SYMPOSIUM ON FINANCIAL STABILITY
April 14, 2011
Aula Magna, Romanian-American University
Macroeconomics of Crisis: Borrowing Time
Adrian Mitroi, Secretary General, CFA Romania
unusual uncertain times?
Macroeconomics of Crisis
Buying time
Decreased •Correlation: stocks, growth, inflation, deficits, exchange and interest rates
correlation •Cyclical vs. countercyclical; conventional vs. non conventional policies
•Financial sector, a pro cyclical indicator of real economy
•Lending to negative equity; solvability vs. liquidity
•Real estate market; LT real assets vs. ST financial liabilities
A PsiFinance Perspective into
the New Normal Economics
Borrowing time
Change in •Propensity to spend, save or invest in highly volatile markets
paradigm •Risk aversion vs. loss aversion in economic recession
•Decrease in bear markets correlation; only local black swans
•Net wealth effect can be substituted for net income effect
•Ultralow/easy money leads always to bubbles
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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Macro policies and markets
Learning by doing
Conventional •Cyclical: pro cyclical, correlated with overall state of the economy; ex.
tightening monetary policy in recession (hawkish); higher than equilibriumappropriate exchange rate, fiscal tightening (VAT increase)
•Conventional: monetary rate, (ex. strong Ron = tightening but decreased
MRR = softening), open market; higher bound for repo interest = dovish
•Countercyclical: activist (vs. laissez faire), against current economic
tendency, lower monetary rate (dovish), simulative in economic downturn;
ex: progressive tax, unemployment
Terra Incognita in Macroeconomics
Trial and error
Ron Non conventional: easing cost and availability of funds; fiscal monetization:
appreciation
limited effect on •aimed at reduced risk spreads, affecting longer term rate across the board,
independently of their liquidity and credit risk, affecting the market for risk
inflation
free assets, government bonds (QE- ‘quantitative easing’); BCE repos
Unchartered •targeted on the risk spread across assets classes, between those whose
territory markets are particularly impaired (PIGs junks as collateral) and those that
are more functioning (CE- ‘credit easing’); EU/IMF/EC Stability Fund
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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One size monetary without fiscal policy
Combination
of reasons
Not sure working
•Common to all major crises, is a combination of reasons: overleverage, real
estate boom, loose fiscal and monetary policies, overspending - debt difficult
decisions: higher tax or lower spending/expenses?
•ECB: one size fits all monetary policy has drawbacks, mostly in a downturn
economy. Front runners (G) in recovery would rather enjoy an % increase once the
growth picks up, but laggards (P, S) would rather see very low % for a longer term
From 2 big to fail to 2 big to bail
Bail outs
equals bail ins
Probably working
•Moral hazard introduced by EU/IMF/EC stand by PIGs bailout was a necessary
evil (write off). Probably, restructuring would have been better, but EU is not yet
prepared to accept, manage, convince; China capitalizes Spanish Banks
•Europe’s financial tribulations reflect investors concern that governments have
borrowed too much to revive their economies; how do US manage?
•No matter how smart and big is the bailout (EU Stabilization Fund), most
important stakeholders have to buy in: population (to sacrifice) and private
investors (to roll over next debt, at reasonable prices)
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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Conventional vs. nonconventional
policies
Debt
transportation
Which one is better?
•Too much debt is dangerous. During boom, central banks, investment bankers
and politicians all signed up to the cult of debt; SE Asia is the least levered, best
prepared for sustained economic growth (financial and commercial)
•Companies went for balance-sheet "efficiency" - and homeowners, piled on huge
mortgages, were caught out, then discover that it is much harder to deleverage
than to leverage up; basically, only rented home from the bank
•When the Fed stops buying Treasuries, does the private sector take the baton
and run the last leg of the relay race?
New Normal Global Economics
Change in
paradigm
Crisis or recession?
