Monday, May 9, 2016

Disentangling the nature of Italy’s capital flights

The ECB T-LTROs and the QE efforts are fueling significant outflows toward the core countries, driven by the non-banking sector. 

Guest post by Marcello Minenna

Net balances in the Eurozone continue to widen as capital flows from the periphery to Germany and other core countries. Much of the convergence in net balances that took place between 2012 and 2014 has reversed. As for the underlying reasons, we’ll show that empirical evidence points mainly to the combined effects of the new ECB programs of monetary expansion (T-LTROs and Quantitative Easing).  As of March of this year, Italy reported its largest Target 2 net deficit 2012 (€ -263 billion), followed closely by Spain (€ -262 billion) and Greece (€ -95 billion). Germany’s Bundesbank saw its surplus grow to over € +600 billion once again (see Figure 1).

Figure 1.

The ECB itself has seen its deficit widen to  € -90 billion due to quantitative easing purchases (see Figure 3).  Around 10% of QE assets are risk-shared between Eurozone countries and thus are accounted as an ECB “debt” towards National Central Banks (NCBs).

Figure 2.

This unusual accounting confirms that, also because of complex technicalities involved, a clear explanation of the driving components of this central banks' accounting method continues to prove elusive. Even the same ECB is explicitly warning not to infer bold assumptions from analysis of these data since simplistic explanations could lead to wrong conclusions.

Some academic research on the importance of Target2 balances has progressed considerably from the seminal but disputed work of Sinn (2012). The Sinn research has the merit in attracting attention on the relationship between the current accounts and the Target2 balances of Eurozone countries. A surplus in the current account should lead to a positive Target2 net balance, and vice versa. In this perspective, the Sinn research considers the Target2 balances in terms of a “stealth bail-out” of peripheral countries by the creditor central banks. According to Sinn, in the case a “debtor” central bank would leave the Eurosystem, the Target2 net balance would become immediately payable. A subsequent default of the debtor central bank would turn into a net loss for the Eurosystem to be absorbed jointly by all the remaining members (risk mutualisation or risk-sharing). Whelan (2012 and 2014) contested this view in many papers, pointing out that any central bank can always operate with “negative equity” (in other terms it could offset losses "printing money", without fiscal transfers from the taxpayers).  Now it seems understood (Szécsényi, 2015) that Target2 assets and liabilities could eventually lead to losses in case of a Euro break-up, but these should be a lot less than the raw net imbalances suggest.

At the present, a large part of the financial community seems to acknowledge that diverging net balances in the last two years are driven by purely financial transactions.  The current accounts of Eurozone countries are mainly in surplus (see Figure 2) due to the depreciating Euro and the compression of the level of prices and wages in the periphery (i.e. a phenomenon also known as internal devaluation). Hence, it could be inferred that the intra-European trade between Germany and the periphery (the Sinn hypothesis) is not the leading factor in explaining Target2 net balances.

Figure 3.

Digging deeper, it’s interesting to highlight also the strong correlation between the size of the ECB balance sheet and NCBs Target2 numbers. When the ECB inflates its accounts via expansionary measures, newly created money flows towards Eurozone banks that use it to regulate different kinds of transactions. When they are settled and accounted, these operations produce variations in the Target2 net balances. Let’s investigate the Italy’s case. As Figure 4 clearly depicts, Italy’s Target2 net balance and central bank balance sheet show a 96% correlation between 2011 and 2016.

Figure 4.

In the pursuit to understand movements in Italy's Target2 net balance, a detailed decomposition has been calculated by exploiting financial account data from the balance of payments (see Figure 5). The reconstruction has a good degree of precision, with little unexplained residual flows (the orange bars).

Figure 5.

In 2011 and 2012, core Eurozone banks sold significant amounts of Italian government bonds on the secondary markets because of an augmented perception of Italy’s credit risk (the green bars grew quickly). Those bonds were then purchased by Italian banks, which increased their exposure to national public debt. At the same time, German banks were deleveraging from long-term commercial credit exposure to Southern Europe. Net borrowing by the Italian banks on the Euro area interbank market also decreased markedly, due to the substantial reduction of deposits abroad and the missed renewals of existing loans. These phenomena (together with a progressively higher cost of financing) were signaling stress on the Italian banking sector’s funding practices  (the yellow bars). Together, this led to large capital outflow from Italy to the Eurozone core (denoted with a positive sign in core Target2 accounts; vice versa for Italy). The ECB’s LTROs and other unconventional measures have supplied over € 1 trillion to the Eurozone banks (€ 270 billion to Italy alone) that have been employed to finance the capital flight and transfer risk from the German banking system to the ECB.

When LTROs repayments began in 2013, the ECB balance sheets gradually deflated along with the Target2 net balances. Foreign investment in the Italian public sector resumed, though it did not reach previous levels. The missing amounts were partially compensated by a positive influx of foreign money in the private sector (sky blue bars). The divergence returned in June 2014 when Mr. Draghi launched the new T-LTROs in an effort to revive the sluggish Eurozone credit growth. In March 2015, PSPP’s launch accelerated the growth of ECB assets and had widened the spread between Target2 net balances.

New money flows (TLTROs loans and revenues from the selling of government bonds) reached Eurozone banks but only partially were employed to increase the exposure on national government bonds. A new source of capital flows has emerged and become the primary driver of Italy Target2 negative net balance: a shift in Italy’s private non-banking sector from government and banking bonds to foreign shares and mutual funds.  Looking closer at Figure 6, one can infer that the Target2 net balance (blue line) was only affected by the sell-off and the subsequent repurchase of Italian government bonds (green line) until June 2014. Afterward, foreign investment by the non-banking sector (red line) played a larger role in dragging down the Target2 balance. Moreover, the last few months of decline could be attributed to a renewed – albeit moderate – flight from government bonds.

