal rules by countries big and small, periphery and core, compounded by countercyclical fiscal expansion in 2008/09, has run its course. We seem to have reached the point where monetary union can no longer function without a viable political union, which despite all past illusions Europe clearly lacks. Compare the actions of the EC, ECB and Germany to those of the Fed, Treasury and White House at the height of the financial crisis. That's right...they don't compare at all.
Ultimately contagion is the biggest risk to Europe and the financial system, and I am considerably less confident this evening that a cataclysmic shock wave across European sovereigns can be avoided. Just look at the tangled web of exposures and liabilities running throughout the European banking sector (via the NYT). Without getting into the weeds, but I highly recommend seeking out analysis on the European banking system's complex exposure to Greece, one important point should be made: Greece is to Europe's banks what AIG was to Goldman Sachs. AIG was nothing more than a pass through mechanism to bail out Goldman Sachs, just as much of the bailout money heading into Greece will be paid right out to the holders of Greek debt, mainly German and French banks. Too bad Angela Merkel didn't do a better job explaining this to the German people, she might have had the courage to act, and Spain and Portugal might not be staring down the barrel of a gun tonight.
Tuesday, May 4, 2010
I try to avoid business people. They tend to be crass, abrasive, materialistic and above all productive: always finding ways to provide goods and services to society. It's very unpleasant. But today I held my nose and attended a talk by a prominent entrepreneur from the high tech industry discussing how to foster innovation. The solution, I heard stated very clearly, was protectionism.
Not blatant protectionism, mind you. He was not interested so much in protecting mom & pops from the Walmarts of the world or insulating giant industrial conglomerates from competitive pressures. Given his background in a rapidly-changing, capital-intensive industry, his focus was primarily on creating "incentives" and "enablers" and "tweaks in the system" to encourage small, domestic companies to get a leg up. Examples included government funding, creating a venture capital-friendly environment, tax credits for investments in small firms, and providing incentives for the commercialization of university research.
Another example included creating a "bias" in government procurement procedures towards small domestic firms. His argument was that of a high schooler: everybody else is doing it. Despite WTO commitments, all the biggest players in the game have this bias, so your country should be no different. The game is rigged, so there's no point following the rules to the letter.
Of course, this flies in the face of everything one learns in international economics courses. It also breaks the traditional mold of business people as anti-government and free-marketeers. But it is not really all that surprising: from the point of view of a rationally-thinking entrepreneur, you want to make starting up a business as easy as possible. If you face an unfair competitive advantage in foreign markets, then you should pressure your domestic government to respond in kind.
And from my own point of view, it was quite entertaining to see a highly-successful businessman getting quite animated about how we used to be "protected" by tariffs, or how we should force domestic pension funds to invest a percentage in the domestic market. A couple of points:
1. I am obliged to drag out the ECON101 notion of what is seen vs. what is not seen. There are always trade-offs when you provide government support for a particular industry. The benefits are clear to the industries on the receiving end. But you always need to consider the unseen costs - what are the alternative uses of those funds? who is getting snubbed? and so on. That was not part of this entrepreneur's thinking process.
2. While our intrepid entrepreneur was busily pointing out the value-added of having small, innovative firms grow into global competitors, he failed to mention the value-added of having your market open to innovative foreign firms. Domestic firms are not the only source of wealth creation. For instance, he tells the story of how he recently bought a pair of scissors for 23 cents (made in China). He used it as a cautionary example of how we faced competitive disadvantages from foreign firms. What he failed to mention was the wealth-creating effects that 23-cent scissors and their equivalents have for consumers.
3. While I am in general agreement that most countries continue to give domestic firms an unfair advantage, it's worth remembering that things used to be worse. The entrepreneur, for instance, was able to set up his companies abroad and raise capital for his firms in a dozen foreign markets . That would have been very difficult if not impossible 30-40 years ago. If we take his advice, writ-large, we may not see any further improvement over the next 30-40 years.
Still, I'm not rejecting his argument entirely. Since all governments provide support to their domestic firms in some form, the question becomes how to get the most "bang for buck" from subsidies while minimizing distortions. At what point does the benefit from stimulating domestic innovation outweigh the costs of subsidies? This is not an easy question to answer, but it's naive to reject the question out of hand.
UPDATE: John Robertson asks: "do small firms account for most net job creation?" Not really, but:
"Research... suggests that, at any point in time, a relative handful of high-performing companies account for a large share of job creation and innovation. This conclusion suggests that a key to long-term economic growth may lie in ensuring that the economic environment is conducive to the ongoing creation of these types of high-growth performers."