•Globalization doesn't work smoothly by itself. Free movement of capital has
facilitated rapid shifts in cross-border capital flows, currency values and prices of
commodities; insufficient financial depth (savings and investments/GDP) makes a
country vulnerable; first: save; then: invest; only then: spend
•Most probable we all, insufficiently saved, inadequately invested and irrationally
spent future cash flows (governments, corporations, individuals)
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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Central Banks matter
Armada of measures, inflated BS
Decreased •During a normal recession, the Fed, ECB and other central banks
correlation responded with non conventional monetary policies by buying short-term
government/quality (except for PIGs junks) debt from banks
•Process drives rates on government debt down; investors seeking a
higher rate move into other assets, driving other rates down; normally
these lower rates will lead to economic bounceback; in recession, fiscal
also matters
Interchangeable fiscal, monetary
Borrowing time; how/when to exit?
Change in •A lower bound to rates advocates higher government spending: when
paradigm monetary policy is ineffective and private sector can’t be persuaded to
spend or borrow more, the public sector must take its place in supporting
the economy
•Probably the fiscal stimulus is Keynesian answer to current economic
situation and a good mix with monetary policy. New normal recession
requires CBs to be less concerned on inflation? Milton Friedman for
growth and John Maynard Keynes for recession?
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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Central banks do matter since monetary and fiscal policies
look interchangeable, lately
ECB (Apr. 2011):
•Marginal lending facility: 1.75 %
•Main refinancing operations: 1.25 %
•Deposit facility: 0.5 %
FED (Apr. 2011):
•Discount rate (charged to banks,
refinancing, psychological): 50 bp
•Fed Funds (o/n, benchmark,
target, main policy rate): 0-25 bp
12
10
8
6
FED
ECB
BNR
4
2
0
31/01/2007
31/01/2008
31/01/2009
31/01/2010
SYMPOSIUM ON FINANCIAL STABILITY,
31/01/2011
April 2011, Romanian-American University
NBR (April. 2011):
•Deposit facility: 2.25%
•Policy rate: 6.25%
•Lend facility: 10.25%
•MRR FX: 20%
7
Hold rates, strengthen Ron, prop solvability
Sovereign debt pressure
2nd generation
of structural
reforms
no pain all gain solution
•Actual rate probably lower with 100 -150 bp than neutral
•6.25% vs.~7% current neutral (5% historical) - need to tighten (100
bp) but output gap is negative (-4%). M. Finance % rate < LT GDP g %
•VAT added (1st and 2nd) round 2.5%-3% fiscal inflation
•Permanent increase in the inflation risk premium
•Economic contraction positive countercyclical effect (March poor 8%)
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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Old answers to new questions
Monetary medication plus fiscal diet
Systemic risk
Decreased •A bubble in government bonds has been deflated but yields will rise,
correlation inflation, oversupply.
•Need to print money to pay interest on new debt; result: a slower
recovery; growth is a key determinant for deficits
•Add corporate and private debt to government debt / GDP, the prospect
of economic growth paying all that off is moving further in time
Sovereign debt pressure
Public loss private gains
Change in •Debt restructuring, could be the new currency devaluation in the euro
paradigm zone if not proper measure taken;
•Higher borrowing cost (LT) could lead to higher deficits; EU
Stabilization Plan targets MT/LT rates
•Creditors are also massive debtors. If the value of their assets
declines, the only way they can stay solvent is by reducing their debt,
sell assets, pushes price down further, exacerbating and spreading it to
other securities/currency (€)
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April 2011, Romanian-American University
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Real vs. financial/virtual economy
Wealth effect vs. income effect
Commercial •Governments have borrowed too much to revive economies, causing
(2011) volatility, pushing the limits of fiscal and monetary stimulation;
vs. financial prosperity, however, takes time
Financial
•Banking and financial sector, a lagging, pro cyclical indicator of real
economy; although economy hoped to clearly rebound in 2011, GDP
growth is not enough
•Banks will not give loans on concerns of negative equity; pro cyclical
attitude: the more credit you need, less able you are. Unemployment is
a key indicator
The weak Dollar syndrome
Easy FED takes $ from savers
Bernanke's floor and put
$ 15% yoy •Post real estate boom market: real assets vs. financial liabilities
decrease - big
stability: bail out countries (PIGs) is to keep financing
loss for China •Financial
banks sovereign exposure solvable; money-printing is just another
way for governments to silently default on their debt
•ChIndia, probably best market capitalists have socialist ideology and
US will not make it easier for EU; EU does not make it easier for EU
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April 2011, Romanian-American University
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Liquidity
Bail out
Decreased •Liquidity (ST, EU Stabilization Fund) and solvency (LT, deficits) are not
correlation inter changeable. Interest rate risk vs. credit/counterparty risk
•Liquidity provided by CBs can make a difference on ST but not on a LT;
markets are becoming completely dependent on Central Banks. Dark
side of Euro: one size fits all could be suboptimal in times of crisis
•Negative equity: market value of assets < present value of liabilities.