Figure 6.

As of the beginning of 2016, over € 180 billion has shifted from Italy towards mutual funds located in Luxembourg, Netherlands and Germany. Only 20% of them can be traced back to Italian entities (i.e. round trip funds). The hunt for yield in a unprecedently low-interest-rate environment can only explain part of this sustained capital flight towards Northern Europe. Subtle but persistent redenomination risk (the risk that a euro asset will be redenominated into a devalued legacy currency after a partial or total Euro break-up) affecting Italian assets. Moreover, the fear of adverse effects of the bail-in regulation that came into effect in January 2016 may have had a meaningful role in explaining this massive portfolio readjustment by the private non-banking sector.

References and Further Readings:

Publication of TARGET balances (2015)

Minenna et al. (2016 - forthcoming) “The Incomplete Currency: The Future of the Euro and Solutions for the Eurozone”, Wiley.

Sinn H.-W., Wollmershäuser T. (2012b), “Target balances and the German financial account in light of the European balance-of-Payments crisis”, CESifo Working Paper No. 4051, December.

Szécsényi P. (2015), “Nature of TARGET2 Imbalances”,

Whelan (2012) “TARGET2: Not why Germans should fear a euro breakup”,

Whelan K. (2014), TARGET2 and central bank balance sheets, Economic Policy January 2014


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Sunday, May 8, 2016

Fiscal Policy to the Rescue?

Guest post by Norman Mogil

When appearing before their political masters, central bankers, invariably, urge them to adopt an expansionary fiscal policy. Ben Bernanke, and now his successor, Janet Yellen have pleaded with Congress to adopt a more simulative fiscal policy. Mario Draghi continuously stresses the need for fiscal policy in support of the ECB's easy money policy. Most recently, the head of the IMF, Christine Lagarde, stated that some countries “may have room for fiscal expansion", citing Canada as one country that has "made the most of this space." Indeed, the Governor of the Bank of Canada (BoC) has made it a selling point that they believe that Canada's latest fiscal stimulus measures will have a positive effect on the real GDP. In part, the fiscal policy shift has allowed the BoC to refrain from cutting its lending bank rate.

Monetary policy is reaching its limits in terms of stimulating economic activity and has carried that burden well beyond what was envisioned immediately after the 2008 crisis. This blog looks at the issue of fiscal policy, especially the fiscal multipliers that are considered to be the drivers behind the movement towards fiscal expansion.

The Multipliers

The Keynesian multiplier is at the centre of  the analytical debate regarding the impact of a central government's budget on promoting growth. Simply put, the multipliers measure the bang one gets for the fiscal buck .That is, the amount of short-run economic expansion one gets from a dollar of government spending, or, from changes in tax policy. Multipliers can be calculated to measure any kind of expenditure change on GDP. Thus, for example, if government spending were to increase by $100, leading to an expansion of $150 in GDP, then the spending multiplier is 1.5. Other types of multipliers can measure the impact of government transfers or of specific tax changes affecting profits and wages.

Using historical data, a recent IMF study calculated the average multiplier impact for major industrialized countries (see Chart 1). What is striking is the relatively wide-ranging implications of stimuli for these countries. The US and China have experienced a multiplier effect of 1.5 and 1.7, respectively; Canada, Australia and the Eurozone have experienced less effective results. We will return to this point later.

Not all fiscal stimuli act with the same degree of potency. Chart 2  separates the type of stimulus between " investment" and "tax" measures.  The governments obtain the greatest bang for the buck when undertaking infrastructure projects, both for their immediate impact on jobs and income as well as for their longer term benefits in adding to productive capacity (e.g. urban transportation systems). Next in importance are stimulus programs generated by increasing government consumption of goods and services  (i.e. day-to-day expenses associated with government operations).

Tax measures, on the other hand, have not proven to be anywhere nearly as effective in promoting growth. The impact of reductions in personal or corporate tax cuts are de minimis. Since some portion of a tax cut is usually saved rather than entering the spending stream,  tax multipliers are lower than government spending multipliers.

Thus, economists have long urged governments to look to stepping up their capital investment activities as the primary driver of fiscal stimulus policy.

Conditions Affecting the Multiplier

How effective fiscal policy can be depends largely on the following conditions:
  • the stage of the business cycle. If the economy is fully utilizing all its resources, then a stimulus program would have no effect and might even worsen conditions as the government would tend to "crowd out" the private sector in the competition for workers and for physical and financial capital.  This is  not the situation today. Government expenditures simply will augment aggregate demand and contribute to overall growth without any inflationary results. In fact, recent research has shown the multipliers are likely be higher those of the past--- there is that much slack in the economy. Furthermore, some researchers even go further and argue that these expenditures will, in time, ease, not exacerbate the government’s long run budget constraint (1).
  • reliance  on international trade. For countries such as such as Canada, Australia and those in the Eurozone, international trade accounts for as much as  25 percent  or more of national income. In these cases, there will be some leakage as consumers and businesses purchase products made overseas resulting a net reduction to national income. This may account for why the multipliers for those countries are lower than for the US and Japan which are more closed economies.
  • the level of interest rates. As long as interest rates are less than growth in nominal income, the amortization of the additional liabilities will negative. This is a very cost-efficient means to finance long term infrastructure projects.
  • on the fiscal policy mix. As we pointed out earlier, it is important to emphasize government " investment" expenditures over "tax" expenditures as a means of stimulating growth. The mix often depends on the political forces at work at the time that budgets are being drawn up.
We did mention that economists debate the value of fiscal stimulus. Some point to the experience of the US stimulus bill of 2008 had very little impact. However, that program was dominated by tax cuts which have the smallest impact of any stimulus measure. Also, the size of the program, roughly $750 billion was less than 1 percent of the economy and would not likely have produced the desired impact. The program was designed to kick start only, rather than to provide for sustained increase in economic activity.

