Friday, March 27, 2009

Links of the Day

Jhong-Wha Lee & Ju Hyun Pyun argue that globalisation (specifically growth in trade) reduces the probability of conflict:

"The results may derive from the fact that an open global trading system will prevent a state from initiating a war against any trading partner because other trading partners in global markets prefer to do business with a "peaceful" player. Hence, global trade openness of the dyad can reduce the incentive to provoke a bilateral conflict. We also think that open states can be more peaceful because they become more susceptible to political freedom and democracy. They apply international law better and employ good governance. Trade openness can also lead to an "expansion of bureaucratic structure," which concerns itself with economic interests in addition to security interests — and is thus less likely to support military action."

Does that mean "engagement" is better than "sanctions"? Shall we then engage more with Iran, Myanmar and North Korea?

Jon Danielsson says more regulation is not the answer for financial market reform:

"In a financial crisis, where financial institutions are required by regulations to hold minimum capital, just that fact is destabilising. If asset prices are falling, the financial institutions need to sell high-risk assets which depress the price and therefore by itself erode their capital. This is why risk-sensitive capital increases systemic risk and forces banks to withdraw lending...Indeed, the banks are now doing what they are supposed to do. They are being prudent. It is a bit disingenuous of regulators and politicians demanding that the banks increase lending when the banks are just following the regulations designed by the very same regulators and approved by the very same politicians."

Thursday, March 26, 2009

Exchange Rate Policy 3: Equilibrium exchange rates

How does one tell whether an exchange rate is over- or under-valued? Driver and Westway (2004)* lists 11 different methodologies on how to do this. If you recall from my first exchange rate policy post, structural models have the potential for making this determination. The insight into using these types of models is that exchange rates are affected by many factors, not just one or two, i.e. currencies should move in relation to the underlying fundamentals of an economy. If this sounds familiar, it’s because this is a common refrain of Tan Sri Zeti when talking about the level of the MYR. By implication, the fundamental equilibrium view rejects the concept of purchasing power parity or PPP, or alternatively that the PPP changes across time (depending on which model you use).

*Rebecca L Driver & Peter F Westaway, "Concepts of equilibrium exchange rates", Working Paper no. 248, Bank of England (2004). Link is here - warning! PDF link.

Which fundamentals are important to which currency can be radically different – a lot of the time spent in specifying these models is determining which variables actually matter. For instance, for countries like Malaysia with strong natural resources, commodity prices are an obvious starting point, although there are many more factors to take into account. A non-exhaustive list of fundamentals would include:

1. Government consumption, which is presumed to fall more on non-tradables. Higher government consumption in that case should in theory (through the Balassa-Samuelson Hypothesis) cause an appreciation of the exchange rate;

2. Relative real interest rates, where higher rates cause appreciation;

3. Openness to trade, where higher openness allows for greater tradable goods arbitration. This will equate to a depreciation of the exchange rate;

4. Net foreign assets, which measures capital stocks. A typical approach is to take changes in stocks as the variable i.e. a flow approach using changes to the current account, or the international investment position. The impact depends on the policy stance and structure of the economy – where economic growth is slower, a higher net foreign asset position implies greater income flows which result in an appreciation. However, empirical evidence suggests in high growth periods or for fast growing developing economies, capital inflows can appreciate the currency despite decreasing the net foreign asset position;

5. The terms of trade, which measures the price of exports in terms of imports. The result on the exchange rate here depends on the relative strength of income and substitution effects, although the empirical evidence suggests the former. This implies an appreciation of the exchange rate;

6. Relative productivity, both internal (between the non-tradable and tradable sectors) and external (in tradables). Higher international productivity in the tradable sector suggests a depreciation, while higher productivity in the tradable sector relative to the non-tradable sector implies an appreciation;

7. Demographic structure, such as the dependency ratio.

I have seen a lot of variations and proxy alternates in the variables used, some due to specific country effects and others due to data limitations. Some of the variables, such as trade openness, are subjective. Government consumption sometimes is not significant, but the government deficit might if borrowing is primarily external.

The different modeling approaches also yield different estimates of the equilibrium value of the exchange rate. There is in fact no single, correct way to go about this. The consensus is to always apply two or three different modeling approaches, which should give a good ballpark figure as to how far a currency is off its “true” equilibrium value. If on the other hand all the models are pointing in one direction, then that is something our fictional central banker has to take seriously. In terms of actual use, I would take the following three models as the most prevalent:

1. Macroeconomic Balance model (MBM) – measures the difference between projected medium term current account balance with an estimated equilibrium current account balance.

2. External sustainability model (ESM) – a variant of the MBM model, but measures the difference between actual current account balances with the balance that would stabilise the net foreign asset position at some benchmark.

3. The Reduced Form Structural Model – equates the medium term equilibrium exchange rate as a direct function of medium term fundamentals. The term "reduced form" indicates that variables that don't impact the exchange rate are dropped from the specification i.e. these aren't "full" structural economic models.

These are the models in general use by the IMF* in assessing currency misalignments, and where possible all three are calculated to get a balanced view of a currency’s equilibrium position. I’m not about to lay out in any length of how the models are calculated – even within the broad categories above, you can use different statistical approaches in the estimation, and results may vary according to the sample period chosen as well as the presence of any structural breaks.

* Press statement here, PDF document here

Neither is data gathering a trivial exercise. If you take the 15 currencies I’m using in my short term broad MYR index, that means you have to have the required data for all the variables for all the currencies involved, and in the correct frequencies for the full sample period selected. Secondly, some of the theoretical concepts don’t translate well to real world data – such as for example trade openness – which requires using some form of proxy. Third, some data is just not collected, or available for limited periods or not accurately measurable, such as net foreign assets. There’s thus a lot of room for specification error and measurement error.

Even with those caveats, there’s still no alternative to making the attempt at measuring currency misalignments. Any currency that is not following a full free float with open capital account regime can get into serious misalignment problems, with potentially expensive adjustments required to regain equilibrium either through currency adjustments, real economy adjustments or both. The worse case of course, is when these adjustments are imposed by the market, as we saw in 1997-98.

This naturally takes us to the choice of exchange rate regime, which will be covered by the next post.

Department of "Huh"?

Apologies to Brad DeLong for the title, but this op-ed in the Star had me scratching my head:

Control speculative trading in commodities
Making a Point - By Jagdev Singh Sidhu


"The price of crude oil has been kept from falling through a combination of planned supply cuts by oil-producing cartel Opec to meet an anticipated reduction in demand in 2009, and the hope of demand increasing as the global economy recovers...The argument is that too low a price will mean trouble for the energy markets as higher costs have already seeped into the business. Refining costs have gone up and so too have exploration and drilling costs over the past few years as oil companies venture off the deeper waters and harder-to-access places in search of the commodity."

This is an argument that the current highish oil price is being supported by a restriction in supply as well as a higher cost structure - an argument based on fundamentals.

This is then followed by:

"Plans to limit excessive speculative trading in commodities by hedge funds must be carried through and enforced. The world doesn’t need higher priced commodities raising inflation, hitting the public’s wallets and slowing any recovery in the economy."

This suggests that speculators are driving up the price of oil - an argument based on market manipulation. So which is it? Given the current deleveraging and risk aversion going on, does anybody have the stomach for "speculating" at all?

Tuesday, March 24, 2009

Exchange Rate Policy 2: Measurement

In Malaysia, it’s common to take the bilateral rate of the Ringgit (MYR) against the US Dollar (USD) as the exchange rate. This is understandable because not only does Malaysia have substantial trade links with the USA, the USD is important as a reserve currency and as the currency of international trade contracts. However, the USD bilateral rate is not the sole influence on MYR movements – other countries like Singapore also have substantial trade and capital links. How then to capture the multiplicity of influences on a currency? What we need is a single composite measure of a currency, an index of movement.

