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October 2015

In a Nutshell(Part 2) – A Macroeconomist’s View of the Sub-Prime Mortgage Crisis

Part 1        Part 2         Part 3

From a macro point of view, there were mainly 2 macroeconomic causes that contributed to the creation of the housing bubble.

  1. Loose Monetary Policy – 2000-2007

A possible hypothesis that has emerged claims that the creation of the housing bubble was due to loose monetary policy after the dotcom bubble burst in 2001. Following the 2001 recession, a result of the burst of the technology bubble, the target fed funds rate(effectively interest rates) fell from 6.5% in December 2000 to 1.75% in December 2001 and 1%  in June 2003. As seen from the graph below, these rates have not been seen since the 1950s and it was only reverted back to normal range towards 2006.

The Taylor Rule was popularized by Noble Economist, John Taylor, as an interest rate forecasting model that acts as a ‘recommendation’ for how central banks should set their federal fund rates to stabilize the economy in the short-term while maintaining long-term economic growth.

It can be seen quite broadly that using the Taylor Rule(Blue Line) as a general guide, fund rates were consistently lower than recommended rates from 2001 to 2006. Loose monetary policy increases incentive for asset managers in financial institutions to search for higher yield investment products thus increasing risk taking. Moreover, low interest rates fuel increase lending, especially in investment, which contributed to the credit expansion of the housing bubble as more liquidity flowed into unrealistic expectations.

  1. ‘Persistent’ Global Imbalances

From 1970s to 2008, emerging Asia and many of the oil-exporting countries managed to achieve large current account surpluses due to their successful export-orientated strategy. Such a trend should have predicted a general rise in their exchange-rates.(Demand for currency is a derived demand for goods) or a breaking down of the USD due to capital flight that would have triggered a confidence,currency and financial crisis(reminiscent of the 1997 Asian Financial Crisis). The surplus countries delayed such a disaster by reinvesting the surplus funds back into the US which further expanded the monetary base, encouraging excessive consumption and risky investment. The financial crisis indeed manifested but not envisioned by experts, it came in the form of the implosion of the real estate bubble as excess liquidity resulted in unrealistic asset prices.

The imbalances were a result of the following factors:

  1. The US current account deficit can be identified as a result of excessive consumption, low household savings, accomodative monetary policy(as previously mentioned) and a gradual lost of export competitiveness in certain sectors of the economy. Moreover, the US is the world’s reserve currency which entitles it an ‘exorbitant privilege’. As previously mentioned in an older article(Check out the ARTICLE), the US is able to issue out government securities indefinitely due to the importance of its role in global trade and financial sector.
  2. On the other hand, the surplus countries especially China are disposed to assume the role of creditor as a result of domestic economic conditions.
    • Export Orientated Growth(High X-M)
    • Undeveloped financial sector results in a lack of viable local investment opportunities(Investment dearth). It thus leads to excessive savings in financial institutions that aid state-own enterprises but hurt SMEs and the rest of the population(low returns since supply of funds is big)
    • Weak social security nets encourages precautionary savings
    • Cultural reasons
    • Under-valued exchange rates sustained the export-orientated economic boom among many of the developing countries.
    • To build up large foreign-exchange reserves(US Dollar) in response to the painful experience of the Asian Financial Crisis in 1997

    The result was a global savings glut that was contrasted with a investment boom centralized in US. The excess liquidity result in the inflation of asset prices, significantly contributing to the creation of the financial bubble. Many of these financial products were also sold to investors from emerging economies as they entered the US market for investment opportunities.  The global savings glut resulted in the gradual fall in long-term interest rates which further fueled credit expansion. The financial crisis was thus a result of ‘mutual cooperation’ deemed to be unsustainable from the beginning.

Questions to ponder about:

  1. Is there a justification to burst potential credit bubbles with monetary policy?
  2. Have there been an improvement in the persistent global imbalances after the crisis?

Check out Part 3…..