Summing Up 

As the monetary policy options are exhausted, the industrialized countries are going to look to fiscal policy to boost growth. In the recent the G-20 meeting, the IMF  recommended the G-20 stand ready to implement coordinated stimulus equal to 1 percent to 1.5 percent of GDP. More importantly, should this be a coordinated action the multipliers cumulative affects would be even greater than each country going it alone. Hence, the urging by the IMF to have the major players work together.  A tall order, indeed.

(1) "Fiscal Policy in a Depressed Economy",  J. Bradford DeLong U.C. Berkeley and NBER  Lawrence H. Summers Harvard University and NBER,2012

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Monday, April 11, 2016

Understanding Negative Interest Rates

Guest post by Norman Mogil

When the central banks of three European countries and the European Central Bank (ECB) itself introduced negative interest rates (NIR)  in mid -2014, many considered it be a temporary measure, a new experiment in monetary policy. But when the Bank of Japan did the same in January 2016  and when the ECB  pushed rates further into negative territory in March 2016, the international investment world stood up and took notice. Policy makers are now prepared to test this unconventional technique in an effort to stimulate growth and tackle deflation.

The financial press is full of articles on the dangers of this policy. These unconventional moves have provoked a lot of criticism, especially from the banking community who fear a strangulation of normal banking activities. A lot has been written about the dangers that NIR  pose to the stability of banks and to the possible harm to savers and investors alike. This article is an attempt to put the whole question of NIR into a more balanced perspective. To begin with, it is important to have some background to why and how NIRs have come to characterize so much of government debt.

How Pervasive are NIRs?

 According to the JP Morgan international bond index, approximately 25% of its government bond index is in negative territory ( see Chart1). More importantly, the size of that market has grown rapidly and dramatically from zero in mid- 2014 to more than US$6 trillion today.

Source: FT

Table l lists the countries whose official central policy calls for NIRs and whose interbank lending rates are negative. The interbank lending rates are a measure of how willing commercial banks are prepared to lend to each other on a very short term basis. In Europe, alone, nine countries' interbank lending rates are in negative territory.

Initially, the sub-zero debt instruments were confined to the very short end of the yield curve. However, as Chart 2 reveals, NIRs have been extended to the middle and longer ends of the yield curve. In Germany, sub-zero rates extend up to five years and, in Japan negative rates extend out to 10 years - the Japanese 30-year bond trades at a mere 0.50 percent. It should be emphasized that, although the central banks set only bank policy rate, the market place determines all rates along the yield curve from 2 years to 30 years. Clearly, the goal of lowering long-term interest rates has been achieved in Europe and Japan. It will take an extraordinary shift inflationary expectations to eliminate negative rates this far out on the  yield curve.

Source:, March 18,2016

In the case of non-Euro countries like Sweden, Denmark and Switzerland, these countries adopted a policy of NIR to hold down the external value of their domestic currencies. Money was flowing into these nations' coffers from the Euro countries, putting undue upward pressure on their domestic currencies to the detriment of their trade and capital balances. Despite the fact that the Federal Reserve has signaled that it wants to raise the short-term rates as part of its efforts to `` normalize`` monetary policy , Janet Yellen said last November that certain economic conditions could put negative rates "on the table". Never say never.

NIR bonds are not solely confined to the government sector. Recently, such blue chip European corporations as Nestle, the energy corporation EDF,Royal Dutch Shell and drug makers, Sanofi and Novartis, have been trading at sub-zero rates for more than a year .Chart 3 sets the dramatic drop in investment grade corporate bond yields since the announcement of NIRs by the ECB in 2014.

Source: FT

What Gives Rise to Negative Rates?
One way to approach this question is to consider the nature of a " liquidity trap'. In describing  monetary conditions in the 1930s, John Maynard Keynes coined the term "liquidity trap" in which  declining interest rates fail to promote  greater consumer borrowing and spending. The demand for money from consumers and business owners are no longer sensitive to the drop in interest rates.

Another way to look at this phenomenon is to consider that money is essentially trapped in the financial system--- even at zero rates of interest, the economy fails to show any signs of meaningful economic growth. We have not seen this situation since the 1930s when Keynes first labelled it. So, it is quite a shock to the policy makers that even a zero rate of interest did not stimulate borrowing and spending . Now, some central banks have resorted to introducing unconventional means such as NIRs,

 Economists have cited various reasons for a liquidity trap and some are featured in today's environment:
  • expectation of deflation. In Japan an entire generation since the 1989 financial and property market crash has experienced deflation;  consumers feel no urgency to go out and spend now, since they expect prices to fall further in the near future. In the EU, the debt crisis of 2012 has ushered in a period of austerity, accompanied by expectations of stagnation and further deflation.
  • credit tightening. Following the 2008 banking crisis, banks worldwide have had to raise capital in order to improve their balance sheets ; they are reluctant to lend, regardless of the creditworthiness of the borrowers.
  • savings rate increases. A pessimistic outlook will lead to  consumers increasing their savings as a precaution; the debt crisis in Europe has prompted consumers and government to hold back on expenditures as part of an overall austerity policy. Savings as share of GDP is relatively high in countries featuring NIRs.