Let’s take the example of Malaysian trade with Aruba. Since this trade is pretty much non-existent, the exchange rate between the Ringgit (MYR) and the Arubian guilder (AWG) shouldn’t matter to Malaysia very much. From this example we can take the basic principle for constructing a composite view of the Ringgit or any other currency – taking the trade share* as the basis of a weighting scheme. Obviously, the greater the trade share, the more important a particular currency should be. The general rule is that weights don’t need to be changed very often (the IMF changes weights every ten years or so), although if a country’s trade patterns change substantially you can get gross errors in the index without knowing it.

* A more complicated scheme also uses the concept of third-country export competition as part of the weights. The IMF and Federal Reserve incorporate this in their currency indexes, but most do not. New Zealand uses share of global GDP as a proxy.

There is also a choice to be made at this point – which currencies to put in the “basket”. The more currencies involved the more work is required in gathering data and calculations, but the more accurate the measurement. The Federal Reserve uses a 0.5% export or import share threshold for their broad index, while the BOJ uses 1% overall trade share. I favour using 1% of exports or imports as giving a broad enough selection of currencies, without losing too much information – 15 currencies altogether based on 2007 Malaysian trade data. This also nicely allows me to avoid tracking Middle East countries, where data holes are a serious problem.

Having gathered the required trade and exchange rate data, we now have enough to construct a nominal effective exchange rate index. This is what MYR has been doing for last eight years (2000=100):

Ideally of course, real prices (net of inflation) are more important, so inflation data has to be incorporated in our measurement. This is complicated by having multiple types of inflation – consumer inflation (Consumer Price Index), producer inflation (Producer Price Index or Wholesale Price Index), and whole economy inflation (GDP deflator). Since trade competitiveness is the basis of our exchange rate measurement, PPI** is probably the best series to use (CPI and the GDP Deflator include non-tradable goods inflation). Unfortunately, PPI is not often available particularly in emerging markets, so CPI is often used as a proxy. In practice, most researchers have found that the price series used doesn’t really matter.

** The OECD use changes in real manufacturing wages

Deflating each currency by their respective inflation measures, we arrive at the real effective exchange rate index, here contrasted with the nominal index:

There's little to choose from between the two, which suggests the MYR is tracking pretty well with the currencies of our trade partners.

So now we have a pretty accurate idea of MYR movements holistically. Unfortunately, this still doesn’t tell our poor central banker very much, because all it shows is the movements of the currency relative to any other specific period - it says nothing of where the currency should be. While it’s better than nothing, he still has no idea of the valuation of the currency relative to all the others. This is where econometric models come in, which I'll cover in my next post.

However, even using the nominal and real charts can tell us something. First, here's a graph of trade shares (exports and imports), relative to the trade within the currency basket I'm using:

Note the massive decline in trade share to and from the US and the corresponding rise of China. Next, the nominal and real exchange rates against the G3 currencies:

The general interpretation is that if there is a difference in inflation experience between two currencies, there will be pressure for the nominal rate to close on the real rate. By that standard, MYR is about 17% overvalued against the JPY, but close to even with USD and EUR. Not surprising since Bank of Japan intervention to prevent JPY appreciation is common. This second batch of currencies also shows relatively high misalignments relative to the real rate:

The MYR appears overvalued against the HKD and TWD, but undervalued against the KRW, on about the same order as the misalignment against the JPY.

This last batch is so ridiculous, I had to triple check my calculations (please note the respective scales):

The differences here range from 33% against the PHP and IDR, to 87% (!!!) against the INR. These are serious misalignments that can only be explained by highly restricted capital accounts or heavy intervention (definitely true for the Reserve Bank of India). Given that the MYR is relatively close to “fair value” against the G3 currencies, it follows that the four currencies above are seriously out of whack with the rest of the world too.

Bear in mind, however, that I’m using inflation as the only currency alignment metric here – other forces can be at work as well that may explain these gross divergences.

Either that or you’re looking at the next good candidates for speculative attacks. I suspect the Rupee especially, might be in for some rough times ahead.


I should point out that because these are index numbers, measuring misalignments can be problematical because the index year has an impact on the perceived divergence. If I had taken 2005 as the base year for example, the misalignments would appear considerably smaller. The underlying assumption behind the analysis I'm using here is that currencies were largely in alignment in 2000. This weakness doesn't apply to econometric models.

Also forgot the acknowledgements:

1. (Free) foreign exchange data from the PACIFIC Exchange Rate Service. Forex data used are monthly averages.
2. CPI data from IMF International Financial Statistics (IFS) and the International Labour Organization, supplemented by national sources where necessary.
3. Trade data is from DOS and various issues of BNM Monthly Statistical Bulletins.

Exchange Rate Policy 1: Concepts

If it seems I’ve taken a break from blogging, it’s because I’ve been hard at work reconstructing my MYR exchange rate indexes. Since I’m still in the midst of refining them, this post should serve as a holdover until that’s done.

Nothing in economics is quite so confusing as exchange rates. The problem is that exchange rates are in essence relative prices, not absolute prices, and because in a world of multiple exchange rate regimes, making sense of exchange rate movements can be complicated. For instance the chart below shows the cumulative movements of the Ringgit against the G3 currencies since 2000 (2000=100):

Relative to the start date, Ringgit (MYR) is 6.9% stronger against Dollar (USD), 9.5% weaker against Yen (JPY), and 26.9% weaker against the Euro (EUR). Can we therefore say that the Ringgit is generally weaker or stronger? More to the point, what are the implications for policy and trade? At what stage should authorities decide that a currency is overvalued or undervalued enough to merit intervention? These and other questions will be the topic of this series of posts I’m embarking on.

The most intuitive and attractive concept of exchange rates is the theory of purchasing power parity, or PPP. In its strong form, PPP states that the same good should have the same price everywhere (aka The Law of One Price). Therefore the exchange rate of any two currencies should equate this price in local currency terms. For example if a Big Mac is RM8 in Malaysia, and US$2 in the USA, then the PPP exchange rate should be US$0.25 if we use MYR as the base and RM4.00 if we use USD as the base. If PPP is true, and the actual exchange rate is RM3.80, then we could consider the MYR as being 5% overvalued against the USD.

Unfortunately, empirical evidence for strong form PPP is patchy even over periods of hundreds of years. There is better evidence for weak-form PPP, where prices differ but the difference is constant. Even here, the proof is not absolute as exchange rates appear to deviate from the PPP predicted value for extended periods. The last 60 years has seen a lot of effort to decipher how this can be, given the importance of the exchange rate to international trade and the balance of payments.

One notion, called the Balassa-Samuelson effect, suggests that only tradable goods face price arbitrage in international markets and PPP should hold for these goods, but not for non-tradable goods and non-tradable components such as tax structures, property rentals, and so on. This effect should be particularly strong in services, which by definition are difficult to trade (imagine the relative value of the haircut for instance). The general effect of a strong non-tradable sector is an appreciation of the exchange rate.

Another school of thought focused purely on monetary effects and the impact of real interest rate differentials, called the concept of uncovered interest parity. The idea is that capital flows to where the real yield is highest, which in turn moves the exchange rate to equate the relative differences. Since investors view countries as having different risk profiles, a risk premium can also affect the exchange rate, which is the concept of covered interest rate parity. Inflation should also have an impact, as it is a measure of the relative supply of each currency – the higher the relative inflation rate, the more a currency is expected to depreciate.

The problem with these and other theories is that, taken in isolation, none do a good job of explaining exchange rate movements in the floating rate period (1972 onwards). The best statistical model of short term exchange rate movements is and remains the random walk, which in statistical notation is:

X(t) = X(t-1) + ε

Notice that this differs substantially from a simple regression model in that there is no intercept and no slope to the equation. What the random walk model states is that the best predictor of tomorrow’s market price is today’s price!

