Bonds and Stocks

When I read the headline, I thought the article would be about the difficulty of finding a return in the current low yield environment. It turns out its on something completely different (excerpt):

In search of higher yields

THE correlation between yields and stock markets are clear to see. When yields are high, stock markets are down. When yields are down, money pours into the stock market, and hence it goes up (see chart).

From the chart, it is obvious that since the Fed launched quantitative easing in 2009, rates have sunk to all time lows – close to zero. Meanwhile stock markets start rising when money is in search of yield and growth. Thus when yields are low, the stock market moves up. 

An interesting observation from the chart is the huge gap between rates and the stock market from 1985 to 1993. 

In 1985, the US Treasury 5-year notes were offering yields of above 10%. Not surprisingly, investors would gladly take their money out of the markets and put it in treasury notes or bonds, which are almost risk free. 

Now, as the yields started to drop, notice how the stock market starts inching up. This is because investors start to realise that bonds can no longer give them the best yields, and thus they shift their money into the stock market. 

From 1993 to 2006, yields on the 5-year note and the stock market moved almost in tandem. 

Over that period, the yields moved in a band of between 4% to 6%. At this level, bond yields and stock market returns are about equal. So investors are interchanging; when yields go closer to 4%, they shift their assets into the stock market. Then when yields move up again, they shift back out of equity markets and into treasury notes….

Emerging Markets: No, It Isn’t 1997 Again

It seems to be my day to get beaten to the gun. I was going to write a post on this issue, but Lars got there first (excerpt):

Please don’t fight it – the risk of EM policy mistakes

Emerging Markets are once again back in the headlines in the global financial media – from Turkey to Argentina market volatility has spiked from the beginning of the year….

…Lets take the case of Turkey and lets assume Turkey is operating a pegged exchange rate regime – for example against the US dollar. And lets at the same time note that Turkey presently has a current account deficit of around 7% of GDP. This current account deficit is nearly fully funded by portfolio inflows from abroad – for example foreign investors buying Turkish bonds and equities.

Capital Inflows Across Asia

A new IMF working paper looks at capital inflows and what can be done about them (abstract):

Surging Capital Flows to Emerging Asia: Facts, Impacts, and Responses
Balakrishnan, Ravi and Sylwia Nowak; Sanjaya Panth & Wu Yiqun

Summary: Net capital flows to emerging Asia rebounded at a record pace following the global financial crisis, raising concerns about overheating and financial stability. This paper documents the size and composition of the most recent surge to Asian emerging markets from a historical perspective and compares developments in the broader economy, asset prices, and corporate variables across the different episodes of strong inflows. We find little evidence of a significant build-up of imbalances and resource misallocation during the most recent surge. We also review country experiences in managing the risks associated with inflows and argue that Asian countries have used regulatory measures during past surges, although there is not strong evidence of their efficacy without supporting monetary and fiscal policies.

Developing Bond Markets In ASEAN

Here’s my weekend reading - researchers at the IMF have released a duo of papers on the bond markets in ASEAN (abstract):

Developing ASEAN5 Bond Markets: What Still Needs to be Done?
Gray, Simon; Joshua Felman, Ana Carvajal, & Andreas Jobst

Summary: This paper examines a range of issues relating to bond markets in the ASEAN5 (Indonesia, Malaysia, Philippines, Singapore and Thailand) - physical infrastructure including trading, clearing and settlement; regulation, supervision and legal underpinnings; and derivatives markets - and finds that the frameworks compare well with other Emerging Markets, following a decade of reform. A number of areas where further enhancements could be made are highlighted. The paper also examines the interrelationship between central bank management of short-term interest rates and domestic currency liquidity, and development of the wider money and bond markets; and suggests some lessons from the recent crisis in developed country financial markets which may be important for the future development of the ASEAN5 markets.

ASEAN5 Bond Market Development: Where Does it Stand? Where is it Going?
Felman, Joshua; & Simon Gray, Mangal Goswami, Andreas Jobst, Mahmood Pradhan, Shanaka J. Peiris, & Dulani Seneviratne

Summary: Since the Asian crisis, ASEAN5 countries have expended considerable effort in trying to develop their domestic bond markets. Yet today these markets are not much larger, relative to GDP, than they were a decade before. How can we explain this? And does this mean that domestic markets have not, in fact, developed? The paper argues that bond market growth has been held back by a sharp fall in investment rates, which has left firms with little need for bond borrowing. Even so, markets have developed in other ways, to such an extent that substantial amounts of foreign portfolio investment have begun to flow into ASEAN5 bonds. These developments have important ramifications. With the investor base growing and infrastructure investment likely to rise, ASEAN5 bond markets could expand rapidly over the next decade, holding out the prospect that the region could finally achieve "twin engine" financial systems.