Who Buys Negative Interest Bonds?

So, who would buy a NIR bond?
One category include institutional  investors who have to own government bonds, regardless of their returns . Central banks own bonds as part of their foreign exchange reserve positions. Insurance companies and pension funds need to hold bonds as part of their reserve requirements and to match long-term liabilities.And, commercial banks need bonds to meet liquidity requirements.

A second group include speculative investors who  expect bond yields to fall further in response to other monetary policy shifts, eg. the ECB announcing an extension of its bond buying programme ( QE) , Or, these investors anticipate a currency appreciation that more than offsets the loss due to negative yields. Many foreign investors buy Japanese bonds with expectation that the yen will appreciate beyond the loss in yield. In fact, the yen has been strengthening against the US dollar over the last couple months, since the BoJ introduced its NIR policy.

A third group of investors have no alternatives . The security and transactional cost of holding very large cash balances can be very expensive compared to a small loss from an NIR bond. Finally, government bonds ,even if yielding negative returns, are considered as a relatively cheap and safe haven in the time of market volatility.

How do NIRs Work?

Let's clear up a few misconceptions.

First, the negative rates are really aimed at the institutional investor, eg. pension funds, large corporations, The retail investor is not the target and has not been directly impacted; rates may be low, but there are positive for the retail saver.

Second, no government is forcing an investor to accept negative rates. After all, the investor can seek higher returns in more risky assets. In fact, that is precisely the desired goal of the policy makers. However, given what happened in the 2008 financial crisis, it is entirely rational for a risk-averse investor to buy a highly liquid and safe investment to protect against a future financial crash. For example, foreign banks have approximately 17 billion Swiss francs on deposit in the Swiss central bank at negative rates as a way of protecting capital and having access to liquidity; both are prudent corporate policies.

Third, Japan, for example, cut its deposit rate on cash held at the BoJ by the commercial banks that exceeded the legally required reserves; banks often find themselves with cash reserves in excess of their  banking requirements and those excess reserves are normally lent to the central bank. The BoJ wants to encourage the commercial banks to make these excess reserves available for lending to consumers and businesses. The BoJ made it clear that the aim is to make more money available at lower costs to stimulate growth and inflation.

The Bank for International Settlements (BIS) recently examined the how NIRs are implemented within Europe, the area with the most experience to date. The BIS concluded that:
  •  NIRs work through the money markets and other interest rates in the same way that positive rates do; no disruptions were identified.
  • the one major exception is that banks have been reluctant to pass negative rates to their retail customers; the fear was that negative rates would lead to major deposit withdrawals.
  • the drop in longer-term interest rates has taken place at the same time as ECB adopted a programme of purchasing government debt ( QE ); so, it is difficult to isolate the impact of negative rates from that of its bond buying programme.
The BIS concludes that `` looking ahead, there is great uncertainty about the behaviour of individuals and institutions if rates were to decline further into negative territory or remain for a prolonged period`` . Nevertheless, the policy, to date, has not harmed the banking system nor has it disrupted savings patterns (1).

Are NIRs necessary?

NIRs are part of a long list of unconventional monetary policy moves which include purchases of government bonds, purchases of mortgages and  other asset-backed securities,forward guidance and currency devaluations. To date, these efforts have failed to stimulate growth. Had these governments adopted expansionary fiscal policies, there would not be the need for so many unconventional policy moves, of which the latest is NIRs. In a sense, governments have been struggling to shake off slow growth and deflation with one hand tied behind their backs.

Summing up, NIRs have permeated the banking world, especially in Europe and Japan and by all accounts this is not just a temporary condition. Subzero rates now extend into the longer end of the yield curve as the demand for government  debt continues to remain strong. Reasons vary by investor groups as to why they participant in what is , on the surface, a counter-intuitive investment strategy. The strategy may not have been necessary had governments adopted  more expansionary fiscal policies. Nevertheless, the jury remains out regarding the longer term effectiveness of NIRs.

(1) BIS `How have central banks implemented negative policy rates? ", M. Linnermann and A. Malkhozov, March 2016



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Thursday, March 24, 2016

Canada`s Fiscal Policy Shift

Guest post by Norman Mogil
After nearly a decade of fiscal policy taking a back seat to monetary policy, the newly elected Liberal Government moved public spending into the driver`s seat with its first budget since the election last October. Canada will now use fiscal deficits to re-invigorate its limping economy. It has launched a policy of fiscal stimulus, lead by large infrastructure investment for at least the next five years. While the political analysts argue as to which election promises were kept and which were broken, the principle issue in the budget concerns the role of deficits in generating economic well-being.

Deficit financing has been used in Canada several times over the past four decades, as successive governments contended with economic downturns (Chart 1). Recovery from the severe recession of 1980-82 and again in  1991-93, Canada ran very large deficits - in excess of 4% of GDP. From 1997 to 2008 government finances returned to the black, only to be hit hard with the 2008 global crisis, necessitating a return to deficits in the order of 3% of GDP . That deficit position was ultimately eliminated by 2014-15.

Once again, Canada faces a very difficult economic environment and now turns to deficit financing to clear a path towards higher economic growth.

When the election was called in the summer of 2015, the Liberal Party advocated deficit spending and proposed a deficit of C$10 billion in the first year. By the time the budget was delivered on March 22, 2016, the forecasted deficit was increased to C$29 billion and the Government planned to run up a total C$100 billion in deficits over the next five years. What  happened in the interim between the election call and the budget delivery?

