Financial Market Turbulence, the Economy and the Global Debt and Financial Crisis

Financial Market Turbulence, the Economy and the Global Debt and Financial Crisis
Carlos M Pelaez

The world economy and financial markets have moved into a different environment in which improving general economy indicators contrast with significant turbulence in financial markets. The explanation for the decoupling between the growing general economy and higher financial risk is related to events in China, the sovereign risk affecting the euro zone, the US fiscal imbalance and shock waves of regulation in the US and worldwide. The sections below consider (I) financial market turbulence, (II) China and commodities, (III) European sovereign debt and the euro, (IV) United States fiscal imbalance, (V) bank and financial regulation, (VI) the general economy, (VII) interest rates and brief (VIII) conclusions.
I Financial Market Turbulence. Economic turbulence is manifesting in the form of sharp oscillations of key financial variables. The euro US dollar rate depreciated from the closing rate of $1.513/euro (EUR0.6609/USD) on Nov 25, 2009 to the closing rate of $1.236/euro (EUR0.8096/USD) on May 14, 2010 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_curr_dtabnk&symb=CUR_EURUSD&sQuote=1 ), equivalent to a depreciation of the euro of 22.5 percent (0.8096/0.6609 – 1). There are five important effects among many of the depreciation of the euro. (1) European exports may gain competitiveness in world markets, which is important for example to Germany, a leading global exporter, but the reverse may be true for American exports. (2) Direct investment in Europe becomes relatively cheaper than investment in the US; dividend and earnings remittances from Europe to the US decline in dollar value. (3) The most critical effect is the typical perception of an increase in regional risk because the depreciating euro may reflect higher financial and economic risks. (4) The US dollar strengthens temporarily as a reserve currency for holdings by foreign countries because of its higher purchasing power in Europe. (5) Euro denominated assets and liabilities decline in dollar value. If euro-denominated assets are less than liabilities, the net international investment position (NIIP) of the US improves because the decline in assets is less than in liabilities. If euro-denominated assets are higher than liabilities the NIIP of the US deteriorates because the decline in assets exceeds that of liabilities (Pelaez and Pelaez, The Global Recession Risk, 200-2).
The Global Dow index declined from 2087.12 on Apr 15 to 1852.23 on May 14 or by 11.3 percent (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_intl_dtabnk&symb=GDOW&page=intl ). The DJIA of the US declined from 11,205.03 on May 26 to 10,620.16 on May 14 or by 5.2 percent (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_uss_dtabnk&symb=DJIA ). The Shanghai SE Composite declined from 3164.96 on Apr 15 to 2626.63 on May 14 or by 17 percent (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_intl_dtabnk&symb=CN:SHCOMP&page=intl ). The DAX (TR) of Germany declined from 6332.1 on Apr 24 to 5715.1 on May 7 or by 9.7 percent, recovering to 6056.7 on May 14 but still lower by 4.3 percent relative to Apr 24 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_intl_dtabnk&symb=DX:1876534&page=intl ). Wide fluctuations of shares of companies affect savings and retirement funds and may also influence investment decisions by the companies. It is difficult to relate stock market behavior to the general economy and even to other financial variables. The credit/dollar crisis and global recession of 2008-2009 was accompanied by sharp declines of stock market values.
Three key indicators of financial risk analyzed by Bloomberg have been reflecting higher risk perceptions of financial counterparty credit risk (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aQGk_KOnqwGY ). (1) The 3-month LIBOR rose to 0.445 percent on May 14, constituting the highest level since Aug 12. (2) The dollar LIBOR OIS spread, measuring reluctance to lending by banks, increased to 22.5 basis points (bps) to the highest level since Aug 19. On Oct 10, 2008, the LIBOR-OIS spread stood at 364 bps while it had been 11 bps on average during ten years before Aug 2007. (3) The swap spread, defined as the difference between the two-year swap rate and the Treasury note of comparable maturity, widened by 4.19 bps, or 13.5 percent, reaching 35,13 bps, much higher than 9.63 bps on Mar 24 prior to the turbulence. The widening of the spread and the rise of LIBOR reflect expectations of increasing credit risk.