Deleveraging is a must (7/91 stressed European Banks w/ Tier1 < 6%)
Solvency
Bail in
Change in •Solvability (LT, renewable ability to borrow) vs. liquidity (short term)
•High debt/GDP, high deficit/GDP, low growth – LT endangered species
paradigm •An absolute economic pecking order:
1: recovery
2: growth
3: expansion
4: prosperity
•What if Oil does not decrease till Q4? What when FED stops buying?
•Bail out: €B 865 (EFSF: 440, IMF: 280/US 50, EFSM: 60, Bilateral: 85)
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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Carry trade the easy money
Ultralow monetary for net wealth
Decreased •Then (2009): reverse correlation; when the dollar would fall, stocks
correlation would rise and vice versa; euro was strong, EM currencies, including
Ron, were under pressure
•Why: CT investors were using a currency that cost almost nothing to
borrow ($,¥) to buy undervalued stocks, with a bias toward emerging
markets; combination lift stocks off their 2009 March lows
Currencies and stocks
Competitive re(de)valuation
Change in •Now (2011): stocks and the dollar are moving up in tandem again, but
paradigm not down (weak Euro from B/Outs?); a signal for investors to put more
money into $ denominated assets? a signal to sell Euro denominated
assets and buy into emerging markets (Ron?)
•Countercyclical Dollar and Yen are now less favorite CT currencies,
due to strengthening and overall volatility; with $, ¥, and volatility up
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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Dollar
Cyclical tailwind
Decreased •Typical paradigm for an export oriented Europe was that a strong dollar
/ weak euro is good for trade, for both US and China. A weakening euro
correlation (a political not economic currency) is of benefit to PIIGS, alleviating
some excessive deficits and making their products more competitive
•Raw materials, mostly denominated in dollars are making inputs prices
more expensive adding additional strain on expected growth differential
vs. US. This will lead probably to an earlier interest rate hike, make now
dollar assets attractive; now: strong CHF, J¥, €; undervalued C¥
Euro
Structural headwind
Cyclical or •During the toughest part of recession, the dolar weakend against most
of other currencies. A depreciating currency is a good antirecessonary
countercyclical tool; a low $ exports recession and a strong $ imports growth
•Banks are a lagging economic conditions. CBs, trying to protect
currency stability and debtors, would rather sacrifice future, potential
debtors/present depositors than curent debtors solvability position
•Main risks to fiscal consolidation stem from too optimistic assumptions
and lack of specification; if EU didn’t have common currency, it would
have bigger problems or vice versa?
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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Diversification along sectors, assets, managers
Economy (2011-2012)
Probability
A (energy sector)
B (financials sector)
Boom
0.25.