According to Finance Canada documents, surveys of private sector economists taken in June 2014, indicated a relatively robust growth path. ( Chart 2). However, the collapse in the commodity markets changed everything . Forecasts were significantly lowered for nominal growth GDP, by as much as 7% for 2017. The original deficit projections could no longer be justified.

The principal culprit was the severe drop in investment plans in the energy sector and its knock-on effects for the rest of the economy. Industrial sectors, outside of the energy-producing provinces, were suffering a decline in nominal incomes. Overall, capital investment in Canada has been on a decline for several years, and the collapse of commodity prices has only served to accentuate that decline. No longer can we count on the commodity sector to sustain economic growth.

Canadian governments at all levels have made considerable strides in reducing debt ratios over the past 25 years. Chart 3 traces the debt-to-GDP ratio for all governments over that period. The ratio has declined from nearly 90% in the mid -1990s to under 50% today. As the deficit ratio fell, the  bond rating agencies raised Canada's ratings  and today the country enjoys one of the highest ratings in the G-7 countries. Within the Federal sphere, the debt-to- GDP ratio has fallen from nearly 70% in the 1990s to just over 30% today. The 2016 budget projections expect that ratio to continue over the planning time horizon.

Starting in 2016-17, the deficit will be financed by a record issuance of C$133 billion of which C$92 billion is rolling over old debt from the previous borrowings and the balance represents the deficit to be financed this coming fiscal year. Interestingly,   Finance Canada recommends issuing bonds in the two-, three-, and five-year borrowing periods, rather than locking  into low rates for 10 - and 30-year bonds. One could argue that, given that much of the deficit arises from infrastructure investment, they should be financing with long term rates which are at historic lows. However, if the goal is to return to a balanced budget at the end of five years, then using short-term rates seems appropriate. This was the strategy of the Harper government as it sought to return to a balanced budget by 2015. Either way, today's borrowing costs affords an opportunity to expand the budget without measurably adding to the burden of interest costs.

Turning to Table 1, the outstanding Federal debt will be increased by C$113  billion over the period. Nonetheless, the debt as a percent of GDP remains static at approximately 30% throughout the period. And, more importantly, interest costs as a percent of total revenues marginally increase from 8.8% in 2016-17 to 10.3% in 2021. Both measures suggest that the Federal debt position is sustainable and does not impinge on the expansion of programs designed to stimulate the economy.

 In the past, Canada has relied on foreign capital inflows to help finance it public sector deficits. Given the Federal Government's sound bond rating and also that Canada's offers competitive interest rates - certainly higher than those in Europe or Japan - there is every reason to expect that the international investing community will look favourably upon future bond issuances.

The budget has prompted many forecasters to reassess their earlier growth projections.TD Canada and BAML both bumped up their forecasts for 2016 and 2017 on the strength of the proposed budget.  It is no secret that the Bank of Canada has had its hand stayed, awaiting Federal budget .This level of deficit spending will be welcomed by the Bank as a tool to augment its accommodating monetary policy. The central bank  estimates growth of 1.4 percent in 2016 and 2.4 percent in 2017, in the absence of fiscal stimulus. At least, the Bank now finds it has a partner in promoting economic growth.

A final word. With the EU countries under austerity regimes and the US operating with a relatively non-expansionary Federal budget, Canada now embarks upon a program of deficit financing to counter its problems of slow growth. It will be of interest to many other nations to see if this strategy is what is needed to pull out of the current weak economic environment.


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Sunday, March 13, 2016

Canada`s Changing Financial Landscape, Part 3: Lifecos and Real Estate

Guest post by Norman Mogil


Although innocent bystanders in the 2008 financial crisis, the life insurance companies were most impacted by the knock-on effects of the fall in equity prices, declines in long-term interest rates, poor credit quality of debt and a general decline in economic activity.

As Table 1 demonstrates, the industry remains permanently ( i.e. long lastingly) impaired. Share prices of the major lifecos are, largely, below pre-2008 levels and/or have not participated in the upswing of equity prices enjoyed by other financial institutions. Major lifecos, such as Manulife and Sunlife, remain well below levels of a decade ago. More importantly,  prior to the 2008 crisis, the industry commanded price-to-book values  of 2.5 times, only to see that metric drop down to 1.5 times today. The industry continues to face a challenge of repairing  balance sheets and of tailoring their products to reflect the changes in today`s economic environment.

Above all else, the lifecos have suffered at the hands of today's low-interest rate world. They are in a constant struggle to match  the return on assets to the requirements of future liabilities. Re-investing fixed income assets at successively lower rates, in effect, increases the risk of long-term liabilities. In particular, the liabilities most at risk are annuities and guaranteed income products. Low rates also affect reserves and capital margins, necessitating capital infusions to meet industry regulations.

Although the bulk of the industry`s assets are in fixed income, the industry was compelled to seek greater returns from equities and other asset classes-- the familiar "stretch for yield". Many of these other assets groups failed to provide the needed additional returns to offset the declining returns from bonds. For example, Manulife assumed a higher risk profile from the purchase of equities, specifically in the oil and gas sector; the slump in energy prices has hurt profitability. Any mismatch between assets and liabilities leads to profit volatility, a state of affairs that continues to exist.

Persistent low-interest rates are changing the product mix that lifecos offers, for example:
  • certain long-term guarantee products will likely disappear ( e.g. permanent life insurance);
  • some risks will be shared with customers; and,
  • premiums will rise, at the risk of losing potential customers.
One bright spot is that the aging population allows the industry to expand its
wealth management business. The industry is increasing its ``investment  type``
products, such as mutual funds, universal life policies and managed accounts. The growth of this segment is reflecting the maturity of the baby boomers and their needs for retirement income. Finally, given that the domestic market is quite mature, if not saturated, the majors are looking at markets internationally, especially in Asia.