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Photo via WNYMedia.net
Monday, April 19, 2010
This post was meant to have been written a couple of months ago, as a follow-up to this piece, but as I am easily distracted – especially by shiny objects – the draft was set aside and ultimately forgotten. Forgotten, that is, until the IMF went ahead and published their take on the matter. Since the IMF report is an Official Publication and contains things called “Granger causality tests,” and other such statistical chicanery, I will leverage from it quite heavily:
The issue at hand is the increase in capital flows from rich countries to “receiving” economies, and how that will affect the latter. Starting in 2003, but really expanding from 2007-present, the Liquidity-Time Explosion (that’s my term, not the IMF’s) resulted in large outflows of capital from the G4 (US, UK, then later Japan and the Euro-area). This was the result of interest rates in those economies hitting rock bottom, or close to it. Cheap money in the G4 (if one can get any) is logically channelled from the low-interest rate environment to economies that have higher rates of return.
The receiving economies are mainly emerging markets in Asia, emerging Europe, Latin America, the Middle East and Africa. To be clear, capital inflows can be a very good thing for these countries as it helps fund domestic investment and long-term growth. It especially makes sense for capital to be flowing to countries that have rosy growth prospects, which is the case for many emerging markets.
However, the IMF looks at the rapid rate of asset price growth in some emerging markets recently and asks the following, crucial question: “Are capital flows into receiving economies primarily driven by the countries’ strong economic fundamentals and, therefore, likely to remain stable over the medium to long term, or are they primarily driven by the abundant global liquidity?”
Looking at the data, the IMF concludes that, yes, global liquidity is playing a significant role. But the effect is not uniform: the type of exchange rate regime in the receiving economy plays an important role in determining how it is affected: “… the higher the flexibility of the exchange rate, the lower the spillover of global liquidity and the more the cushioning impact of domestic asset returns.”
So countries with fixed exchange rates should expect to have seen a significant impact on domestic asset valuations. And wouldn’t you know it! Just last week, fixed-exchange-rate China announced almost 12% growth in their economy last year and almost 12% growth in their housing market last month alone. That’s not to say that China doesn’t have huge growth potential, but you’ve really got to wonder.
So what are the implications of this Liquidity-Time Explosion, anyway? As the IMF paper explains, benefits aside, surges in capital flows can lead to large swings in the exchange rate (which can be de-stabilizing), or it can lead to a boom in domestic credit creation, possibly resulting in inflation, asset bubbles, and a general overheating of the economy.
Indeed, historically speaking, financial crises in emerging markets are usually preceded by a surge in capital inflows from abroad - often linked to factors identified in the previous paragraph. The recent work by Reinhart and Rogoff provided further evidence for that trend. The capital inflows are particularly de-stabilizing if they are short-term debt and denominated in a foreign currency.
Aware of all of this, the IMF paper explores the various policy options available for receiving countries, including an in-depth look at capital controls. Explore that if you wish. In macro-terms, I think it’s important to recognize that this situation exists and that it is a source of vulnerability. Remember that the capital is flowing out of the G4 due to low interest rates – if those rates go up, the capital inflows to emerging markets could slow down or even reverse. It is here that policy coordination in bodies like the G20 will prove to be crucial.
But even policy coordination cannot insure against the fact that Shit Happens – there are outlying events, black swans, fat tails of all kinds that can rapidly change the situation in any given economy. We have seen two examples of that recently with Iceland’s volcano and the tragic plane crash in Poland. This uncertainty about the future means that economies on the receiving end need to insulate themselves from potential shocks, while sending countries need to be aware of the knock-on effects of their policies. What seems clear, however, is that the status quo has potential for disaster.
Thursday, April 1, 2010
- Arsenal rallies, with a touch of luck, to a 2-2 draw in Champions League play against a dominant Barca, but at huge cost. With an injury list this long, the young Gunners will need to show something special to stay in the Premier League title race.
- Update: Our friend Patrick has a guest blog over at WSJ Real Time Economics on the gains from reviving world trade negotiations
Thursday, November 20, 2008
The Economist has a fanciful, tongue-in-cheek editorial on the possibility of solving some of the world's troubling dilemmas by purchasing bits of other countries. Spurned on by the recent proposal by the Maldivian president to buy a new homeland for his drowning nation - rising sea levels threaten the tiny island nation with extinction - the Economist suggests using this approach elsewhere:
The Israelis, for instance, could put an end to a hundred years of futile hostilities by buying somewhere for the Palestinians. If they clubbed together, they could get somewhere really nice—Florida, maybe. China could stop making aggressive gestures towards Taiwan and buy Malaysia instead. It’s already run by
Chinese, so they’d hardly notice the difference.
When I was a teenager, I naively toyed with the idea of a land-swap to address some sticky international issues (the citizens of N. Ireland might actually enjoy the weather along the West Bank, after all), but the market solution seems a better approach.