20%
5%
Normal
0.50
10%
10%
Recession
0.25
0%
15%
•Ra =
(0.25) (0.20) + (0.50) (0.10) + (0.25) (0.00) = 0.10
•Rb =
(0.25) (0.05) + (0.5) (0.10) + (0.25) (0.15) = 0.10
•Σ2a =
(0.25) (0.20-0.10)2 + (0.5) (0.10-0.10)2 + (0.25) (0.00-0.10)2 = 0.005
•σ2b =
(0.25)(0.05-0.10)2 + (0.5)(0.10-0.10)2 + (0.25)(0.15-0.10)2 = 0.00125
•σa =
(0.005)1/2 = 0.07071 = 7.071%
• σb =
(0.00125)1/2 = 0.03536 = 3.536 %
•Covab =
(0.25)[(0.20-0.10)(0.05-0.10)]+ (0.50)[(0.10-0.10)]+ (0.25)[(0.00-0.10)(0.15-0.10)]=
- 0.0025
•ρ(a,b) =
cov (a,b) / σ2a σ2b = - 1
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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Risk appetite increases at the wrong moment and for the
wrong reason, just when risk capacity decreases; net wealth
effect (market) compensates for net income effect (lower wage)
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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2011 Portfolio diversification: 50% stocks + 50% bonds
Probability
Equity fund %
Bond fund %
50% equity +
50 % bond
Recession
1/3
-7
17
+5
Normal
1/3
+ 12
+7
+ 9.5
Boom
1/3
+ 28
-3
+12.5
Expected return
11
7
9
Variance
204.7
66.7
9.5
Standard deviation
14.3
8.2
3.1
•Cov(s,b)
•ρ(s,b)
= 0,3333(-7-11)(17-7)+0.3333(12-11)(7-7)+0.3333(28-11)(-3-7) = -116.67
= cov (s,b) / σaσb= -116.66 / [(14.3) (8,2)] = - 0.99
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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Emotional Phases; case study: PIGS
Phase 1
Phase 2
Phase 3
Phase 4
Phase 5
Overall
1
▪
Emotions and
guts
do matter
2
Survival of
the able
planner
3
▪
▪
▪
▪
▪
Markets are
not always
rational
▪
▪
4
Confidence
▪
▪
Individuals always act
in their own best
interest, economic
Success and
prosperity are strong
anesthetics
▪
Biological rigor prevails
History is written by
winners
Right decision feels,
right, investor sentiment
▪
Unstable balance
between fear and
greed
People have
noneconomic reasons
and irrational
behaviors
▪
Achievement begets
success
Success begets
confidence
Confidence begets
opportunities
Individuals make
mistakes
Pain is a strong
evolutionary trick that
quads us against
dangers
▪
▪
▪
▪
▪
▪
Behavioral biases
create bubble and
bust phases that are
hard to predict
Contrarian strategy
needs steadfastness
Both markets and
investors evolve and
adapt
Frame dependence
Mental accounting
Risk is rewarded, in
general, by higher
return, but not
necessarily
Risk is seriously
punished during crises,
rational or not
▪
▪
▪
▪
▪
▪
▪
▪
▪
▪
▪
Individual learn, adapt
(heuristic) but make a
lot of mistake in the
process
Residual risk aversion
Overconfidence
▪
Even best strategies
wax and wane over
time
If the market is
efficient, what is the
use of stock picking
ability?