The Canadian Housing Market

If you live in Toronto or Vancouver, you cannot help but be confronted constantly by conversations about the hot housing market. Continuing a trend started more than a decade ago, home prices in these two cities registered double-digit increases in 2015. The accompanying Table 2  shows that Vancouver's home prices increased by over 20% and Toronto's by more than 10% in the past year; whereas, the rest of the country exhibited  quite modest increases. The reasons behind this two-city housing market were examined previously. (

There has been no end of warnings by domestic and international organizations that the Canadian housing market is primed for a major fall, a correction that many consider long overdue. The Canadian Mortgage and Housing Corporation ( a crown corporation) cites the " problematic overvaluation conditions in local markets". The OECD claims that the Canadian market is anywhere from 30-50% overvalued. It is not our intention to get into this debate directly. Rather, we want to point out a number of mitigating conditions that will operate to cushion, if not actually prevent, any  major decline in house prices.

From the borrowers' perspective, one of the most often cited metrics is that which measures the level of household debt  to household incomes. There is no magic ratio that will automatically trigger a significant market decline. No one can answer the question: how high is too high? What is more relevant is the nature of  the household sector's balance sheet.

Table 3 sets out some basic parameters by which to judge the vulnerability of the housing market from the perspective of household wealth. In the past 12 months, households' net worth to disposable income has increased by more than 2%. At the same time, debt-to-assets remain constant at a very low level of 17%. And, most importantly, owner's equity in their homes remains constant at 73%, indicating that homeowners have amassed a considerable amount of equity. Hence, there is an adequate buffer within the household sector, providing stability in the housing market.

From the mortgage lender's perspective, over the past 5 years, the Federal government has tightened up lending practices by:
  • reducing  amortization periods from 40 years to 25 years;
  • reducing  the loan-to-value( LTV) lending percentage from 95% to 80%;
  • reducing the cap on gross debt services levels, and
  • upping  the insurance premiums on mortgages with less than 10% down payment.
The commercial banks dominate the mortgage market, capturing over 80% of all mortgages issued. These lenders' have been relatively conservative in their management of their mortgage portfolio. On average, the major banks have issued mortgages with an LTV between 65-70%, and , in addition,  50-60% of all mortgages are insured (Chart 1). For the industry as a whole, 3% of its total loan portfolio is in uninsured real estate in Alberta. In sum, there is  a considerable buffer created by the banks and the insurers in the event of a sharp decline in housing prices. Both borrowers and lenders are reasonably able to maintain stability in the Canadian market.

Summing Up

The Canadian financial institutions have weathered the storm of the 2008 crisis, yet many challenges lie ahead. Investment dealers are struggling with changes due to technological innovation, government regulations, and a seriously weakened natural resource sector. The commercial banks are challenged by persistently low interest rates and the current weakness in the energy sector and its spillover into the national economy. The lifecos are looking at new strategies to ease the task of matching assets and long-term liabilities in an effort to stabilize profits.


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Sunday, March 6, 2016

China's Wealth Management Products, a Q&A

We've had a number of questions regarding the growth and the risks surrounding China's Wealth Management Products (WMPs). Here is an overview in a Q&A format.

Q: What are the reasons for the continuing demand and proliferation of WMPs in China?

1. China's bank deposit rates have been extremely low over the past decade and until recently have been artificially capped by the nation's central bank, the PBoC. The reason for these low rates is Beijing's effort to make sure that the banking system has access to cheap financing in order to stimulate credit growth.

Source: Tradingeconomics, PBoC

These days, awash with deposits, many banks pay even less than the latest rate set by the PBoC. Here is one example showing why China's depositors have been desperate for yield.

Source: Bank of China (one of the 5 biggest state-owned commercial banks in China)

2. Another reason for the explosion in WMPs in China is the rapid growth in money supply, with limited options to deploy all the new cash. The chart below shows China's  broad money supply (M2), now 15 times the size it was at the end of 1999. That's a great deal of liquidity sloshing around.

3. More money poured into WMOs last year after the massive "correction" in China's stock market, as investors looked for other sources of yield.

Q. What rates do banks offer to their WMP customers?
A. In 2015 the typical WMP product yield ranged between 4.5% and 5%.

Q. What is the typical WMP term?
A. According to HSBC, "more than 90% of China’s fixed duration WMPs are shorter than a year".

Source: HSBC

Q. How do WMPs generate returns?
A. These days most are invested in corporate bonds although some also invest in private loans. The most popular type of bond in WMPs' asset portfolios is a AA corporate (domestic agency ratings of course) with a 4-5 year maturity.

Q. What is the yield on such bonds currently and is it sufficient to pay the WMP rates?
A. Here is the RMB AA corporate yield curve. With a little help from leverage (usually via the repo market) and/or a big duration mismatch, WMPs generate the necessary yield.

Source: HSBC

Q. Has the WMP growth impacted corporate bond yields in China?
A. Yes. Since early 2014, China's corporate bond yields have been steadily declining. A great deal of this is the result of China's WMP demand.

Source: S&P

Q. Who manages WMPs?
A. While banks actively market these products, these days the management is outsourced to brokers (and other non-bank entities) with asset management/trading desks. Banks used to manage WMPs but due to regulatory and resource constraints have shifted the process to third parties.