So what is a poor central banker to do? What finally made sense, at least in identifying medium to long term movements of the exchange rates, were structural models which put a lot of these concepts together. In real life therefore, it’s a combination of factors that influence the exchange rate, not one or two. But before models like these can be used, we have to figure out how to actually arrive at a single view of a currency rather than the multiplicity of rates that any currency is subject to, which will be the subject of the next post.

Sunday, March 22, 2009

What Kind Of Economist Am I?

WY asks what school of economic thought I support. The answer in a nutshell is...whatever works.

Here's the story - strike that, here's my summary of the history of economic thought:

The classical school - Adam Smith, David Ricardo, Hume, Bentham, Marx, Marshall and many others - really set the foundations of economic thought. They gave rise to many competing ideologies which didn't necessarily agreed with each other. For instance libertarianism and the Austrian school take freedom as the sole guiding principle of economic organisation, while Marx suggests the diametric opposite. Both are considered on the lunatic fringe in modern economics.

The classical school eventually gave way to the neo-classical school, which attempted to describe economics within a mathematical framework. The Great Depression and the rise of the Keynesian revolution derailed this movement momentarily, but it revived and assimilated Keynesian thought under the neo-classical synthesis starting with John Hicks (the ever popular and still relevant IS-LM model).

The 1970s brought stagflation and the breakdown of heretofore established macro-relationships, bringing about a resurgence of classical ideas, with an emphasis on micro-foundations for macro analysis - the new classical school.

The 1960s-70s also coincided with the rise of monetarism, which combined some of the ideas of the Austrian school with the neo-classical synthesis. Also known as the Chicago School from its identification with Milton Friedman, monetarism reduced economic policy management to essentially one tool: "2% money supply growth" (see Goodhart's law to see why this failed).

The new keynesian school essentially takes a cue from the new classical school by applying micro-foundations to keynesian macro analysis. These two competing schools of thought comprise mainstream economics today.

Then there is the heterodox school. Well not really a school per se, but rather a loose term covering economists who don't fall under a convenient label. These include people like Joseph Schumpeter and JK Galbraith.

The reason why you see economists disagree in the current crisis on seemingly basic questions like the effectiveness of fiscal stimulus or its structure, or whether it will work at all, goes back to their basic ideologies:

1. New classicals believe in complete markets and rational agents, and that government is less efficient in allocating resources. As such fiscal stimulus is less likely to be effective, and if stimulus has to be done, tax cuts are preferred.

2. New keynesians believe that markets can fail and prices are sticky, in which case there is a strong case for government to step in. Inefficient allocation of resources is better than no use of resources at all.

3. Monetarists don't believe fiscal stimulus works. All we need is 2% money supply growth.

4. Austrians and libertarians don't believe in government. All we need to do is go back to the gold standard and abolish all the central banks.

5. Marxists believe capitalism is doomed to fail. All we need is...never mind.

Where do I stand in this milieu? I admit I began my career a monetarist, with some leanings toward libertarianism. Age and (hopefully) some wisdom now puts me somewhat left of centre - markets do fail, frequently in fact. I also have some sympathy for some of Galbraith's and Schumpeter's ideas, which while often in conflict, do a better job of describing the real world then either mainstream school. It's hard to accept the efficiency of price signals, when competitors are essentially oligopolistic.

Having said that, I think my approach to economics is purely pragmatic. Some ideas work at some times, but not at others. It is a mistake to take a one-size-fits-all approach, especially when contemplating a developing country with immature markets and institutions. Just as important, I lean on empirical evidence rather than relying purely on the dictates of theory.

Theory only provides a framework for thinking, and it pays to listen a little to all the schools of thoughts - even Marxists and Austrians occasionally have something worthwhile to say.

Thursday, March 19, 2009

Why I Don’t Like Gold As The Monetary Base

After yesterday’s verbal diarrhea, this post will hopefully be shorter and easier to digest. I argued yesterday that using gold as the basis for money is inappropriate, as the slow rate of increase means money will always have a deflationary impact on real output, and the conflation of gold-as-money=wealth results in mercantilism with all its evils. The second contention is largely ideological, and can be disputed. The first contention is more amenable to examination, along with its implications such as the function of gold as a store of value.

The following is based on the estimate of a stock of 145,000 tonnes of gold as of 2001 (source: World Gold Council), global gold production data from the US Geological Survey, and real GDP growth data from the IMF World Economic Outlook Oct 2008:

So much for that - I think its pretty clear that over the last half century, gold supplies could not have kept up with global growth. This implies that this growth would not have happened under a gold standard or a continuation of Bretton Woods, as deflation and recession would have been required to equalize growth with the real money supply. Incidentally, here’s the corresponding comparison for silver:

As further proof, I converted a number of commodity series* from USD value to gold value (specifically, per troy ounce). I expected to find relatively flat and declining price trends over time. What I found instead was absolutely fascinating, and requires some explanation. Here, I’m showing the price of Beef in troy ounces:

The rest of the charts are broadly similar, with the exception of pepper, which was highly cyclical against gold (incidentally, pepper looks like a 5 year bull market waiting to happen). What struck me immediately were three things:

1. The relatively low volatility from the 1980s onwards;
2. The sharp decline in price in the 1970s, which I more or less expected;
3. The relatively high volatility both in and prior to the 1970s.

My take on this is that because of the expansion of the USD money supply in the mid to late 1960s due to Vietnam and Lyndon Johnson’s domestic policies, the USD became increasingly overvalued relative to its convertible price to gold – i.e. real activity in excess of the monetary base. When Nixon took the USD off gold convertibility, the next decade saw a combination of inflation and stagnation, which may have been an adjustment process of real goods and services with the nominal money supply. Equivalently, the USD had to fall to its ‘true’ value against gold. Thereafter in the 1980s, market forces (and Paul Volcker) took over and gold became just another commodity.

The 1960s however, is harder to explain, with volatility an order of magnitude higher than the 1980s. It is somewhat ironic to me that Bretton Woods (which was essentially a gold standard but without the necessity of holding gold reserves) provided nominal price stability, but real price instability, and the floating rate period the exact opposite. While this is insufficient empirical evidence against using gold as the monetary base, it tends to confirm my doubts about the stability of such a system.

Gold Stocks - World Gold Council
Silver stocks -
Gold and silver production data - US Geological Survey
Commodity price statistics - Unctad Handbook of Statistics

*Beef, Cocoa, Coffee, Cotton, Palm Oil, Pepper, Rice, Rubber, Tin, Wheat

Financial Fragility and Fractional Reserve Banking

This post touches on one of the fundamental attributes of banking systems in the present day, and how it contributes to financial fragility. I've known about the fractional reserve system since my student days, but never really thought about it much in terms of the impact on systemic risk or stability. The thinking really started when my brother in law pointed me to Web of Debt by Ellen Brown, which purports to show the problems with the monetary system we use today, and how it can be solved. I wouldn't recommend reading the book - it's a polemical tract that had me choking with laughter at some of its attempts at “analysis”. Nevertheless, despite the flaws Brown's book does point out some of the essential problems with the fractional reserve system.

If you're not familiar with the term, or how money is created under the modern monetary system, here's a short narrative. Let's say we have person A, B and C. A owns a bank, B has $100 in cash, and C has nothing. B puts his money with A, who now has $100 in assets (the cash from B), and $100 in liabilities (B has a claim on A's assets). That $100 is now the sum total of the money supply.