These are absolutely technical papers, though not in a mathematical or econometric sense. Rather they concentrate on the nitty-gritty of regulation and market microstructure, things that sometimes get lost in the parsimonious world of economic modelling. These two papers (which benefited from input at a Deputy Governors central bank regional seminar last year) form a fantastic resource for anybody researching capital market development in Asia.

Technical Notes:

Gray, Simon; Joshua Felman, Ana Carvajal, & Andreas Jobst, "Developing ASEAN5 Bond Markets: What Still Needs to be Done?", IMF Working Paper No. 11/135, June 2011

Felman, Joshua; & Simon Gray, Mangal Goswami, Andreas Jobst, Mahmood Pradhan, Shanaka J. Peiris, & Dulani Seneviratne, "ASEAN5 Bond Market Development: Where Does it Stand? Where is it Going?", IMF Working Paper No. 11/137, June 2011

In Defense of EPF

Strictly speaking this post isn’t about economics, but the reaction to EPF’s dividend announcement is a good argument for greater financial literacy:

Good, but it could be better, groups comment on EPF dividend rate

PETALING JAYA: EPF’s 5.8% dividend rate has been lauded, but some say the amount should have been even higher, given its large investments and the higher dividends offered by other funds and unit trusts.

Consumer activist and Federation of Malaysian Consumer Associations (Fomca) adviser Prof Datuk Dr Hamdan Adnan said the increase was good as it showed the economy was picking up.

However, he said it could have been higher, given EPF’s long-term existence and the dividend performance of other funds, which were not as old as EPF.

“We are glad it is higher. But there are funds that are offering dividends of between 8% and 10%. Even Amanah Saham Bumiputra is offering almost 9%. EPF is not even giving bonuses like trust funds do.

The Impact Of Financial Liberalisation

I usually publish only the abstracts when highlighting research papers, but this one’s so fascinating and not a little controversial from a Malaysian perspective, that I’m taking excerpts from the introduction instead (excerpts, emphasis added):

Rethinking The Effects Of Financial Liberalization
Fernando A. Broner & Jaume Ventura

...The conventional view, part of the so-called Washington Consensus, was quite optimistic regarding the effects of financial liberalization...

Book Plug: Fixing Global Finance

I’ve an awful lot of research papers that I want to highlight, in addition to going through the ETP proposals in detail. As such there won’t be any posts for the next couple of days, so in the interim, I’d just like to showcase a book and a working paper that supports it.

Back in July, I highlighted an article on VoxEU regarding the imposition of capital controls in East Asia. The author got in touch with me, and has now published a book on the subject:

Fixing Global Finance
A Developing Country Perspective on Global Financial Reforms
Kavaljit Singh

The financial crisis which erupted in mid-2007 has been widely viewed as the most serious financial crisis since the Great Depression of the 1930s. The crisis which originated in developed countries quickly spread to developing countries and the rest of the world. The turbulence in financial systems was followed by a significant reduction in real economic activity throughout the world. The crisis has highlighted that financial markets are inherently unstable and market failures have huge economic and social costs. The crisis has renewed debate on the role of global finance and how it should be regulated.

The aim of this book is to encourage and stimulate a more informed debate on reforming the global finance. It examines recent developments and problems afflicting the global financial system. From a developing country perspective, it enunciates guiding principles and offers concrete policy measures to create a more stable, equitable and sustainable global financial system. Several innovative measures have been proposed to reform the global finance and to ensure that it serves the real economy.

ETF’s, Index Tracking Investment, And Irrational Markets

One of the seminal contributions to the macroeconomic literature of the last fifty years was the Lucas Critique, which in short states that changes in policy affects individual behaviour, which in turn means that you can’t reasonably expect that policies implemented would have the intended effects based on historical macro relationships. More generally, everything affects everything else, and you can’t take things in isolation.