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In a Nutshell(Part 1) – Sub-Prime Mortgage Crisis

Part 1        Part 2         Part 3

Recently, I just finished reading “The Map And The Territory: Risk, Human Nature and the Future of Forecasting” by Alan Greenspan, who served as the Chairman of the Federal Reserve of the United States from 1987-2006 and was struck by his succinct explanation of the factors leading up to the disaster.(It is an excellent book btw, HIGHLY RECOMMENDED if you are an Economics enthusiast like I am).

As with all Economic problems, one has to look beyond the surface of evil bankers and large banks to understand the complexity of the issue and the contribution made by different parties that culminated into a large housing bubble. In this 3-part special, we will give a short and brief analysis of the micro and macro reasons that resulted in the crash.

A crisis of historic proportions

The financial crisis that struck the world beginning from the summer of 2007 is without precedent in economic history. Although its size and global impact was exceptional, it had many features that were common among other historic financial crisis. It was preceded by long periods of credit growth, low risk premiums, abundance of liquidity, strong leveraging, soaring asset prices and the creation of a massive bubble, this time in the real estate industry. Financial Institutions(Banks) overly leveraged profile resulted in their vulnerability to even small dips in the mortgage industry.

Though the crisis fully exploded towards the summer of 2007, cracks in the real estate industry were emerging by 2006, the market has been expanding over too long and space capacity was bound to emerge. There was a clear detection of over-confidence as housing prices, historically averaged around USD 150,000-200,000 but by the end of 2006 were reaching nearly USD 350,000

In its early stages, the crisis manifested itself merely as a liquidity shortage among financial institutions as mortgage defaults resulted in increased difficulty to clear their short-term debt as confidence declined. While there were increasing concerns over the solvency of banks, there were still no clear signs of systematic default. However, this perception dramatically changed after the bankruptcy of a major US investment bank, Lehman Brothers, (may have been a mistake to allow the bank to default).

From then on, there was massive market panic. Confidence plummeted, investors and financial institutions fire-sell their assets, regardless of price, to acquire liquidity which was deemed to be the safest and the stock market went into a massive downward spiral. This further depressed asset prices thus further endangering investors and banks which thus culminated into a dangerous feedback loop.

Banks distrusted one another and refused to lend which further sapped liquidity from the market. Business investment and consumer demand nose-dived and the massive layoffs were only a matter of time. Many swarmed to banks to retrieve their savings and a bank run was in way.

While the massive panic was eventually stopped, the damage has been done. Unemployment rates will eventually soar from 4% to nearly 10%.

The whole world was affected but it was the advanced economies that were hit the hardest due to their exposure to the financial sector.

In the next series of posts, we will aim to explain the factors contributing to this massive crisis.

Check out Part 2.….

The Reserve Currency – Benefits and Complications

It is a well-established fact that the US$ position as the world’s reserve currency confer it many benefits that other countries yearn for. With China’s economy booming, many have highlighted that the China RMB may eventually pose a threat to the US’s position as the world reserve currency. They worry that the RMB will replace the US$ eventually much as how the US$ replaced the sterling gradually after the first world war. That still seems to be mere scare-mongering tactics with the closed financial system of the China’s economy.

However, the questions remains:

  1. What are the benefits of being a reserve currency?
  2. What are the lesson known complications of being the reserve currency?

 What are the benefits of the reserve currency?

  1. Currency Stability

The US$ constitutes almost 80% of world transactions. More than 60% of foreign reserves of central banks and governments are US$. Given the dominance of the US$ in world trade and financial transactions, the world is dependent on the issuance of US$ to sustain the economy. Investors typically will want to avoid currency swaps to reduce profit lost. As a result, they will pick the currency that serves as the most common medium of exchange or simply the reserve currency. When the sub-prime mortgage industry imploded in 2008, the US$ in fact appreciated for a short period of time. This reflect a general swamp to a safe haven both by government and investors even though USA was fundamentally at the center of the crisis. This differs significantly from other crises such as the Asian financial crisis in 1997 and more recently the Eurozone crisis, both of which the currency has significantly depreciated. This reliance on the reserve currency allows it to ensure currency stability which further boost the confidence of investors on its economy. Currency stability ensure stable expected rate-of-return for businesses and becomes useful to sustain economic growth.

