Straight From The Horse’s Mouth

Mind that I’m not calling our central bank governor a horse, but Tan Sri Zeti was on BFM radio this morning, talking about household debt, this year’s economic outlook, and internationalisation of the Ringgit, among various topics:

As with any central bank communication, there was a lot of talk, but very little was actually said. Still there are clues as to what central bank policy is likely to be this year.

A lot will depend on the incoming data over the next few months, but the way I’m reading it is that there’s little chance of a rate cut at the next meeting unless the data is really bad. The focus will be domestic rather than external, so a couple of bad months of bad trade data won’t weigh on MPC deliberations too much unless there’s evidence that it’s being passed through into domestic demand. And I don’t see domestic demand really having been affected much by falling export growth these last few months.

BNM Watch: Liberalisation Measures

Announced yesterday, among the first moves under the new Financial Sector Blueprint:

Liberalisation measures to develop the domestic financial markets

As part of continuous efforts by Bank Negara Malaysia to enhance competitiveness in the economy and to develop the domestic financial markets, Bank Negara Malaysia wishes to announce the following liberalisation measures, with effect from 31 January 2012:

• To further spur the domestic foreign exchange market through greater product innovation, licensed onshore banks are permitted to trade foreign currency against another foreign currency with a resident.
• To further deepen the domestic interest rate derivatives market, a licensed onshore bank is allowed to offer ringgit-denominated interest rate derivatives to a non-bank non-resident.
• Towards enhancing the asset liability management of residents, flexibility is permitted for a resident to convert their existing ringgit or foreign currency debt obligation into a debt obligation of another foreign currency.

The above measures which are in line with the broad thrust of the Financial Sector Blueprint will contribute towards increasing the liquidity, depth and participation of wider range of players in the domestic financial markets.

The Future of Banking

VoxEU has a new compilation of the latest European thinking on  reforming finance. While a lot of it is in EconoEnglish, I think many will find some sympathy with the ideas and issues being addressed. For example, since in a crisis the importance of finance to the economy means that banks will be bailed out or at least debt will be worked out, there is a socialisation of losses but gains will be private in more normal times. In other words, there is a negative externality involved in banking, which is not fully reflected in its pricing, the pursuit of gain or risk taking, or in its distribution of profits.

These and more issues are discussed, so if you’re willing to wade through some of the jargon, the e-book is still a worthwhile read.

Technical Notes:

Beck, Thorsten ed., “The Future of Banking”, Centre for Economic Policy Research, October 2011

Economic Modelling: Status Quo Ante

While there have been alternatives proposed (see for instance this post), large scale structural and stochastic models are still the bread and butter of macropolicy. Yet the inability of virtually every statistical model to provide substantive guidance on policy issues remains a problem.

This article on VoxEU provides an insight as to why (excerpt; emphasis added):

Dynamic stochastic general equilibrium models and their forecasts
Rochelle M Edge & Refet S. Gürkaynak

Dynamic stochastic general equilibrium (DSGE) models represent a major strand of the modern macroeconomics literature and are an important tool for policy analysis at central banks...

...The success of the DSGE model-based forecasts relative to other methods was viewed as evidence in favour of DSGE models’ reliably capturing the dynamics in the data…

...To see the absolute forecasting ability of the DSGE model, we run a series of standard forecast efficiency tests, where the realised inflation is regressed on forecasts made at different times in the past. A good forecast should have a zero intercept and unit slope as well as a high R-squared. Table 1 shows the efficiency tests for DSGE model forecasts of inflation at different maturities and demonstrates clearly that the forecasts are very poor. R-squareds at all horizons are essentially zero, implying no forecasting ability. All Figure 1 is therefore telling us is that all other forecasting methods perform just as poorly....

Want An Independent Assessment Of The Malaysian Economy? Try The IMF

I stumbled across the IMF’s latest country report on Malaysia the other day while culling my email. Article IV consultations are conducted with all IMF member states on a regular basis – read this article on the background of IMF surveillance. A summary of the report is available here, if you don’t want to wade through the entire 60-page report.

