Summing up the week

The chinese revaluation continues to be discussed though some think a devaluation is in the cards rather than an appreciation (see also Goldman saying the Yuan is no longer cheap). With most governments still in competitive devaluation mode scrapping for demand, it is hard to imagine the renminbi not attracting a flight to quality bid on the basis of a domestic economic growth and high savings rates. It is an interesting point of view though and if Chinese growth slows or demand picks up in the rest of the world, maybe the yuan will fall.

Swap spreads turned negative. It is pretty stunning but I can't see it as anything other than a squeeze. There is little logic to banks borrowing at below government rates. The move also coincides with some sharp yield rises across the treasury curve which also looks like liquidation. I expect both the swap spread and high treasury yields will reverse in a couple weeks time after positions are squared and weak hands shaken out. We shall see. I fall into the camp that sees deflation as more of a problem than inflation in the near term (at least a year) due to excess capacity and weak demand.

The economic data still shows the US economy running near stall speed.  Drivers for a slowdown might be 1) growing mortgage delinquencies based on rate resets or 2) a slowing in China (perhaps others too) as liquidity is withdrawn.  To break away from stall speed probably takes a surge in developed world household consumption leading to faster than expected reduction in unemployment.

Watching the rise in stocks against the drop in bonds looks a bit like inflation bets are being put on.  The under-performance in commodities (especially gold) indicates they are no longer the market of choice for such bets.  I tend to think these moves will reverse in the next couple of weeks.  Earnings expectations and multiples still seem to high in stocks, as I said above I don't think inflation is a meaningful threat, and the large debt balances held by governments give plenty of incentive to weaken currencies against commodities.  Of the moves the gold drop is most interesting as clearly a lot of big bets have been placed on its continued rise.

Lastly, on financial reform, I came across some interesting comments in the Aleph blog which makes a fair point that spotting trouble spots is not rocket science:

But, I am sorry, the crisis was anticipated by many of us.  Here is the secret, Alan: the area receiving the greatest increase in debt is the area where systemic risk is growing.  Finance is a mature industry.  Large increases in debt are likely bubbles.  After all, given that the accounting rules allow risky loans to recognize credit margins as paid, in the short run it always pays to write risky loans, until illiquidity kills the lender.

This is similar to the point I tried to make last week, that financial innovation needs to be viewed with more skepticism.  There is very little in the way of diversification, hedging or slicing of risks that is not already being done in a highly efficient way.

China will revalue the Renminbi in Q4

Martin Wolf and Macro-man illustrate the difficulty China finds itself in by continuing to rely on the US as the consumer of last resort.  China is sticking with a policy of favouring export led growth driven by pegging its currency against the dollar.  While fiddling at the margins of policy and sometimes making statements to the effect that it uses a basket, a dollar peg has been the policy and it has been successful.  This seems likely to change.

Beyond the political rumblings, which seem more likely to cause China to dig in its heels, it seems like finally the US consumer is unwilling to play the role China desires.  This is indicated by the slowing trend of retail sales as pointed out by Tim Duy.  An updated chart is below, and by my math the trend since July 09 is still running at 0.31% and still below the 0.37% trend Tim calculated from January 03 to November 07.


(Note the y-axis does not begin at 0 to better illustrate the change in trend)

In the past consumption growth would resume with falling interest rates leading to increased borrowing.  This path is now less effective as both consumers and banks look to rebuild balance sheets.  This is shown by increased personal savings rates and balance sheet rebuilding by financials here.

Most recently China has stated plans to review its currency policy after Q3 and at that point in time it seems likely that a gradual appreciation against the dollar will be allowed.

A systems approach to the Global Financial Crisis

John Robb at Global Guerrillas writes:

In the case of the financial system, the simplified component of the bow-tie control system is money.

The regulatory system for these simplified components are markets (price discovery). Through this lens, what happened in the financial system is actually relatively simple.  The financial industry created a system called the shadow banking system (a notional value of $400 trillion ++), which is essentially a complex web of interconnected derivative contracts. 

These contracts are, by and large, NOT regulated by market mechanisms (they "derive" their value from other things, including market prices).  Instead, they are customized and complex.  These derivatives created a set of interconnections that bypassed the financial system's simple bow to directly connect inputs to outputs.

A systems approach and perhaps a bow-tie model is correct but his analysis and explanation does not really fit the crisis.  Why would new off balance sheet entities (shadow banks) create a more direct linkage between inputs and outputs than already existed?  Why did OTC derivatives suddenly become a problem when they have always existed along side the exchange traded instruments?

His analogy to the internet that places bits of data at the bow of the system is where John wanders off course.  Beyond the data bits, to work effectively the internet needs standards so that the programs that read and present to users display the received bits in the intended way.  As seen when upgrading or trying a new browser it is these evolving standards that lead pages to sometimes display incorrectly.

For the Global Financial Crisis the standards also came into play.  Investors misunderstood the borrowing levels for the large banks because the banks had moved assets and liabilities off balance sheet into "shadow banks".  Investors further misunderstood OTC derivative contracts because the ratings applied to the mortgage pools did not imply the same level of safety as it had in the past for standard debt.  Examples like this continue with new surprises like Lehman's Repo 105 transactions which were explicitly done offshore to bring another legal standard into the mix so that once again investors could not render the correct financial picture from company statements.

A second system element was the willingness of regulators to experiment with relaxed leverage restrictions.  There is no feedback loop - other than bankruptcy of individual firms - that restricts the amount of leverage in the system.  This is done instead by regulating the amount of capital that most be held and in some cases by specifying the amount of margin that needs to be posted on an individual transaction basis.  These rules were relaxed.  For instruments like no down payment home loans and total return swaps the lack of margin is explicit.  For other newer innovations, like AIG's CDS portfolio or the shadow bank entities used by banks like Citigroup, it seems likely that the regulators, like investors, did not have an accurate picture of the leverage involved.

These misunderstandings and relaxed lending standards compounded through feedback in a couple of ways.  Once the misunderstanding of leverage existed it was able to compound as too much reliance was placed on obligations from Lehman, Bear Stearns, AIG, AMBAC, and MBIA.  The increased leverage was primarily focused on property, leading to rising prices creating an illusion of safety and driving demand for more borrowing in the sector.   This was the primary driver of a higher than normal level of borrowing throughout the economy.

Seeing the system a bit differently than John, I diagnose different problems and solutions.  I view the primary causes of the crisis as inadequate lending limits and a lack of transparency in financial companies.  This lack of transparency was enabled by unnecessary complexity being represented as innovation.  In terms of re-regulating finance reform should focus on the following:

• Greater reliance on exchanges and margining.  Exchange cleared products are more likely to be standardised and are more accurately valued due to margin requirements and  more actively traded markets.
• A rethink of what is meant by financial innovation.  Too much of what was labeled innovation seems to have really been obfuscation leading to poor judgement by investors and regulators.  Some clear signs that this is happening are when the profits and valuation changes due to "innovation" are disproportionate to the stated benefit of the new product.  I.e. should slicing up and reselling banks' loan portfolios really lead  to the record real estate values and record profits for banks?  Standardisation and a long track record for a product should be given a lot more weight in terms of the capital required to be held against a product.
• Principles based reporting standards.   This fits with the point above as limiting the use complexity that is without purpose will also limit the tools available for misrepresentation.
• An overall limit on the level of credit that is acceptable for any given institution and for the economy as a whole needs to be set.  In avoiding risk of ruin all individuals do this and it is not clear that any better method can be established for companies or countries.  At some point leverage will always be too high and lead to bankruptcy and where exactly this point will be reached is unknown except with hindsight.