Now assume that the central bank places a 5% reserve ratio on the banking system and this reserve has to be placed at the central bank- in other words, A is required to hold only 5% of any liabilities in cash, and can lend out the remaining 95%. C then approaches A for a loan which is granted, the maximum of which is $95 (95% of $100). A gives a $95 loan to C who promptly deposits the cash with A, thus creating on A's books a $95 asset (the loan), and a $95 liability (the cash owing to C). A's balance sheet, and thus the money supply, has been inflated to $195. Assuming B and C are irrational and don't mind paying A a whole bunch of interest, this round-robin of borrowing and depositing can be carried out ad nauseum to the point where the money supply has now increased by a factor of:

m = 1/r = 1/0.05 = 20

...where m is the money multiplier, and r is the reserve ratio. Using our $100 initial cash position, the total amount of money at the end has grown to $2,000, with B and C owing A $1,900 in loans, but A owing B and C $2000 in cash, which from our example doesn't actually exist - only the original $100 cash is available.

Money is thus created or destroyed as if by "magic" - because all money under the current system is fiat money, there is no intrinsic value to money save for its functions as a medium of exchange and (with qualifications) a store of value. The fractional reserve system evolved over the centuries from a behavioral characteristic that bankers and money lenders have observed - people don't really use all their cash at once, even under the metallic system. Under normal circumstances, it was thus profitable to lend out the excess cash.

From the example, we can see how such a system contributes to instability:

1. If B or C default on any of their loans, that will reduce A's assets but not his liabilities. This is a solvency problem.

2. If either B or C withdraw the cash due to them from their deposits in excess of $100, then A doesn't actually have sufficient cash on hand. A corollary is that, if either B or C suspect that A may not be able to meet his cash obligations both will attempt to withdraw the total cash owing to them, which leads to a bank run. This is a liquidity problem.

In either case, A is in deep trouble, and has to run to the central bank for help. I think you can see the relevance of the two scenarios above to the situation in the global banking system today. To be fair, central banks now regulate fractional reserve money creation through the liabilities side of the balance sheet, rather than the reserve or asset side. Based on Basle I risk-weighted capital requirement of 8%, the maximum money multiplier (irrespective of reserve ratios) is about 12. In accounting terms, this is analogous to the gearing ratio.

In addition, there are some systemic issues that are intrinsic to fractional reserve banking:

1. There is no doubt that the fractional reserve banking system actively encourages taking on debt. In my example, from a zero debt and $100 asset position, the system creates $1900 in debt with the same $100 in assets. If any of the debts are not honored, the system has a solvency problem.

2. Then there is the issue of inflation and deflation, where money supply and real output are not in equilibrium with each other. If money supply is greater than real output, then you have the phenomenon of inflation (assuming money velocity is constant). If money supply is lower than real output, you get deflation. Both change the relative value of money with respect to real goods and services, making money less trustworthy under a fiat money system. Under the fractional reserve system central banks can at best influence the supply of money to support economic growth, but not directly control it. On the other hand, it is very easy for central banks to trigger inflation or deflation, by supplying too much or too little cash into the banking system.

Further, there are some philosophical and religious objections to fractional reserve banking:

1. Banks get essentially a free ride through the money creation process. Profits through lending are gained not through the production of real goods or services, but through recycling (non-existent) cash. This issue is disputable - the intermediation process does require performing a service, which is vetting borrowers for credit risk. There's understandably more angst over this issue in light of the origination-securitization model now prevalent, where the performance of this service has been passed on through the securitization process to rating agencies and investment banks, who obviously dropped the ball.

2. Relating to the above, since money held in deposits is a claim on cash which doesn't exist, fractional reserve banking can be likened to fraud perpetrated by banks on the public.

3. An additional claim of fraud can also be attached to central banks and governments. The money supply can be raised to cause inflation, which has two effects: reduce the claims of monetary units on real goods and services, as well as reduce the future real value of debts (including that of the government). Since fiat money represents an obligation of the government which guarantees its convertibility, inflation can be construed as an act of fraud by monetary authorities.

Both Christians and Muslims thus have serious problems with the modern banking system as it stands. From an economics point of view however, the only opposition to fractional reserve banking comes from the Austrian School. These disparate groups prefer full-reserve banking (or alternatively free banking as argued by some in the Austrian School), as well as tying money to some object of intrinsic worth such as gold. This would have the following effects:

1. Full reserves means bank runs would be avoided, as there is no issue of liquidity. However, potential solvency problems will remain.

2. Tying money to gold removes government interference from the money supply. Since the Austrian School sees inflation as purely a monetary phenomenon, inflation (and deflation) would not be possible.

From my point of view however, to paraphrase Winston Churchill, fractional reserve banking is the worse form of banking, except all the others.

Let’s contrast the two systems:

1. Solvency is and remains an issue whatever the system of banking, so I will not touch on it here.

2. Liquidity problems are resolved in the fractional reserve system in two ways: first is recourse to the interbank market; and secondly the function of lender of last resort that central banks typically take on. Banks who are short of liquidity can borrow liquid assets from banks with excess reserves. If this is not possible, banks can borrow directly from the central bank, but typically under sanctions such as penal interest rates. If the liquidity problem is really severe, central banks can in extremis take over the bank concerned. Under the full reserve banking system, of course, liquidity is never an issue.

3. In terms of debt creation, because of the requirement for full reserve backing money can only be lent out if depositors agree to it, i.e. waive their claim to their money for a certain period. This is analogous to today’s time or fixed deposits. Since money available for loans is limited, debt creation never exceeds the total amount of available reserves.

4. Under a full reserve system, the money supply is independent of real output and it follows therefore that inflation and deflation cannot be artificially created. Which sounds good until you realize that counter-cyclical monetary policy is also impossible – in fact monetary policy of any kind is impossible. I’ll expand on this point later.

5. The banking business model is quite different. Whereas under fractional reserve systems interest is paid to depositors and charged to borrowers, under the full reserve system banks act more like custodians so depositors pay banks for keeping their money in the system, except where deposits are allowed to be lent out. Interest (or profit, if you prefer), continues to be charged to borrowers.

Now, going through the above it would appear as if full reserve banking is a viable replacement for fractional reserve banking. It reduces the level of debt possible, takes care of liquidity problems, and removes the temptation for government to inflate their debts away.

Here’s the gotcha…full reserve banking also definitely removes support for economic growth. It is no accident, in my view, that fractional reserve banking (and by extension fiat money) has facilitated the explosion in real economic growth and the substantial increase in human welfare over the past two centuries.

Since money can be created and destroyed on demand, the fractional reserve system fully accommodates economic activity. In other words, money supply and money demand will always adjust to equilibrium. The process can be helped along and smoothed out by application of monetary policy, i.e. influence through the creation or destruction of high-powered money, or through changing the price of money (the interest rate). It is therefore possible for monetary authorities to apply counter-cyclical policies to reduce the impact of booms and busts in the economic cycle, although this is predicated on how much trust you can place in monetary authorities (for counter-examples refer to the Weimar Republic and the current government of Zimbabwe).

This adjustment isn’t possible under a full reserve system, as money demand must adjust to a relatively fixed money supply. If the Fisher identity holds, then assuming the velocity of money is constant real output growth must always converge to the rate of growth of the money supply. While the velocity of money is never a constant as I demonstrated before, it does vary within a range. For excess economic growth to persist and be supported by a full reserve system, the velocity of money must always be ever increasing, which is not plausible. I won’t repeat here the arguments for limited resources (i.e. the supply of gold will run out), but the rate of increase in gold supplies has historically been very low (evidence to come in a future post). A further implication is that under the full reserve banking system deflation and depressions are not only possible but probable, since there is no scope for using counter-cyclical monetary policy. The argument that inflation and deflation are not possible at all under a full reserve system is complete bunk as far as I’m concerned. This is borne out by the historical record, as the discovery of the New World in the 15th century along with its gold and silver mines, caused a long period of inflation in Europe.