While this is part and parcel of the now controversial doctrine of rational expectations (for which Robert Lucas won the Nobel Prize in 1995), the fundamental point that Lucas was driving at is still valid – you can’t assume that interrelationships will always stay the same, if you change something within a system. The mania over structured finance products that helped drive this past global financial crisis is a case in point, but it applies to virtually any financial product or government policy.

Which brings me to this article in The Star today:

What are ETFs and why is it beneficial to buy them?
Personal Investing - By Ooi Kok Hwa

LATELY, the number of ETFs that get listed on Bursa Malaysia has been increasing.

At present, we have a total of five ETFs listed in Malaysia. Unfortunately, we have noticed that not many investors are aware of these instruments and there is also a lack of understanding on the true value of these ETFs.

Credit Rating Agencies In The Spotlight

The IMF says that markets should reduce their reliance on credit ratings (excerpts, emphasis added):

Reducing Role of Credit Ratings Would Aid Markets
By John Kiff

New IMF analysis says that ratings have inadvertently contributed to financial instability—in financial markets during the recent global crisis and, more recently, with regard to sovereign debt.

The analysis, in the IMF’s Global Financial Stability Report, recommends that regulators reduce their reliance on credit ratings as much as possible and increase their oversight of the agencies that assign the ratings used in regulations...

...In the case of sovereign debt, the IMF said in the report released September 29, the problem does not lie entirely with the ratings themselves, but with overreliance on ratings by market participants, coupled with deleterious selloffs of securities when they are abruptly downgraded — called “cliff effects.”…

Market Completeness and Financial Regulation

Adair Turner on economic ideology:

The Uses and Abuses of Economic Ideology

...Indeed, at least in the arena of financial economics, a vulgar version of equilibrium theory rose to dominance in the years before the financial crisis, portraying market completion as the cure to all problems, and mathematical sophistication decoupled from philosophical understanding as the key to effective risk management. Institutions such as the International Monetary Fund, in its Global Financial Stability Reviews (GFSR), set out a confident story of a self-equilibrating system...

...So risk managers in banks applied the techniques of probability analysis to “value at risk” calculations, without asking whether samples of recent events really carried strong inferences for the probable distribution of future events. And at regulatory agencies like Britain’s Financial Services Authority (which I lead), the belief that financial innovation and increased market liquidity were valuable because they complete markets and improve price discovery was not just accepted; it was part of the institutional DNA.

ADB Thinks Emerging Asia Should Think About Capital Controls

Seems we're getting an outbreak of sanity here, especially after the IMF's change of heart (excerpt of press release):

Emerging Asia Should Be Ready to Act on Potentially Destabilizing Capital Inflows - ADB Report

The report said recent surges in capital inflows have been driven by portfolio equity flows as investors take advantage of widening earnings potential between emerging Asian and mature markets.

The use of capital controls may be appropriate in circumstances where capital inflows are transitory and are adding undue pressure on exchange rates and where effectiveness of macroeconomic policy measures to counter the inflows and the exchange rate movements is uncertain.

"Managing capital flows requires a wide array of policy measures; sound macroeconomic management, a flexible exchange rate regime, a resilient financial system and sometimes the use of temporary and targeted capital controls," Mr. Madhur said.

How and why do capital flows cause problems? There are a number of dimensions to this question, and most of the answers are bad.

First, on an overall basis, there’s little evidence that an open capital account, where portfolio capital is allowed to freely move into or out of a country, has any beneficial effect on economic growth or development (as opposed to capital market growth and development). In fact the opposite effect is more prevalent – liberalisation of the capital account in developing countries has a distressing tendency to turn into a full-fledged currency/financial crisis.

There may be an argument that inflows of foreign capital can lower the cost of capital, and thus increase real investment, but I find this line of thought unpersuasive. As I pointed out once, investment in the stock market is not investment in an economic sense, and does not contribute to a nation’s stock of real wealth – unless shares and bonds are bought at source via the primary market i.e. IPOs or auctions.

More to the point, the real problem with foreign portfolio inflows is twofold – they can just as easily leave as they come in; and they have a destabilising impact on nominal (but not real) valuations. The first problem is well-known, and complicates everything in macro-economic management, from volatility in exchange rates, money supply, and market interest rates, to the increased financial fragility of the financial system through cheap short-term foreign funding recycled through the banking system into long-term illiquid assets such as loans. This is exactly the problem that underlay the vulnerability of Malaysia and other East Asian economies in the run-up to the 1997-98 crisis.