II China and Commodities. There are three conventional arguments on the role of China on the world economy and financial turbulence. (1) China’s fast growth requires raw materials such as iron ore, copper and oil, maintaining high demand and prices for these industrial commodities. There are fears in market commentary of a possible “forced landing” or milder orderly deceleration of China because the overheated economy and appreciation of property values would motivate more measures of control of credit by the country’s monetary authorities. However, these fears have been common over many years without an adverse GDP event that actually occurred in much earlier history in 1989-90 (Pelaez and Pelaez, The Global Recession Risk, 56-80). It is difficult to explain the fluctuations in commodity prices with fundamentals such as those that would be used in partial equilibrium demand and supply models. The Jun crude light oil contract of NYMEX closed at $72.05/barrel on May 14 (http://online.wsj.com/mdc/public/page/mdc_commodities.html?mod=mdc_topnav_2_3000 ) after pressing toward $88/barrel in April for a decline of about 18 percent. The decline could be attributed to lower growth perspectives for China and the world economy and to changes in stocks. An alternative explanation is by appeal to the carry trade promoted by the zero or near zero policy interest rates of major central banks that could also explain the rise toward $149/barrel in 2008. The carry trade consists of a short position in the low yielding currency, such as short US dollar long euro, simultaneously with a long position in commodity futures such as oil (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). The depreciation of the euro could have caused significant losses in the short dollar/euro leg of the carry trade, causing the unwinding of the long commodities futures leg with offsetting short positions, thus forcing a decline in prices of industrial commodities. It is quite difficult to separate these two and other probable factors of the fluctuation of commodity prices but the appeal to China’s growth as the only factor may not be complete. (2) A more appealing argument is based on Asian interregional trade in which China plays a key role. The deceleration of the economy of China could cause lowering interregional trade, creating adverse growth expectations in other Asian economies with possible fluctuations of exchange rates and stock market valuations. (3) China allowed revaluation of about 21 percent of the renminbi between 2005 and 2008 and then fixed it again to the dollar. There are expectations that revaluation could occur again with possible adverse effects on China’s exports and fluctuation of Asian currencies. The revaluation of the renminbi between 2005 and 2008 was not a panacea for domestic industrial production in countries importing Chinese goods or disaster for the economy of China and more revaluation likely to be subdued may not have significant effects.
III European Sovereign Debt and the Euro. The European rescue effort of highly-indebted, high-fiscal imbalance member countries of the euro zone can be analyzed in terms of the same principles that motivated the creation of central banks. Walter Bagehot proposed the principle which bears his name that central banks should lend through the discount window to solvent but temporarily illiquid banks by discounting their high-quality paper at a punitive rate that would discourage “moral hazard” or borrowing to take reckless risks with subsequent long tradition of central banking theory and practice (Pelaez and Pelaez, International Financial Architecture, 175-8, 194, Financial Regulation after the Global Recession, 69-90, Regulation of Banks and Finance, 99-116). The International Monetary Fund (IMF) manages a safety net for its member countries, initially designed for solvent but temporarily illiquid members but that eventually included countries in need of rescheduling of unsustainable foreign debts. The dual objective of the safety net is to soften the impact of adjustment on the member countries while avoiding adverse effects on the rest of the world economy. The joint European Union (EU), IMF and European Central Bank (ECB) plan consists of an unusual structure for international debt management but that is reminiscent of the structured investment vehicles (SIV) or “conduits” of the credit crisis in 2007-2009. The assistance to the highly indebted countries consists of EUR442 billion from governments in the euro zone, EUR60 billion from an EU emergency fund and EUR250 billion from the IMF for a total close to the magic number of one trillion dollars (http://professional.wsj.com/article/SB10001424052748703674704575234371941567524.html?mg=reno-wsj ). The EUR440 billion are not in the form of immediately disbursable cash. The euro zone government would create an off-balance sheet special purpose vehicle (SPV) that would borrow with the guarantee of the AAA-rated sovereigns of the euro zone to lend to indebted countries. Banks in the US and Europe created off-balance sheet SIVs which issued commercial paper that was rated AAA because of letters of guarantee from the AAA-rated bank creating the SIV. The AAA-rated commercial paper was financed in term sale and repurchase agreements (SRP) with the proceeds used to acquire portfolios of also AAA-rated collateralized debt obligations (CDO). Following the default of the nonprime mortgages in mortgage-backed securities in tranches of the CDOs or in other instruments referenced to nonprime mortgages the SIVs encountered difficulties in refinancing the SRPs of maturing commercial paper. Banks had to provide the liquidity guarantees and eventually write down the assets