More dangerously, tying money to gold or any other object of intrinsic value can give rise to the conflation that money=wealth. If that sounds innocuous to you, look up mercantilism. I think that there is no doubt that free trade (or at least, freer trade) has had a positive impact on global prosperity. Just as important, removing the link between money and wealth (and thus the applicability of mercantilist theory) reduces the impetus towards war, colonialism, and imperialism. If real output growth on a global basis is restricted to the rate of growth in money (i.e. gold), then the only way an individual country can raise the welfare of its own citizens is through appropriation (i.e. steal wealth from others) or annexation (i.e. take over and oppress others). Despite the fact that two massive world wars were fought in the last 100 years, the latter half of the 20th century has been amongst the most peaceful periods in recorded human history – yes, even with the conflicts in the Middle East, Asia, Africa and the Balkans. Incidentally, this ties in rather nicely with the shift from the Gold standard to a full fiat money system – you can draw your own conclusions.

The only way I see a full reserve banking system being even remotely attractive is if the monetary base is convertible into an asset which has a higher rate of growth than real potential output. This will of course apply a moderate amount of inflation, which is not necessarily bad as it allows for a low real interest rate as well as providing the correct incentives to borrowers and producers. But that still doesn’t allow for discretionary monetary policy, or remove the logic of mercantilism.

In short, at the present time, I see no real alternative to the fractional reserve banking system despite its many flaws. There is no doubt that the current global financial crisis represents a failure of the system on a wide scale, but I believe there is a case to be made that the fundamentals of the system has been short-circuited over the past ten years by the origination-securitization model, as well as the rise of the shadow-banking system. On the whole, I would rather have a system that generally supports increases in human welfare rather than one that restricts it, even if it means lots of bumps along the way.

As far as an Islamic financial system goes, I don't believe a debt-based banking system is the best way to intermediate between savers and entrepreneurs - but that's a post for another day.

Friday, March 13, 2009

Links of the Day

Dani Rodrik starts a debate against global financial regulation:

"Mr Rodrik identifies a number of problems with the idea of global regulation. Would the major economic powers of the world surrender their financial sovereignty to international regulators? No, he says. But if they were willing, could the nations of the world agree on the right set of regulations? They may not, he argues, pointing to the Basel process. Is there even a one-siz-fits-all solution? No, he concludes, citing the fundamental problem with the idea of global regulation."

Check out Richard Baldwin's post for a useful roundup of proposals for reform. I also like this little tidbit from Baldwin as well:

"My friends who are experts in financial regulation tell me that the whole Basle II exercise was subject to ‘regulatory capture’ by the big international banks, so I take Buiter’s point seriously."

Thursday, March 12, 2009

Down The Slippery Slope: January IPI

A picture is worth a thousand words (log changes in IPI over the same period last year):

and here's the month on month (log changes in IPI over the previous month):

Unfortunately, DOS have changed the base of the index to 2005 starting this month, which precludes any deeper analysis until I get my hands on the complete time series and splice it into the old one. It's clear however that the carnage is largely in manufacturing.

Maxis, iPhone and competitive markets

I'm going slightly off topic with this post, but since it's something I feel strongly about, I think it's justified.

The Star reports that the Apple iPhone will be launched on March 17, and only available with 6 month/24 month contracts through Maxis. I have nothing against the iPhone per se - it's a nice piece of hardware and engineering - but I truly deplore the idea of lock-in contracts, subsidised hardware, and exclusivity. The cheapest plan requires a monthly commitment of RM100 for 24 months, on top of the phone price of RM1900/RM2290 (8GB and 16GB models), and this comes with 333 minutes talk time and 500MB of data (full details of rate plans here). If you are already a Value Plan subscriber the phone costs RM2,540 for the 8GB model and RM2,960 for the 16GB model.

My opposition to this is that the way this is structured constitutes monopoly behaviour and restricts consumer choice. All the telcos have shifted to this model for wireless broadband modems, so the business model itself is nothing new. But putting it into practice with handphones is in my view a dangerous precedent, because that takes the business model mass-market. Here's my take:

1. Lock-in contracts means customers can't leave a telco without paying a hefty penalty.
2. Subsidised hardware distorts the price signals for handsets. Check out the difference between the new customer prices and old customer prices.
3. Exclusivity is market distortionary as well - want the iPhone? You have to be a Maxis customer, and never mind their service level. I can't confirm the exclusivity aspect, but I suspect it's there as that has been Apple's standard practice in every market they've tried to enter.
4. As a result of all the above, both Maxis and Apple will gain monopoly profits.
5. The incentive for maintaining after-sales customer service is substantially reduced.
6. The pressure to compete on price and service as far as voice and data are concerned, is also substantially reduced.

My biggest fear is that the iPhone deal will force other handset makers to follow suit - want a Samsung Omnia? Go to this telco. Want a HTC Touch Pro 2? Go to this telco. Want the latest, greatest Nokia? Go to this telco. The market becomes defined not by who has the best or cheapest service, but rather who has the best subsidy and hardware. If consumers were fully rational in the economic sense and take into account the total cost of a contract, this business model would never get off the ground. But the lower upfront costs relative to unsubsidised hardware seriously colours consumer perceptions, and we contribute to reducing competitive pressures in the market.

This business practice is one American import I truly wish we didn't get. Look at the structure of the US telco market - choice of handsets are far more restricted; services and features are defined by what telcos want to offer, not what the hardware can handle; and the pace of innovation is slow. France did the right thing in forcing Orange to supply iPhones unlocked and unsubsidised - I wish we had done the same.


Hah! Someone agrees with me:

"I think American cellular customers, businesses especially but also individuals, are not well served by linking handsets and carriers so tightly. Is it going to change? Not likely. Unless consumers speak up, Americans will probably continue to get second-rate cellular forever."


" I do not know how we end these subsidies. I do not expect the government to intervene, though I do wish the FCC would take a deep breath and show some gumption for a change...Hardware subsidies by wireless carriers are anti-customer and need to stop. Wireless hardware and services should be purchased separately, which will lead to enhanced competition in both areas and wider choice/lower prices for customers."

And this link goes to a study of the American cellular industry that supports the contentions in this post.

Wednesday, March 11, 2009

Malaysian Mini-Budget and National Debt Implications

I won't make any commentary on the mini-budget - there's been enough in the blogosphere today, both for and against. But here's some of the implications for the national debt that I covered yesterday. Only RM35 billion out of the RM60 billion total package will be direct spending, and a further RM7 billion will be PFIs or off-balance sheet expenditure which won't be financed by the government.

That leaves a net increase of RM28 billion additional borrowing required, on top of the original RM21.8 billion projected budget deficit plus last year's RM7 billion stimulus package. Assuming next year's (2010) deficit is around the same ballpark figure as this year's (I'm leaving aside for now potential revenue shortfalls), we're looking at an increase of the national debt to about RM365 billion by the end of 2010 (net of the new Savings Bond scheme), or just under 50% of 2008 nominal GDP. In per capita terms, the increase is approximately RM3,000 per person.

As far as the increase in gross debt is concerned, there's really no historical precedent. However, in terms of the debt to GDP ratio, the two year increase is on par with the increase in debt after the severe 1981 recession. Let's hope we don't follow the same trajectory this time - debt to GDP peaked at 69.7% in 1987.

Funding the borrowing shouldn't be too much of a problem, as there is enough excess liquidity in the banking system to take the whole lot. But at this scale we're now in crowding-out territory where considerably less funds will be available for the private sector, not to mention the impact on monetary policy. RM80 billion of MGS, even spread as it is over two years, is going to significantly contract the money supply - in fact, yields on MGS have already increased in anticipation (thanks satD!) - unless BNM monetizes the debt i.e. print money.