Q. What sort of arrangements do banks have with WMP managers?
A. WMP managers operate like hedge funds, retaining 20-30% of the upside above the "guaranteed" contractual return of 4.5% - 5% (this is on top of the management fees).

Q. What type of risks are inherent in this market?
A. Given the hedge-fund style upside, this can be an extremely profitable business, encouraging higher leverage as rates decline. Since this activity is concentrated outside of the banking system, it is not yet regulated, resulting in rapid growth in China's "shadow banking". In fact this is one of the key reasons the PBoC has been so reluctant to lower the target interest rate, focusing on the reserve ratio (RRR) instead. Lower rates will encourage further "reach for yield" and increase leverage in the system.

An even greater systemic risk in the WMP market is the asset-liability mismatch - one of the key problems that precipitated the financial crisis in the United States (funding illiquid mortgage bonds with asset-backed commercial paper or repo). The chart below shows the amount of WMP placed vs. what is actually reported at year-end by banks. Many WMPs are timed to mature before the bank reporting date ("window dressing"). Most WMPs of course mature several times a year and the industry relies on the WMP customers to roll (on a net basis) their maturing WMPs. Moreover the market's tremendous growth has banks and managers believing that rolling would not be an issue. If some investors pull their money out, there will always be plenty of new ones wanting to come in. Sounds familiar?

Source: HSBC

Q. Why isn't Beijing addressing this rising systemic risk?
A. The PBoC has to tread carefully in order to avoid disrupting its growing domestic bond markets. The situation is quite fragile and any hint of a serious regulation could send the corporate and other bond markets tumbling (starting a deleveraging cycle). As the regulators try to figure out how to contain these risks (including endless discussions with the major banks), the WMP market continues to grow.


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Canada's Changing Financial Landscape: Part 2, Banking

Guest post by Norman Mogil

Canadians generally take pride  that their banks have been able to weather the 2008 storm well and continue to exhibit solid performance . Recent financial results point to growing profits, increases in dividends and improvements in reserve requirements. Yet, the industry is aware of serious challenges from the collapse of oil prices as well as the challenges that all banks worldwide face from a low or negative interest rate environment. In this blog we will look at what will influence the performance of the Canadian banks in the near term.

For the benefit of our American readers, we should point out there are significant differences  between the Canadian and US banking systems. The industry in Canada is dominated by six large banks ( Big Six) which are national in scope, each having as many as one thousand branches throughout the country and each providing a full range of commercial and personal banking services ( much like the money centre banks in the US) . There are  dozens of much smaller banks that operate only regionally or in specific market segments In the US, even after a consolidation ,post-2008, there are about 7000  commercial banks and savings institutions , the majority of which operate independently only in local communities and have no national presence.

Canadian banks feature a high percentage of assets in personal loans, especially mortgages; whereas, the US banks sell their loans through the securitization market. The Canadian banks carry very little risk of loss since higher loan-to-value mortgages must carry mortgage insurance.

Finally, the Canadian financial regulatory environment has remained basically untouched even after the 2008 crisis; the US industry underwent dramatic changes that are still being  implemented to this day. With a more stable regulatory environment, the Canadian industry is able to operate with little disruption, compared to what we see happening in the US and in the European market(1)

Lets turn our attention to challenges facing the Canadian industry. To begin, we note the structure of  banks assets and revenues. Chart 1 sets out the asset classes and their relative importance.

Personal lending occupies more than half of all bank assets; personal accounts make up 16% and mortgages for an additional 36%. Business loans make up 31% of all assets. These proportions have remained relatively static over the years.

Regarding revenues, Table 1 reveals that the prime source of revenue ( 47%) is net interest income (NII), the basis of all banking operations. Ever since the banks purchased securities dealers in the 1990s, the industry has grown to rely increasing on capital market returns which ,on average, account for about 21% of all revenues. Finally, the Canadian banks have  steadily increased the importance of fee-based income which now generates about 1/3 of its total revenues. The question we need to explore are :  what  factors will impact bank revenues and, hence , profits going forward?

There are four developments that need to be watched carefully as the industry copes with a changing environment.

1) Asset growth slowing. Domestic personal lending, especially mortgages has slowed . The banks are concerned with their exposure to that segment of their portfolio in view of weak economic growth and, especially, the impact of a hard-hit energy sector. Caution has taken hold.

2) Exposure to the energy sector. Canada's depressed energy sector is now hitting the banking community. The banks have steadily increased  provisions for loan losses with each  new quarterly reporting. However many analysts are arguing that these provisions are insufficient. The banks are conducting various stress tests to counter these arguments. Only six months ago, the price of oil was around $60 bbl and now trades at $30-35 bbl; the full impact of this dramatic decline has not yet been felt by lenders. The longer oil prices remain at this level, the more we can anticipate corporate and  personal loan losses will climb .Time is not on the side of the banks in this regard.

Industry analysts have been trying to get a handle on just what is the exposure  of the Big Six  to the oil patch. Exposure takes two forms: 1) direct outstanding loans and 2) untapped credit lines. In the accompanying Chart 2, according to, the total outstanding exposure is C$107 billion, not the C$ 50 billion highlighted by the banks in their recent quarterly reports. The difference lies principally in how much of untapped credit lines exist and other commitments the banks have undertaken to support clients. To be fair, these commitments in total will overstate the banks' actual risks, since not all lenders will draw down  all these lines, even in times of  greater difficulties; nevertheless, as the energy  sector continues to operate in this tough environment , the banks' exposure needs to  be watched closely.