in the SIVs (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). The public is distracted from the root causes of the crisis, which were the government-created nonprime mortgages resulting from Fed-imposed near zero interest rates in 2003-2004, housing subsidies of $221 billion per year and purchase or guarantee of $1.6 nonprime mortgages by Fannie and Freddie. It is difficult to evaluate the success of the rescue program that will depend significantly on whether the highly-indebted countries with high fiscal imbalances can design and implement credible programs of fiscal adjustment that are not frustrated because of the adverse effects on the population. It is an uphill battle because of the late and weaker economic recovery: euro zone growth was 0.2 percent in IQ10 after 0 percent in IVQ09 and 0.4 percent in IIIQ09 and is negative or weaker in highly-indebted countries (http://epp.eurostat.ec.europa.eu/tgm/refreshTableAction.do?tab=table&plugin=1&pcode=teina011&language=en ). Adjustment with a weak or declining general economy may be quite difficult. Some economists argue that debt rescheduling would be more appropriate because of nearly impossible service of government debts. Rescheduling is not an easy solution. The dual objective of the rescue was to prevent an impact on the banks in the larger economies of the euro zone that have debt exposures to the highly-indebted countries and also to prevent what Paul Volcker has called the risk of “disintegration” of the euro (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aASZ4SCDL3uQ ). The continuing decline of the value of the euro in dollars suggests that the rescue plan may be facing an issue of credibility. In addition, financial risk indicators analyzed by Bloomberg such as LIBOR, the LIBOR/OIS spread and the swap spread suggest that financial risk perceptions are rising. The decline of the yields of government bonds of the highly-indebted countries would suggest the opposite. This may be partly the result of the ECB’s new policy of quantitative easing by which purchases of EUR20 billion of sovereign debt of highly-indebted countries may have caused the decline of their spreads relative to German bonds of equivalent maturity (http://www.ft.com/cms/s/0/7fd69a8a-5eb3-11df-af86-00144feab49a.html#). Analysts estimate that purchases of debt of affected countries by the ECB would have to rise to ERU300 to EUR600 billion but it is quite difficult to measure such numbers relative to success in calming markets permanently. The capitulation of the ECB to the policy of quantitative easing may be considered as a breach of its independence and loss of its credibility as a central bank during a tough emergency while the Fed bloats its balance sheet with dollar swaps with central banks (http://www.federalreserve.gov/newsevents/press/monetary/20100511a.htm ) that may have been ineffective in the credit crisis of 2007-2009 (John Taylor http://www.ft.com/cms/s/0/eedbe85c-5d2a-11df-8373-00144feab49a.html ).
IV United States Fiscal Imbalance. The shock to the highly-indebted countries in the euro zone is actually only part of a tough adjustment of fiscal imbalance facing the advanced economies. Countries with more manageable fiscal situations may suffer less in a global debt/financial crisis. What appears impossible is escaping altogether the effects of such a crisis that originates in the United States and Europe. The Congressional Budget Office (CBO) calculates record fiscal deficits from the President’s budget proposal of $1.5 trillion in 2010, or 10.3 percent of GDP, and $1.3 trillion in 2011, or 8.9 percent of GDP after $1.4 trillion or 9.9 percent of GDP in 2009 (http://www.cbo.gov/ftpdocs/112xx/doc11231/frontmatter.shtml ). Debt held by the public would rise from $7.3 trillion or 53 percent of GDP in 2009 to $20.3 trillion or 90 percent of GDP in 2020. Net interest would quadruple from 1.4 percent of GDP in 2010 to 4.1 percent in 2020. The Fed holds a portfolio of $1.98 trillion of long-term securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) that will cause increases in long-term interest rates when it is sold to the public even using appropriate tools in an optimum exit strategy that may fail operationally. Issuance of debt to pay for continuing high government deficits and refinancing of maturing debt together with the sale of the Fed’s portfolio will cause upward pressure on long-term interest rates with likely adverse effects on the rate of economic growth and employment. The Medicare Board of Trustees calculates under its “budget perspective” present-value net deficits of $45.8 trillion in the next 75 years from Medicare and Old Age, Survivors and Disability Insurance (OASDI) or Social Security that are equivalent to 5.8 percent of the present value of the GDP in that period of $791 trillion (http://www.cms.gov/ReportsTrustFunds/downloads/tr2009.pdf ). The Medicare hospital insurance or Part A trust fund will be exhausted by 2017. The solution to the Medicare financial imbalance could require gradual or immediate increases in the payroll tax from the current 2.90 percent to 6.78 percent equivalent to an increase of the tax by 134 percent or reduction of expenditures by 53 percent. The OASDI Board of Trustees predicts that annual costs will be higher than income by 2016 and that the OASDI trust fund could be exhausted by 2037 (http://www.ssa.gov/OACT/TR/2009/tr09.pdf ). States face unfunded entitlement liabilities while experiencing substantial budget deficits. Adverse expectations caused by the failure of the US to engage in credible fiscal consolidation may bring to the present in the form of financial turbulence a fiscal debacle that is actually only a few years ahead.