The valuation issue essentially arises from this – nominal asset prices on the capital markets are determined by demand and supply of those assets. There’s nothing here to relate these prices to the underlying intrinsic value of any asset. If an asset was already correctly priced, then incoming money flows would inflate the price of that asset beyond its fundamentals – you have an asset price bubble.

The problem is further complicated by portfolio asset allocation, where foreign fund managers follow certain allocation rules – they generally go for highly liquid stocks and bonds (the better to sell in case of trouble), which in our case would be KLCI component stocks, and MGS or AAA corporate bonds. That means that incoming hot money flows tend to overinflate prices of highly liquid assets, and disproportionately reduce them when they leave. So what you get is much higher volatility in highly visible capital market securities.

The problem is much worse if capital inflows stick around for too long, and get recycled through the banking system. Since capital inflows in the presence of a flexible exchange rate cause an appreciation of the currency, that makes foreign funding cheaper for domestic companies. This is even more apposite since BNM is ahead of the curve in raising official interest rates. Foreign money inflows also have the impact of increasing the money supply and reducing market interest rates, potentially opening the door for inflation.

But the flip side is also true – a sudden outflow of portfolio funds will cause the exchange rate to depreciate, which while it won’t affect your funding cost would certainly affect the principal you have to pay back (not to mention creating a constricted monetary environment just when you need it the least). That in essence was Thailand’s and Indonesia’s bugbear in 1997-98, as their private companies had borrowed in USD but had their income streams in Baht and Rupiah. The downfall of the US dollar pegs in those countries caused a massive private debt crisis, to go along with recession and the loss of international purchasing power.

In short, portfolio capital flows tend to exacerbate changes in the business cycle, which has obvious costs in terms of misallocation of real investment.

So are capital controls the answer?

Only an imperfect one, as in it’s really hard to make them truly effective – where there’s profit to be made, there’s bound to be someone willing to take a risk on both sides of the border (China and its “A” shares are a good example). On the other hand, there is evidence to suggest that capital controls on portfolio capital flows does not harm foreign direct investment at all, so that is a positive.

Second is the issue of whether the capital controls imposed are transitory or permanent – the former can make your policymakers look wishy-washy (low credibility), while the latter would hamper development of the domestic capital markets. You have to pick your poison here.

Third, there’s little precedent for designing effective capital controls in the floating exchange rate era. We have very few case studies of effective implementation of capital controls in the last 40 years, and ironically Malaysia’s two flirtations with capital controls (1993-94, 1998-2005) are among the better known and most studied. Chile in the 1990s is another good example, targeting very specifically short term capital flows. The IMF is now advocating more research into policy design in this area, so we might have some hypotheses to test out soon.

Weak or Strong MYR policy? I Say Neither

etheorist has an interesting post that I’d like to respond to, but since my points won’t exactly fit into a comment box, this post will have to do. I’d encourage anyone to read through the rest of his posts, as together they form a lucid argument for the kind of changes required to transform the Malaysian economy, as well as some of the challenges that need to be overcome. But on this specific post, I have some counter-points that I think need to be laid out.

etheorist puts forth the following arguments:

1. Malaysia has followed a weak currency policy since the 1997-98 crisis, which impacts incomes;

2. Money supply growth has also been excessive since then, with inflation again devaluing real incomes;

3. Loan growth during the same period has been directed more to the household sector, and less supportive of business expansion;

4. Hence, the solution is to support a policy of strengthening the Ringgit over the medium term, which would help improve productivity and real incomes.

I have problems with all four points. First the weak currency policy meme:

The notion that currency values are weak or strong based on nominal relative movements is meaningless outside of a Purchasing Power Parity (PPP) based framework. Exchange rates respond to a variety of influences, which completely overshadow the goods-based price arbitrage that underlies the logic of PPP. There is in fact little empirical evidence that PPP is a relevant metric at all when applied to currency movements. To have a currency falling x% against another therefore isn’t equivalent to it being x% weaker except in a purely market sense – it certainly does not equate to it being weaker from a fundamental economic standpoint.

Another factor to consider is that misalignment in a given bilateral exchange rate does not imply misalignment on a multilateral level. MYR has indeed nominally lost ground against many of the major currencies if you consider pre-1997 levels; but at the same time it has gained ground against many developing country currencies in the same period. From an income standpoint, since most manufactures and resources come from developing rather than advanced economies I can’t buy the argument that purchasing power has necessarily fallen generally.