At this stage, I don't think we have much choice in either fiscal spending or quantitative easing to cushion the downturn, but interest rates and MGS yields will bear close watch from now on - yields on 5 year MGS has already jumped 20 basis points yesterday, and are over 100 basis points above January levels.

Tuesday, March 10, 2009

Financial Fragility and Malaysian Banking Consolidation

I was reading this post on Free Exchange yesterday, and one of the comments (by Don the libertarian Democrat) was interesting and thought provoking. He relates an anecdote (from Andrew Haldane via Martin Wolf) that's worth repeating in full:

"No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they
would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight. All of the other assembled bankers began subjecting their shoes to intense scrutiny. The unspoken words had been spoken. The officials in the room were aghast. Did banks not understand that the official sector would not underwrite banks mismanaging their risks? Yet history now tells us that the unnamed banker was spot-on. His was a brilliat articulation of the internal and external incentive problem within banks. When the big one came, his bonus went and the government duly rode to the rescue. The timeconsistency [sic] problem, and its associated negative consequences for risk management, was real ahead of crisis. Events since will have done nothing to lessen this problem, as successively larger waves of institutions have been supported by the authorities."

This nicely illustrates some of the main problems with the banking system as it stands today - the incentive structure promotes a blindness towards risk, a prevalence of moral hazard, and the principal-agent problem. Don then goes on to mention that Shelia Blair, Chair of the U.S. Federal Deposit Insurance Corporation (FDIC), remarked that maybe big banks ought to be outlawed. This struck a resonant chord with me, as I worked in a bank through the worst days of the 1997-98 crisis and its aftermath.

Financial sector consolidation in Malaysia has its advantages, such as stronger balance sheets capable of handling shocks, having the scale to compete on a regional and global basis, and making the best use of scarce managerial talent - I don't think there is any argument that some of our banks were very badly run leading up to the crisis. On the other hand, it is not obvious to me why those banks could not have been allowed to fail, especially as few were large enough to pose real systemic risks. Nor is it obvious that well-run small banks such as Wah Tat should be 'punished' by being forced into a merger. Some of these banks functioned as "community" banks, with a strong presence in their respective markets and a localised knowledge of their customers. Subsuming these banks into a national level bank doesn't strike me as necessasrily increasing the efficiency and efficacy of financial intermediation on the ground. If my memory serves correctly, managerial x-efficiency in banks also peaks at about USD10 billion in assets (this was back in the 1990s), which means profitability falls off at larger sizes i.e. shareholders aren't necessarily getting a good deal either.

More to the point, I think by consolidating the domestic financial instutions into ten big groups, we have probably increased the fragility of the Malaysian financial sector - a failure in any one of these banking groups will pose a risk to the rest of the banking system. First the likelihood of moral hazard being a problem is increased as bank size increases. Second, the principal-agent problem is exacerbated, particularly with the rules on maximum shareholding. While we don't want a Malaysian R. Allen Stanford, insisting on hands-off shareholders divorces management interests from shareholders'. Third, institutional shareholders are probably more likely to pressure bank management on returns, which contributes to the incentive problem described in the quote above.

Note that the US situation right now is indicative of the problems I've described above - it's the big money center banks that are causing systemic problems. The smaller state and regional banks are either failing or doing fine; they just don't make the headlines (and there are an awful lot of them). As long as depositers aren't losing their money (which is where the FDIC comes in), individual bank failures won't trigger a general bank run and a failure of the system.

While I don't think we will have a near term problem in the Malaysian banking system with respect to egregarious risk-taking - too many bank managers still bear the scars and memories of 1997-98 - the next generation of bank managers is another matter. It's easier to do something about it now when the system is relatively stable, then trying to reform the system on the fly in a crisis. I don't know if regulatory limits on bank size is at all possible or desirable, and I'll admit that I have no concrete solutions on hand to suggest (how about unlimited shareholder liability?). But this question does bear thinking about and discussing, as part of the larger debate on global financial sector reform.

Since any post of mine won't be complete without a statistic or two: the US has approximately one commercial bank for every 40k in population. The corresponding ratio for Malaysia is about 690k (including all the new Islamic bank subsidiaries, as well as foreign banks), and 1,230k (including foreign banks only). If we're talking about just the 10 domestic banking groups, the number jumps to 2,700k.

The Malaysian National Debt or How Much Is Everybody On The Hook For

Since the mini-budget is going to be tabled in the Malaysian Parliament today, I thought I'd put up a historical view of Malaysian government debt up to 2008. The following is gross government debt from 1970 to 3Q2008, which is the latest data point (RM Millions):

Note the faster rate of increase since 1997; not surprising given the deficits run up during that period until now. Next is the level of government debt adjusted for inflation in 2000 prices (CPI:2000=100):

And on a per-capita basis:

Translating back to current prices, that's approximately RM10,389 for every man, woman and child, and at least 2.5 times that amount for every potential taxpayer. Luckily, external government debt is less than 10% of the total, so there's little foreign exchange risk.

To counterbalance this frightening looking increase in debt, here's gross government debt scaled to nominal GDP:

This is easier to stomach: as of 3Q2008, the debt to GDP ratio has fallen below 40%.

A word of caution here: while the numbers look a little daunting at an individual level, national debt should ideally be viewed against national assets (both balance sheet items), of which there really isn't a good measure. The debt to GDP ratio is essentially comparing a stock variable (debt) against a flow variable (national income), and is more a measure of repayment capability rather than solvency. There is a lot of idiotic misuse of GDP numbers in that respect, such as statements that Bill Gates or Microsoft are worth more (net worth: stock again!) than many countries GDP (income!). Be warned.

I haven't time to look at how the numbers above compare with our peers, or any of the advanced economies, but I'll update this post when and if I do.

Technical Notes:
1. Government debt and GDP data is from BNM's MSB; CPI and population data is from DOS
2. The CPI series, due to changes in weights is a spliced index with a base year of 2000

Sunday, March 8, 2009

Evaluating the monetary policy stance: back of the envelope calculations

How do we judge whether monetary policy is tight or loose? The central bank has two general ways to impact the supply of money. First is through the price of money i.e. the interest rate. If r is higher than inflation, than the 'real' rate of interest is positive and is the rate at which economic agents base their decisions. The higher the real rate of interest is, the tighter monetary policy could be said to be. When the real price of money is high, the cost of borrowing for investment and consumption is high, and economic activity slows. The converse is true - monetary policy is loose when r is below inflation, and borrowing becomes cheap.

Incidentally, that's why deflation is a dangerous phenomenon - you can get a high real rate of interest even if the nominal r is zero.

The other way to judge the monetary policy stance is to examine the rate of increase in the money supply. Fast money supply growth accommodates faster economic growth but also signals higher future inflation. You can in theory slow down economic growth even with a low real interest rate, by restricting the supply of money. The relationship between money and the economy is described by the Quantity Theory of Money, which takes the form of the following accounting identity:

M x V = P x Y

Which states that money (M) multiplied by velocity (V: the number of times money circulates in the economy), is identical to real output (Y) multiplied by the price level (P). If we transform both sides to natural logs and take first derivatives, and move the price term to the left:

Ln(ΔM) + Ln(ΔV) - Ln(ΔP) = Ln(ΔY)

This states that the rate of increase in (M) less inflation should equal the growth rate of real output if we take velocity as a constant. When this identity doesn’t hold, one of the other variables will need change to bring the identity into balance again. Thus if (ΔM) is greater than (ΔY) + (ΔP), then we would expect inflation to increase if the economy is at full employment, or both output and inflation to rise when the economy has some slack - such as during a recession.