▪
Financial education is
a necessity; manage
assets and liabilities
Think long term
Make sacrifices
Can do attitude
▪
Progress in finance is
cyclical
Economic creativity is
key to human
development
▪
SYMPOSIUM ON FINANCIAL STABILITY,
▪
▪
▪
▪
Individuals act
feasibly, and always
try to satisfice
People consumed to
much and invested
too little
▪
▪
A 95% perfect strategy
is a non performing
strategy
Do the right thing only
after had exhausted
every other alternative
▪
Greed makes crisises
unavoidable; humans
are kind, generous,
Econs are
unscrupulous, have a
limited span of interest
and attention
▪
Inertia is a very
powerful force
Most of the decisions
we make in our lives is
based on our level of
confidence
April 2011, Romanian-American University
▪
▪
▪
▪
▪
Competition imposes
continuous
adaptation
Adaptation, flexibility,
innovation and
compromise are key
to survival
Survival is all that
matters
Pain is temporary,
quitting is permanent
Regret aversion
Pace of change in
business is faster than
ever
Representativeness
Save more tomorrow
People do not react
well to bans or
mandates; they react
best at nudging
19
Too big to fail but fit enough to
carry trade the easy money
Paper out the crisis to the future
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April 2011, Romanian-American University
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What if: 1% (end of 2011, ECB) increase in short-term rates
Expected Balance Sheet for Hypothetical Bank
Assets
Yield
Liabilities
Cost
Rate sensitive $ 500
9.0%
$
600
5.0%
Fixed rate
$ 350
11.0%
$
220
6.0%
Non earning
$ 150
$
100
$
920
Equity
$
80
Total
$ 1,000
$
1,000
NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)
NII = 83.5 - 43.2 = 40.3
NIM = 40.3 / 850 = 4.74%
GAP = 500 - 600 = -100
With a negative GAP, more liabilities than assets
reprice higher; hence NII and NIM fall
ECB tightening will pressure banks, lending, growth
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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Adjust Rate Sensitivity of a Bank’s Assets and Liabilities
(core EU: more fixed rates vs. periphery EU: more variable rates)
Objective
Approaches (core vs. periphery Europe)
Reduce asset
sensitivity
•
•
•
Buy longer-term securities
Lengthen the maturities of loans
Move from floating-rate loans to term loans
Increase asset
sensitivity
•
•
•
Buy short-term securities
Shorten loan maturities
Make more loans on a floating-rate basis
•
•
Pay premiums to attract longer-term deposit
Issue long-term subordinated debt
•
•
Pay premiums to attract short-term deposit
Borrow more via non-core purchased liabilities
Reduce liability
sensitivity
Increase liability
sensitivity
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April 2011, Romanian-American University
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Oil vs. Euro; higher Euro or lower Dollar?
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Gold vs. Euro; higher Euro or lower Dollar?
EU: prosperity by austerity
US: assumption and consumption
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DJIA vs. BET; Dollar weakening (15%) - no procyclical decorrelation
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The Black Eyrar
Yield curve bet vs.
credit quality bet
Global insolvency of
current benefits;
need to transfer/lower
standard of living
Portfolio managers time level
of interest rates relative to
cycle, adjust maturities:
• A pension that has to pay
€10,000 in 50 years (@4 %)
in today’s money, €1,400; use
of 7 % reduces that to €340
today, but €10,000 remains
• IFRS: “discount rate should
reference to market yields on
high quality corporate bonds
with similar durations to those
of benefit obligations”
• Where a deep market of
corporate bonds do not exist
(CEE), pension companies
discount at yield on TBs
• time interest rate peaks,
counter-cyclical strategy: the
changes in loan demand and
the yield curve’s shape
Mrs. Market infinite energy
to prove us wrong
• Solvability and liquidity are
not interchangeable
• Cannot transform liquidly into
solvability except by sale at
loss
(S = L - Current Loss)
• at top of cycle, expanding
portfolio, when interest rates
and loan demand are high
lengthening maturities
• An investor/debtor (The Real
Estate Inc.) can’t get rich by
buying an overvalued asset
except by miracle or luck; luck
is non recurrent
• yield curve generally inverts
when rates are at peak prior
to recession
• Deficit of competitiveness
and Black Eyrar:
• at bottom interest rates and
loan demand are low, bank
contracts portfolio, shortens
maturities
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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The same old sun: easy to be smart on hindsight
Over optimism is a
basic tenet of
human species
In general, people do
not spend time
looking and
understanding bad
news
Investors would rather
prefer to focus on
the bright side of
the moon and they
do not see things
that they do not
expect to see
In the war b/w upper
and lower class, it
is the middle class
that pays the price
Where are we now?
SYMPOSIUM ON FINANCIAL STABILITY,
April 2011, Romanian-American University
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