V Bank and Financial Regulation. There is an ambitious global financial regulation agenda that is being anticipated in the US Senate and is coinciding with regulatory probes on banks and financial institutions. The Senate bank regulation bill is proposed on the basis of the allegation that if it had been enacted before 2007 it would have prevented the credit crisis and global recession of 2007-2009. There is no technical knowledge to support this allegation. The effects of individual regulatory changes throughout several thousand pages of legislation cannot be analyzed properly and much less the overall effects of the legislation, which changes capriciously with each amendment. Even if the Senate bill were originally consistent in providing stability with growth of financial services, which it was not, the amendments could make the whole toxic. One of the most important determinants of the credit crisis and global recession was the guarantee or purchase of $1.6 trillion nonprime mortgages by Fannie Mae and Freddie Mac (Edward Pinto testimony cited in Pelaez and Pelaez, Regulation of Banks and Finance, 219-20, Financial Regulation after the Global Recession, 156) and the two companies operating with reckless leverage of 70:1, lobbying successfully against their regulatory oversight and faking profits in their balance sheets. A Senate bill proposed as an end of bailouts and the “too big to fail” actually perpetuates the “too politically important to liquidate” with Fannie and Freddie now endowed with an open-ended or limitless financing agreement by Treasury with taxpayer funds. The Senate voted down an amendment to consider Fannie and Freddie in its bill (http://professional.wsj.com/article/SB10001424052748704250104575238641146885632.html?mod=wsjproe_hps_TopMoreNews ). However, an amendment passed comfortably to create an unfeasible and chaotic agency to allocate specific companies to providing ratings of thousands of issues of securities (http://professional.wsj.com/article/SB10001424052748704635204575242472908973624.html?mod=wsjproe_hps_LEFTWhatsNews ). The combination of the noise from the financial regulation bill with a web of federal and New York State probes of large financial institutions contributed to the pressure on stocks of financial companies (http://www.ft.com/cms/s/0/cf8c7828-5f81-11df-a670-00144feab49a.html ). The regulatory effort of the US Congress is a clear case of procyclical regulation, accentuating instead of alleviating stress in financial markets, probably strangling needed financing of the overall economy or “Main Street” as typically referred in political statements.
VI The General Economy. The general economy continues to recover in manufacturing and now also consumption. Sales of merchant wholesalers increased by 2.4 percent in Mar relative to Feb and 15.8 percent relative to March 2009; inventories of merchant wholesalers increased by 0.4 percent in Mar relative to Feb but declined by 5.3 percent relative to Mar 2009 (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ). US imports of goods and services of $188.3 billion in Mar exceeded exports of goods and services of $147.9 billion for a trade deficit of $40.4 billion, slightly higher than $39.4 billion in Feb (http://online.wsj.com/mdc/public/page/2_3063-economicCalendar.html?mod=topnav_2_3000 ). The US trade deficit is oscillating with the prices of imported petroleum but the revaluation of the dollar may still be a factor in restraining export growth. US Retail sales increased by 0.4 percent in Apr relative to Mar; the increase relative to Apr 2009 was 8.8 percent. US Sales in Feb through Apr 2010 were higher by 7.3 percent relative to the same period a year earlier (http://www.census.gov/retail/marts/www/marts_current.pdf ). Manufacturing output was higher by 1.0 percent in Apr over Mar and 6.0 percent relative to a year earlier. Manufacturing activity is increasing across many sectors. Capacity utilization was higher by 0.8 percentage point, reaching 7.08 percent, which is 8.4 percentage points below the average in 1972-2009 but higher by 5.7 percentage points relative to the trough in 2009 (http://www.federalreserve.gov/releases/g17/Current/default.htm ). Initial jobless claims for the week ending May 8 were lower by 4000 from the upwardly revised 448.000 in the prior week. Seasonally adjusted insured unemployment in the week ending May 1 was 4.627 million, increasing by 12,000 from the previous week’s level of 4.616 million (http://www.dol.gov/opa/media/press/eta/ui/current.htm ).
VII Interest Rates. The flight out of risk into Treasuries caused a downward shift of the US yield curve. The yield of the 10-year Treasury declined to 3.46 percent on May 14 from 3.84 percent a month earlier but was higher than 3.42 percent a week earlier (http://markets.ft.com/markets/bonds.asp ). The 10-year German government bond traded at 2.85 percent for a negative spread relative to the 10-year Treasury of 60 basis points (bps). France’s 10-year government bond traded at 3.11 percent for a negative spread of 34 bps. Although there are unresolved problems in the euro zone, the yields of government bonds of France and Germany are trading at lower levels than those of the US. Once the risks among sovereigns are evened, US Treasury yields may rise again. The bid rate of 3.43 percent and ask rate of 3.46 percent of the 10-year interest rate swap traded close to the 10-year Treasury yield of 3.42 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=ICAP-140510 ).
VIII Conclusions. The doubts on China’s growth, the sovereign debt crisis raising clouds on the euro, the fiscal imbalance of the United States and the web of probes on banks coinciding with the threat of financial disintermediation resulting from the bank and financial regulatory exercise in Congress are exacerbating world financial turbulence. Higher taxation and increasing interest rates threaten the recovery of the general economy and employment in the short term while the agenda continues its focus on restructuring for the long term. The 26.9 million persons in job stress who are willing and available to work are being neglected. Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10