  1. Increased Borrowing due to lower bond yields

Conventionally, when a nation runs high in government debt and lands itself in a recession, it increases the risk of defaulting on its loans. Thus, bond yields rise due to a lack of investor’s confidence and credit-rating agencies lower the investment grade of government bonds. This has been the case for Greece as high government debts and the inability to produce its own currency has increased its risks of default. Bond yields have spiked to nearly 7% and credit rating agencies(Moody/S & P) have deemed its bonds as junk status. However, this situation is inconceivable in the case of the reserve currency. As a result of the reliance on the reserve currency on monetary transactions and the inertia faced in any attempt to replace it, confidence in the US$ can be considered stable and indefinite. The demand for its government bonds and currency is so significantly high that it results in an unwavering advantage. Its government can typically borrow indefinitely from the world. As of 2015, the US government debt is nearly $18 trillion dollars, constituting around 102% of its GDP and it seems to be continuing to rise indefinitely. Admittedly, there seems to be no limit to its debt accumulation. The long-term result is that the US economy can produce and consume well above other countries since many will be willing to lend to its government.

In other words, the US benefited by paying for imports with costless dollars. In turn, the US’ main trading partners enjoyed robust demand for their products, creating employment and income growth.

This all seems like a good thing for the global economy. But, is it?

 What are the problems of a single world reserve currency – Triffin’s Dilemma?

Originally raised by Belgian born American economist Robert Triffin in 1960s as a reference to the instability of the Bretten Words system in view of the peg of the world currency to the US dollar, it still shows its relevance today. Robert Triffin notes that the US dollar’s position as a world reserve currency resulted in a clash of interest between domestic objectives and international obligations.

On one hand, the world needed the US$ for liquidity purposes but on the other, this made it easy for the US to run consistently large current account deficit. Thus, it is inaccurate to blame the US consistently large currency account deficit mainly on China or lowering export competitiveness. The US$ is thus severely undermined during good economic times which destabilizes the world economy and potentially result in an ability for market forces correction and thus an eventual larger implosion of the world economy.

In the period from 2000-2007, the huge deficits brought about by excess US massive consumption produced a massive amount of liquidity in the world economy. While Triffin’s dilemma would have predicted the collapse of the dollar, foreign governments sustain the value of the US$ by reinvesting its excess dollars back into the US asset markets for several years. However, this excess liquidity flowed towards the mortgage industry and led to the spike of asset prices. The result is an unstable creation of a massive financial bubble build on shaky fundamentals. In 2007, debt accumulation peaked and the collapse of the industry created the largest economic crisis in years.

In such a crisis, the US government will aim to depreciate its currency to gain a certain exchange-rate advantage. However, the US dollar in fact was the only currency to appreciate against the other currencies since it acts as a safe haven for investors. Moreover, much of the liquidity vapourized returned to their source, pushing up the value of the dollar. The point is that in a crisis, the world currency trades above its value although its economic fundamentals is as weak as other economies. The US government may want to pursue a depreciation to increase its net-exports but its status as a reserve currency prevents such economic tools.

Moreover, its position as a reserve currency encourages reckless policies in their attempt to provide global liquidity. The inherent conflicts in the global monetary system that led to the great financial crisis has not been addressed. In fact the massive rise of the US currency in recent months despite a weak economy is a clear reflection of the relevance of Triffin’s dilemma.

Thus, unlikely what many Americans may assume, perhaps China joining the party may not be as poisonous as it seems.

Questions to ponder about:

  1. What are Special Drawing Rights(SDR) that are maintained by the IMF? How could they play a part in resolving the Triffin’s Dilemma?
  2. What is the current status of the RMB? How close are they to challenging the US position as reserve currency?
  3. What role must the Chinese government play to improve the Yuan’s role in the world currency market?