Moreover, the 1998-2005 USD peg while initially undervaluing the MYR on a multilateral basis in the double digit range post-1998, very rapidly turned into an overvaluation by 2001 making the 2000-2001 pseudo-recession more severe than it should have been. So I tend to discard the idea that there is a deliberate government policy of MYR weakness, particularly with reference to the USD.

I’ll return to the question of weakness/strength of MYR later in this post.

Second, money supply growth, far from being excessive post-1998, is well below Malaysia’s historical average (log annual changes):



…and third, so is loan growth (log annual changes):



More to the point, etheorist misses one trend that has been crucial in driving banks towards more consumption-based lending – the rise of the PDS market:



To provide some perspective, in 2000-2005 bank lending grew by RM230 billion of which about RM30 billion went to businesses with the rest going to the household sector. Funds raised on the domestic capital markets (debt + equity) during the same period on the other hand was an additional RM133 billion, with a further RM51 billion raised in 2006-2008.

Corporate financing in Malaysia can no longer be characterized as being solely bank-driven – much like more advanced economies, the debt markets have almost completely overtaken that particular role of the banking sector except in supplying credit for smaller companies and to households. Far from being clueless, bankers have responded in a perfectly rational fashion to a secular change in the structure of the economy (and incidentally helped drive the scramble for investment banking licenses). From personal experience, the shift to consumer lending happened as much because of this structural shift as well as the recognition of just how risky business lending was.

Moreover, growth in residential loans, while exceptionally strong in the early part of this decade, hasn’t overtaken incomes or households’ capacity to absorb supply (unlike in the 1990s):



I’m abstracting obviously from changes in income inequality, but the general sense remains true – if lending for housing was truly excessive, price increases should have accelerated faster but they haven’t. So on that score, I’ve little criticism of the changes occurring in bank lending over the past decade.

So where does that leave us? I have no qualms against a stronger nominal MYR – but only where it is strengthening from changes in the economy itself rather than from a deliberate policy shift. Here are my reasons why:

1. The monetary trilemma – you can only control two out of the three monetary policy variables (interest rates, exchange rate, money supply) at any given time. Targeting the currency ala Singapore or Hong Kong means either letting interest rates or the money supply fluctuate freely and with orders of magnitude greater volatility (IIANM Singapore chooses the former while HK chooses the latter). What are the consequences of such a move? Either option means essentially abrogating some control over domestic monetary conditions, which means less influence on credit, growth and inflation. Malaysia has a far bigger and more diverse domestic economy than either HK or Singapore, which implies the negative consequences would be far greater for social welfare – and the negative consequences can be pretty horrible. (Reminder to self: I still owe a blog post on exchange rate regime choices).

2. The causality running between the exchange rate and other economic variables are not necessarily symmetrical or homogeneous. Take for instance productivity – from the Balassa-Samuelson hypothesis, an increase in productivity in the tradable sector (for instance manufacturing) leads to a depreciation of the exchange rate whereas an increase in productivity in the non-tradable sector (for instance wholesale and retail) leads to an appreciation of the exchange rate. On the flip side, I fail to see how an increase in the exchange rate results in any changes to productivity at all.

3. Finally, I believe a deliberate policy of strengthening the MYR is unnecessary and counterproductive – when present policies are leading us there anyway. The shift to a more services-based economy will, like it or not, lead to a general appreciation of the exchange rate without any further action on the part of the central bank. We are no longer in the era of a dirty float regime, with central bank intervention a constant threat over the market. I find little evidence from the data that there has been BNM intervention in the forex market beyond sterilization operations. The movements of the MYR against other true free-float currencies (no, JPY doesn’t count, and USD is really borderline) leads me to believe that we are truly in a managed float regime, as much as that is possible without full convertibility. Intervention will only be contemplated under those circumstances if MYR strays too far from its medium term equilibrium level.

My current view of the MYR is that it is a little overvalued relative to economic fundamentals on a multilateral basis – but not by much. As economic fundamentals dictate (see here for an incomplete list of potential influences), the equilibrium rate will begin rising and we’ll see that stronger exchange rate that everyone seems to clamour for. But that appreciation will be a reflection of the strength of the economy, and not a policy-induced illusion unsupported by real economic factors.