Source: @business

3) Narrowing  of net interest margins (NII). The biggest single determinant of bank profits is the shape of the yield curve. Particularly ominous for the banks is the spread between short- and long-term rates, between the 2 and 10 year rates. Banks do well by borrowing short and lending long; the  steeper the  yield curve, the greater the opportunity for profits. However, as Table 2 clearly points out, the trend has been moving in the opposite direction. This spread has narrowed considerably, from 100bps in 2014 to just 54bps in 2016. In an era of super low interest rates, this narrowing of the spread is putting tremendous pressure on the banks to generate profit growth quarter after quarter. Worse yet, the decline in long term rates herald a weakening economy and deflationary developments, further pressuring profitability. The spectre of negative interests, as is the case in Europe and Japan, is also of great concern to the Canadian banking community.

4) Capital market volatility.   Capital market revenues have to be earned afresh each day. That is, the revenues are a combination of trading profits, underwriting and advisory services, and as such exhibit a lot of volatility. As such, these revenues cannot be relied upon as a consistent and recurring source of income in comparison to mortgages or business loans. Moreover, as we explained in Part 1 of this series, this segment of the industry is undergoing major structural adjustments and profitability is becoming  illusive. ( ).

5) Housing market .Canada's housing market poses an additional challenge to improving NII. There are many different opinions as to when and to what degree a slowdown in housing prices will take place. It is clear, however, that mortgage originations are not going to continue at the recent rapid rates of growth. The banks have signaled that are  they concerned  regarding the connection between household debt and home prices.  Given that mortgages represent about half of all loans outstanding, this possible slowdown combined with a flattening yield curve will impinge on NII.

We will look at this housing and mortgage topic in Part 3 of this series.

(1) See the CIBC  Bank Primer - 2015


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Sunday, February 28, 2016

The Fed could be back in play in 2016

One or more rate hikes by the Federal Reserve in 2016 remains a real possibility. Why would the Fed consider such a policy action given the recent collapse in inflation expectations?

Over the past couple of months many analysts and the futures markets have assigned a rather high probability to the so-called "one and done" - no change in policy in 2016. Indeed, here is what we've heard recently from St. Louis Fed President James Bullard:
Reuters: - The Federal Reserve must act to stop inflation expectations from getting too low, St. Louis Fed President James Bullard said on Wednesday, reiterating his concerns about continuing to raise interest rates.

The U.S. central bank cannot let low inflation expectations "get out of hand," he told a dinner of bond traders here, adding he "can't stomach" currently low readings. "It's just that they've fallen so far that it's got to be a concern."
Source: @auaurelija

However a number of researches have suggested that with a relatively stable core inflation in the United States, oil prices would need to collapse to levels that are neither consistent with today's forward curve nor sustainable. Therefore, these studies argue, the current market-based inflation expectations are simply irrational.

1. Here is the latest analysis from Goldman Sachs.

Source: Goldman Sachs

2. Also, a study from the St. Louis Fed shows a similar result.

Source: St. Louis Fed

Moreover, US inflation measures are starting to stir - especially in the services sector. This is something the FOMC is not going to ignore. Below we have some of the recent reports.

1. The core PCE inflation, the Fed's primary inflation measure, exceeded consensus on Friday.

2. US CPI measures, both the headline and the core, also came in above expectations.


3. As an example of where some of this inflation is coming from, shown below is the medical care CPI. It has been subdued last year but is now is waking up again.

Source: St. Louis Fed

Additionally, the cost of shelter in the US is now rising at over 3% per year, with the rate continuing to increase. Sadly, this is materially higher than the national wage growth rate, putting pressure on Americans with low-paying jobs.

Source: St. Louis Fed

4. We also see the so-called "sticky" CPI (the less volatile components of the CPI) reaching 2.5% - the highest since 2009.

Source: St. Louis Fed

Some analysts (RBS for example) have been suggesting that deflation is about to sweep the global economy, pulling in the US along the way. For now however there is simply no evidence of deflationary pressures in the world's largest economy.

Other indicators released last week could add to the ammunition of the more hawkish FOMC members.

1. US consumer spending was stronger than expected last month. Alas, some of this increase was driven by higher spending on healthcare, but it's an important data point nevertheless.

Source: St. Louis Fed

2. While this next item is more symbolic in nature, it's an important milestone nevertheless. US house prices (at least according to the government's index) are finally above the pre-recession peak.

Source: St. Louis Fed

The futures markets are starting to react to all these reports, with the Fed Funds futures falling on Friday (lower futures prices imply higher rates).

Source: barchart

In the coming months the Fed will be closely watching two key economic measures as the Committee contemplates further rate hikes.

1. Any indications of acceleration in wage growth will get the Fed going again. The high-frequency Gallup jobs indicator suggests that US labor markets remain stable, but material improvements in wage growth have been elusive.

Source: Gallup

2. The recent market turmoil has ignited concerns about tight credit conditions. The Fed's surveys suggest stricter underwriting standards in business lending while other indicators point to weakness in credit availability for middle-market and smaller businesses. And of course credit spreads have risen sharply, especially for the more leveraged firms. However the overall corporate loan growth remains close to 11% per year - for now.

Source: St. Louis Fed

Some suggest that raising rates in the current environment is nothing short of insanity. Given the monetary easing by the ECB, the BOJ, etc. (as rates move deeper into negative territory) or the dovish stance by the BOC, the BOE, and others, the US dollar is bound to resume its rally, causing further damage to the US economy. In fact the latest PMI measures, (from Markit as well as ISM) suggest that the US economic activity has already slowed sharply in the first quarter. Nevertheless, given the Fed's focus on some of the indicators discussed above, rate hikes in 2016 are now back on the table.

Source: Markit


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