The different reactions to the Trans-pacific Partnership

After 5 years of grueling negotiations, almost 30 chapters of rules and regulations with potentially more to be added, the Trans-Pacific Partnership (TPP) multilateral negotiations are finally done. This is a massive free-trade agreement which is supposed to increase the trade and investment flows between member nations.

As with any huge and monumental event, there have been starkly contrasting views.

Screenshot 2015-10-13 21.57.11

Dr Mahathir, the former Prime Minister of Malaysia, has branded the TPP a bad idea for Malaysia. His main argument is that Malaysian companies will be unable to compete with foreign companies now that there is little means of “discriminating” in favour of local companies, i.e. protectionist measures like tariffs can’t be used anymore to give local enterprises any advantage over the competition.

Across the causeway in Singapore, the mood is very different.

Prime Minister Lee is optimistic that the TPP will give Singaporean companies, including small-medium enterprises, access to a much wider market and investors will get a fair and level playing field. The mood is almost positively buoyant!

Is there something in the TPP that causes these starkly contrasting reactions? This is unlikely. This difference in opinions stem from different starting points in each economy. Singapore has long ago embraced the idea of globalisation while Malaysia has resisted aspects of globalisation.

Singapore’s embrace of globalisation means that we understand and embrace the theory of Comparative Advantage as conceptualised by David Ricardo. When it’s obvious that our factor endowments are not suitable for a particular industry, Singapore allows the industry to decline and die out. We do not resist market forces but instead try to stay ahead of market conditions. As such, we seek new comparative advantage such that when existing comparative advantages decline, our growth and employment indicators are not affected that greatly.

For various reasons, including political and nationalistic reasons, Malaysia chooses to use protectionist measures to protect industries which has not shown evidence of comparative advantage. A classic example is the automobile industry where the tariffs imposed on imported cars allow local car brands such as Proton to have an advantage. Proton however has yet to make any headway as an export after many years in existence, providing evidence that Malaysia doesn’t have the factor endowments for car manufacturing to be considered a comparative advantage. The TPP may compel Malaysia to ease or abolish tariffs and it remains to be seen whether Malaysian companies who have gotten used to protectionism can compete.

The Oil Slump – Causes and Consequences

As oil prices now edge towards $45 a barrel, it is important that we analyze the events of 2014-2015 that culminated into this slump in prices. Oil is a key resource that affects the global aggregate demand and inflation. It also act as an important source of revenue for many oil-producing developing countries(Venezuela/Saudi Arabia) thus shocks to its price can have far-reaching consequences to the global economy.

What are the demand and supply factors responsible for the price slump? 

  1. Demand – (Income):Global oil prices are affected by the state of the world economy, as China now slows down due to its need to reform its economy towards a more consumption based economy, its demand for commodities, including oil is greatly reduced. Moreover, given the Eurozone Crisis, much of the Euro is entrenched in a structural problem of low wages, high government debt and low economic growth. Such global slowdown resulted in a decrease in world demand for oil since production levels are reduced.
  2. Supply – (Technology and Cost of Production): The OPEC countries once had an overwhelming control on oil prices but with the improvement of technology in fracking, oil sands and shale oil. The cost of retrieving oil was greatly reduced in these areas which were once assumed to be non-profitable for firms to extract out of the seabed. This massive swarm of an increase in USA and Canada producers flooded the global market with oil. The success of Texas is a reminder of the success of the shale boom.

The public announced decision by Saudi Arabia- the largest producer in OPEC- not to reduce production in view of steadily increasing world supply and the declaration of OPEC to maintain their collective production ceiling of 30 million barrels a day have all ensured that oil prices remain at low levels.

How persistent is this supply shift likely to be?