This is the current situation in Malaysia now (log changes in M3 less log changes in CPI, compared to log changes in interpolated, seasonally adjusted monthly rGDP, all relative to the same month in the previous year):

The charts show money supply growth was probably excessive in 2007, but got closer to neutral in 2008. Compare that with this comparison between the overnight interbank rate against CPI inflation:

(Correction:) The policy instruments appear to contradict each other in both 2007 (interest rates indicating tight money, money supply loose) and 2008 (interest rates very far below the rate of inflation, while money supply more neutral). One way to explain the discrepancy in the observable policy stance is if we go back to the original equation just now – what if velocity is NOT a constant? Then:

V = (Y x P)/M

which can be proxied by nominal GDP (real output multiplied by the price level) divided by money. One would expect velocity to (slightly) vary positively with economic activity – higher consumption and investment means money changes hands quicker. Conversely, when economic activity contracts, people and businesses become more cautious and cut spending, which reduces the circulation speed of money. Solving the equation for M3, we get:

We have a better than 10% variation in the velocity of M3 in 2008, although I'd be cautious in taking the level of velocity at face value due to the interpolation I've done on the GDP data. Nevertheless, looking at M3 adjusted for velocity and inflation relative to rGDP is instructive:

The interest rate and money supply variables are better matched in terms of their policy stance, though at this point in time monetary policy is far more expansionary than implied by the real interest rate. At this stage, I'd expect both velocity and inflation to continue dropping, which may cancel each other out as far as impacting output. This further implies that expansion of the monetary base would be more effective in boosting output, and would be non-inflationary given a reduction in velocity. It also implies that should the situation reverse, BNM has to react much more quickly in reining in monetary growth to head off a resumption in inflation.

Technical notes:

1. Real GDP is arrived at by deflating the value of nominal GDP with the GDP deflator, which is not equivalent to inflation as measured by the CPI. The main difference between the two price series is that the GDP deflator also takes into account export price inflation, which is not relevant in a domestic context except in terms of measuring output - by definition, exports are not consumed in the domestic economy.
2. The interpolation I did on GDP data is very rough and ready, but since I'm using it mainly to contrast the difference between two policy instruments, I hope everybody will give me a pass on that one.

Links of the Day

Esther Duflo says we can't trust bankers:

"There is another argument, implicit or explicit, for the nationalisation of banks; we can not trust bankers not to leave with the cash, let alone spend any assistance whatsoever in the general interest. Two recent studies that analyse the experience of recent years show that they will not hesitate to enrich themselves at the expense of the public good if they have the opportunity."

Willem Buiter offers a stinging critique of modern macroeconomics:

"In both the New Classical and New Keynesian approaches to monetary theory (and to aggregative macroeconomics in general), the strongest version of the efficient markets hypothesis (EMH) was maintained. This is the hypothesis that asset prices aggregate and fully reflect all relevant fundamental information, and thus provide the proper signals for resource allocation. Even during the seventies, eighties, nineties and noughties before 2007, the manifest failure of the EMH in many key asset markets was obvious to virtually all those whose cognitive abilities had not been warped by a modern Anglo-American Ph.D. education."

Saturday, March 7, 2009

That Sinking Feeling...

MATRADE released the January trade numbers yesterday, you can read the reaction in the Star here. I've added seasonal adjustment to the export and import numbers, but they don't look any better:

Since the y-o-y numbers are insane (Jan 09 exports are down 32% in log terms) and is probably affected by being based on export levels from last year, here's the month-on-month based on the seasonally adjusted series (log change from previous month i.e. non-annualised):

This looks just as bad.

At this point I'd like to discuss forecasting - given that exports and imports appear to move together, can one be used to forecast the other? Common sense and theory suggest you can - the structure of Malaysian imports supports that notion, where almost 70% of imports are intermediate goods used as inputs for export goods. You can interpret this two ways:

1. Higher demand for exports raises the demand for intermediate goods, which then also raises imports.
2. Turning the story around, higher imports indicate exporters are planning higher output, which means higher exports in the future.

So there's a good case for using (lagged) imports to predict exports. To start with, I regressed current exports against the previous month imports (sample range is Jan 2000-Dec 2007), both series transformed by natural logs. This is an exercise can actually be done in Excel: use LN() function for transforming both series, then use the slope(y,x) and intercept(y,x) functions to generate the statistical relationship.

Here’s what you should get:
Ln(exports)= 0.79+0.94 Ln(imports(-1))

The coefficients are all significant, i.e. they test out as being greater than zero; R-squared which measures the goodness of fit is a high 0.85, and the F-stat shows that the equation as a whole is significant. Because of the log transformation, this is actually an elasticity calculation and is very easy to interpret – a 1% rise in imports is associated with a 0.94% rise in exports. Notice I don’t use the word “cause”, because although a statistical relationship has been established, causality has not. So we now have one way to forecast future values of exports – except this regression is wrong.

Why that is I'll have to leave for another day, but I'll close this post with the predictions of this model and we'll see next month if it's correct. Based on the above equation, we have a point forecast of RM35,968 million in exports (non-seasonally adjusted) which represents a 6.3% drop from January, while the 95% confidence range forecast is RM43million-RM30million.

Friday, March 6, 2009

Financial Fragility and the Role of Capital Flows

Via Greg Mankiw, we have this interesting story of Joseph Stiglitz being shunned by the Obama Administration. Here's why this is important:

'In a spate of books, essays and speeches dating from the early '90s, Stiglitz denounced Rubin's support for repeal of the Glass-Steagall Act, which separated commercial from investment banking for precisely the reasons we are now witnessing on Wall Street: new "full-service" banks would seek to hype companies that their stock-market side underwrote and issue loans to them even if they were not credit-worthy. "The ideas behind Glass-Steagall went back even further [than the 1929 crash] to Teddy Roosevelt and his efforts to break up the big trusts," he wrote presciently in "The Roaring Nineties" (2003). "When enterprises become too big, and interconnections too tight, there is a risk that the quality of economic decisions deteriorates, and the 'too big to fail' problem rears its ugly head." Unfortunately, Stiglitz wrote, his worries "were quickly shunted aside"' by the Clinton Treasury team. Earlier, in his book "Globalization and its Discontents" (2002), Stiglitz became the most prominent voice in Washington to say plainly that free-market absolutism, which began with the Reagan revolution and continued under Clinton (who upon being elected declared the era of "big government" was over), was ill-founded theoretically and disastrous practically. "In 1997 the IMF decided to change its charter to push capital market liberalization," he wrote. "And I said, where is the evidence this is going to be good for developing countries? Why haven't you produced some research showing it was going to be good? They said: we don't need research; we know it's true. They didn't say it in precisely those words, but clearly they took it as religion."'

I actually have both the books listed here, but have yet to read them - I'm going to make the time to do that now. What especially struck me was the last point made in the paragraph, which is something I've believed in for some time - that there is no evidence that open capital accounts make sense for developing countries, in fact just the opposite.

In layman's terms, an open capital account means that flows of capital are completely unrestricted. Theoretically, this means capital is free to flow to where returns are highest, which means capital will be allocated efficiently and total welfare increased. In practice, this does not happen. Despite all the hype about China hogging FDI and capital, the number one destination of capital in the world is...the United States. If in fact capital travels to where it will be most effectively used then most of it ought to be going to Africa, where capital accumulation is low and where the marginal productivity of capital ought to be the highest.

At this point I have to distinguish between direct investment and portfolio investment. The former is investment in the classical sense - it is used to produce goods and services. Portfolio investment on the other hand reflects changes in the ownership of productive assets. The difference is crucial - direct investment is illiquid and long term, while portfolio investment is highly liquid and short term.