Interesting reading even if its a bit dated, particularly in the differences in assessing policy between IMF and Malaysian authorities (Treasury and BNM). I’d particular point out pages 15-23, which covers future policy paths (liberalisation, private investment, reducing oil revenue dependency, abolishing subsidies, and fiscal consolidation), and a very interesting box article on page 21 which assesses BNM’s exchange rate intervention post-2005 (summary: it was two-sided, and not intended to force a particular exchange rate level).

Also of interest is a projection of the public sector debt path from pages 3-5 of the Informational Annexe (72% of GDP by 2014).

Not surprisingly, the biggest area of disagreement is on the level of the exchange rate. With the IMF’s three-prong statistical methodology, the Ringgit is considered undervalued though not extremely so, but the policy approach was “broadly appropriate”. Malaysia’s rebuttal is on pages 35-36, which is echoed by the IMF executive director for Malaysia’s statement at the end of the document (pgs 6-7). Here’s an interesting, and highly pertinent, quote from the latter:

“Secondly, while the current account surplus is sizeable, Malaysia is a commodity producer.  Over two-thirds of the current account surplus can be attributed to commodities including oil.  It is fundamentally inappropriate to apply the 3-model CGER estimations when an economy is a significant producer of non-renewable resources.  A Fund working paper by Thomas, Kim and Aslam (2008) estimated that by applying an alternative methodology for assessing the external balance in countries with large stocks of non-renewable resources, the non-oil current account position for Malaysia was in fact in equilibrium, as oil resources can be expected to be depleted in the future.  Our authorities would also welcome accelerated work on the commodity-based CGER approaches that we understand is being undertaken at the Fund. “

Technical Notes:

“Malaysia: 2009 Article IV Consultation - Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Malaysia”, International Monetary Fund, August 2009

Does Finance Create Wealth?

What’s the role of the financial sector in an economy? I came across this question the other day while vetting something (what I cannot say) and the answer was, believe it or not, “to create and maintan economic wealth”.

Stuff like this drives me bonkers.

There’s this perception, especially in the media, that finance and especially the stock market is a way of creating wealth. Sorry but that simply isn’t true, except in a narrow sense for the go-between – the banker, the insurer, the stock broker etc. The economic textbook answer of course is that the financial sector functions as an intermediary: between investors and companies, between borrowers and lenders, between buyer and seller.

Since the intermediary earns fees for this service, from an economic viewpoint this is viewed as income which can be accumulated as wealth. But the actual flow of funds that the intermediary handles does not of itself constitute wealth creation, even if one side or the other makes a profit off the transaction.

How come? Let’s take a stock market example. Say you buy shares in company A for RM1.00 a share, and later sell it for RM1.50. You’ve made a trading profit of RM0.50, and have obviously increased your wealth.

But does the aggregate wealth of the system rise? No, it doesn’t – you’ve got counterparties in each buy/sell transaction. Somebody received your RM1.00 in return for the “A” company shares, and somebody paid you RM1.50 for those same shares. In short, this is a zero-sum game – no wealth is created, it’s just passed around.

So where does this idea of finance creating wealth come from? Because the perception is that share prices tend to go up over time (at least, if you’ve invested in a good company) – hence, the monetary value of shares held by investors likewise go up.

So wealth is created right? Not exactly. Shares are nothing more than a claim on the assets and value of the business of a company. If the value of the company goes up, then the underlying value of the claims represented by the shares of the company will also go up, which usually means the share price also goes up.

But here’s the key point – wealth creation has occurred at the company level, not in the stock market. If the underlying value of a company stays pat, then anybody making a profit trading in the shares of that company did so at someone else’s expense, since the value of the claim represented by those shares has not changed.

Corporate finance exercises, M&A exercises - it doesn't make a difference. Changes in share prices due to these exercises occur because the real and/or perceived value of a company has changed. Again, the change in wealth and value have occured at the company level, and share prices just reflect that.

Zero-sum game. The same thing occurs in banking and insurance, if not quite in so straightforward a manner.

That’s why bubbles are so damaging. Because the difference between reality and perception get so large, somebody (usually the professionals) makes an obscene profit, and somebody (usually the sucker retail investor) takes massive losses. And the aftermath of bubbles typically sees underlying values fall as well, so everybody takes a further hit.

So does finance create wealth? No, nyet, nada, non, nein!