This depends on mainly 2 factors:

  1. Firstly, it depends on whether OPEC, especially Saudi Arabia, will be willing to cut oil production in the future. This in turn depends on motives behind its decision to maintain production despite falling prices. A possible hypothesis is that Saudi Arabia has found it too expensive to ensure high prices in view of increasing production from non-OPEC countries. It risks losing market share and revenue as importers search for better alternatives. If so, unless agreed upon by other heavy producers such as Russia and other OPEC countries to share the burden, the decision to continue production may be a long-term one. Another possible hypothesis is that it may be an attempt by OPEC to reduce profits, investments and eventually supply by non-OPEC suppliers, many who face higher cost of extraction compared to OPEC countries.. (The chart below shows the cost of production by various forms of oil extraction-non-OPEC countries such as USA and Canada extract a large percentage of their oil from shale and oil sands)
  2. Secondly, it depends on how investment and capital expenditure will respond to falling oil prices. Given the nature of firms to respond to current prices, overall capital expenditure by major oil companies is likely to fall. Accordingly to the Rystard Energy, the break-even price for shale oil producers lie around the price of 60USD. With oil prices hovering between 45USD-4USD currently, preliminary analysis suggest that prices may rise in the short-term. However, it is important to note that shale oil and oil sands companies have proven to be exceptionally resilient despite falling oil prices. The graph below shows falling break-even prices reflecting the ability of fracking companies to respond to falling prices. Most have improved productivity due to shorter drilling time(pad drilling) and shorter completion time(increased used of zipper fracs). Given the innovation that US firms have showed over the years, it is likely that over the long-term oil prices may hover around 50USD over a longer period of time than expected. Moreover, with the Iran nuclear deal possibly coming to a consensus, Iran may enter the picture, pushing supply higher.

The Chinese economy will take time to reform itself and its voracious demand for commodity has likely peaked. Moreover, the introduction of new producers from USA and Canada has severely undermined the control of the OPEC countries. These are budding entrepreneurs willing to adapt and innovate to stay profitable in the industry. Evidence seems to suggest that though the oil prices will continue to be subjected to high volatility due to political instability, the slump in oil prices is likely to be a long-term trend.

What are the effects of such a long term price decrease? Which economies will struggle?

With oil prices tumbling down, oil-exporting countries are bound to be affected due to low export revenues. Countries such as Saudi Arabia and Qatar have been able to ensure stability as they have sufficient fiscal space to maneuver around. But, if oil prices were to continue to remain low, it may grind down on the limited fiscal space available. Saudi Arabia especially is at risk as it is caught up in an expensive war in Yemen and its social policies are often expensive but inefficient. Other oil-exporting countries such as Venezuela and Brazil which are overly-reliant on oil export revenues, lavished on social often populist policies and failed to reform their economy during the commodity boom are already experiencing low economic growth and political instability(Petrobas scandal).

On the other hand, oil-importing countries such as Indonesia and Philippines is likely to benefit from low oil prices as disposable income rise can lead to increase in consumption and reduction in cost of production across many diverse set of goods. Energy intensive countries such as India and China will experience a more significant improvement in their economy as production costs fall due to falling energy prices. Low oil prices also provide a good opportunity for many developing countries to cut energy subsidies. For example, India was able to reduce diesel subsidies recently and there were no protests. Indonesia given its high energy subsidies should follow suit given long-term benefits.

Questions to ponder about:

  1. Why have local petrol prices remain high despite the oil slump?
  2. How have Singapore’s petrochemical industry fared in view of the oil slump?
  3. How will the oil slump affect industries? Which industries stand to benefit the most?

References:

Blanchard, Olivier J. and Jordi Gali, 2009. The Macroeconomic Effects of Oil Price Shocks: Why are the 2000s so different from the 1970s? in J. Gali and M. Gertler (eds.), International Dimensions of Monetary Policy, University of Chicago Press (Chicago, IL), 373-428

Rabah Arezki and Olivier Blanchard Seven Questions about the Recent Oil Price Slump, .iMFDirect. Retrieved from http://blog-imfdirect.imf.org/2014/12/22/seven-questions-about-the-recent-oil-price-slump/

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