From the point of view of a developing country, portfolio inflows and outflows can be highly destabilising when the domestic financial system is immature, and become positively dangerous in the presence of pegged exchange rates. The evidence for this is highly persuasive - Mexico, Argentina, Turkey, and of course the whole East Asian Crisis of 1997-98. Here's a short narrative of what typically happens:

1. High growth Developing country is 'noticed' by investors
2. Capital flows in, and placed in the banking system or stock market (which booms). the currency also appreciates, which pulls in more capital.
3. Monetary expansion follows, fully sterilised by the Central Bank until it becomes too expensive, after which the financial system becomes flush with liquidity
4. If bond markets are immature, banks can only respond to expanding balance sheet liabilities by lending aggresively
5. A commodity/real estate/stock market bubble is generated
6. Individuals and companies start borrowing from overseas as the currency has strengthened
7. Investors notice the economy overheating, and become jittery
8. At some point, a tipping point occurs where investors panic and pull out, the currency crashes
9. Net effect: the monetary base contracts sharply and real interest rates rise, banks get saddled with bad debts in speculative activities, companies and individuals with foreign debt finding their debts ballooning, output and employment drop

Sounds awfully familiar, doesn't it. The same general story has occured quite a few times over the last fifteen years in various countries.

Of course, the US capital markets and banking system are far deeper, but let me make conduct this thought experiment. Greenspan cut interest rates to 1% in 2001/2002 in response to 9/11 and the dotcom crash, while the Bush administration increased spending and engaged in the "war on terror". What if the US didn't have an open capital account at the time? Monetary expansion plus fiscal profligacy meant the US financial system would be flushed with funds, and the trade deficit would increase as consumers responded to lower costs. However, in this scenario, the trade deficit can no longer be financed through purchases of US treasuries by surplus nations. That would imply that the excess liquidity would be drained overseas rather than recycled in the domestic system, which further implies a much stronger depreciation in the USD than actually happened and further, causes inflation in imported goods prices. Also, since this source of financing is no longer available, the fiscal deficit has to be financed domestically which drains further funds from the system - we get real crowding out of private investment and consumer borrowing. Interest rates would necessarily have to rise with the increased domestic supply of treasuries, as well as because of excess money demand relative to supply. In short, the US economy would've slowed as would the rest of the global economy, and there would not have been the housing bubble - we might not be in this mess we are now.

Unlikely scenario to be sure, but it makes food for thought.

The Pitfalls of Econometrics

de minimis has an interesting post advocating using more econometric models to guide policy making in Malaysia. While I tend to lean that way myself (there's too much unsubstantiated rhetoric flung around the news and blogosphere for my taste), I don't want to be blind to the potential pitfalls and shortcomings of an applied econometric approach to policy. So this post is both to clarify some of the issues, as well as serve as a reminder to myself not to be too "assertive", as my wife puts it.

First is that econometric modeling (as etheorist remarked the other day) is really an art, not a science. There are many, many ways of looking at an economy and generating forecasts, from simple time series techniques to hideously complex dynamic general equilibrium models. So model choice and specification (as well as accompanying underlying assumptions), and not to mention the ideological bent of the modelers, can lead to very different conclusions about the state of the economy at any given time. The issue is compounded by Malaysia being such an open economy, which means that ideally, you'd have to incorporate all the major trade partners into your model as well.

Secondly, the evolving economic structure within a developing country means that even if you do come up with a model close to reality at some point in time, it might be out of date very quickly later on and you won’t know it until something goes wrong. This is one point where I would be critical of DOS: the Malaysian input-output tables haven’t been updated in years, and you need this to model intra-industry dynamics.

Thirdly, any econometric model necessarily uses historical data, which means there will always be an unobservable error component in any forecast in the presence of a current shock. A corollary of this is that, almost by definition, a trade shock such as we just suffered cannot be predicted on the basis of concurrent data. Models are more useful as a predictive guide to inventory driven recessions and business cycle downturns. You can of course use models to predict what happens when a shock occurs, but not when or if a shock will occur.

Fourth, data accuracy is inversely proportionate to the speed at which data is published. In other words, the faster you publish it, the larger the error rate. Where I think DOS can improve on that score is to follow the general practice in the EU, US and yes, Singapore, i.e. issue advanced, preliminary, and final estimates of major statistical series. The current practice of a 6-week to 8-week lag and quietly revising the historical series, isn't transparent (the loose hair around my workplace is testament to that). Data revisions should always be made clear, especially for national accounts data, which has to be revised even 2-3 years down the road.

One exception to this observation is financial sector data, which is available very quickly. (Side note: I've visited BNM to study their data gathering process, and I was a member of one of the teams responsible for implementing CCRIS in one of our banks - I am very impressed with BNM's operation in this instance. The disaggregated trial balance of the entire banking system is available at about t+4 after every month end – in other words, don’t be fooled by the monthly publishing schedule). (Side note to the side note: this is one reason why monetary policy is generally the first recourse in any crisis – you have better data much faster than real economy data).

However, I should point out that a 2-month to 3-month lag hits the sweet spot between accuracy and timeliness, and is fairly typical worldwide. China for instance tends to issue data on a 1 month lag, but subsequent revisions tend to be very large. Some Canadian series have no revisions at all, but you have to wait 6 months(!) to get them. I cannot fault DOS on that score, though they have made some absolute boo-boos before (pay attention to 2004-2005 trade data before and after revision, for instance).

Fourth: some of the most critical variables required for a predictive model are unobservable. For example, consumer and investor expectations have a big impact on private consumption and investment, but can’t be quantified. It’s possible to use proxies, such as consumer confidence or business expectations surveys, but these are subject to error as well.

Take all the factors above, and you shouldn’t be surprised that most whole economy econometric models have very little predictive power more than a quarter or two ahead, out of sample. I’d note that I’d be very surprised if the government doesn’t have on hand some whole economy econometric models, especially for trade and tax policies. Could more use be made of modeling? Absolutely! Just don’t fall for the promise that they’ll be a panacea and perfect guide to policy.

Thursday, March 5, 2009

The Yield Curve

As if we need more confirmation we're in trouble:

The chart shows the spread between (average) interbank rates for overnight, 1 week and 1 month money. While the spread between overnight and 1 month money was flat throughout 2008, the spreads between overnight and 1 week against 1 month money both turned negative in November and January 2009. In other words, money is cheaper in the future than it is right now, or equivalently demand for money now is higher than demand for money in the future. From a term structure perspective, the yield curve (the ranking of interest rates based on maturities), which would normally be upward sloping to reflect risk and inflation expectations, has inverted. The interpretation for a yield curve that gets flatter can vary depending on the situation, but generally follow along these lines:

1. The market is pricing in an interest rate cut
2. The market is expecting deflation/reduced inflation
3. The market for whatever reason desires short term liquidity

An inversion of the yield curve is more serious, and is usually taken to be a recession signal. Admittedly I'm basing this on just a couple of data points, but given the other data, I'd take this as weak confirmation we're in a technical recession. For comparisons sake, here's the situation around 1997:

Please note the differences in scale between this chart and the previous! If anybody's wondering why I haven't charted any maturities longer than 1 month, it's because the market for 3 month and longer terms has almost completely dried up.

In complete contrast, spreads in the market for MGS have widened instead:

This represents the long end of the money market, looking at spreads between the indicative yield of 1 year MGS against 5, 10, and 20 year maturities. Off the top of my head, I'd say the market is pricing in the likelihood of higher government borrowing (which would raise yields) as well as a flight to the short end, though not yet looking at potential higher future inflation.


satD asked for the risk premium between the interbank market, BNM Bills and Treasury Bills, but it's not terribly informative:

The empty spaces in the chart reflect lack of trades in those periods, especially in the interbank market. There is however, further proof of flattening/inversion in the yield curves of both BNM bills and T-bills (spreads are between 3 month and 6 month maturities):

I'm not even going pretend to know what went on in 2005 for T-bills, though (there's also another sharp downward spike in late 2004).