Monday, June 3, 2013

20130603 Links

1. China's exchange rate; 2. Nigeria's banking system; 3. The Fed indirectly caused low interest rates.

1. Is the renminbi overvalued? Charles Dumas at the FT thinks so.
Overvaluation became a serious problem in 2011. Producer price inflation (PPI) of 7 per cent then matched unit labour costs (in yuan), but crumpled into 2-3 per cent producer price deflation over the past couple of years. April’s 2.6 per cent deflation has intensified from 1.6 per cent in February. Chinese businesses have to slash prices to keep a grip on their export markets. But unit labour costs are still rising at a 5 per cent rate, squeezing profit margins, and are up 20 per cent relative to the export competition since 2011.  
Adding to this problem is the sudden, related, swing into high real interest rates. In mid-2011, the one-year lending rate from state-owned banks was 6.6 per cent, which combined with 7 per cent PPI to give a slightly negative real rate. But a flight of depositors from China’s banks has kept nominal interest rates high. The nominal interest rate is only down to 6 per cent now, but combined with PPI deflation, the real interest rate is close to 9 per cent. Such high real interest rates combined with squeezed profit margins have pushed China into a prolonged “investment-led” slowdown. 
China’s extravagant post-crisis recovery splurge, with capital spending raised to 48 per cent of GDP, much of it debt-financed, has left it with high prices for real estate and industrial commodities. These assets with low-to-negative yield are also the most sensitive to interest and exchange rate changes. Whether or not Chinese real estate is in a bubble, high nominal and real interest rates make these asset prices vulnerable. 
Premier Li Keqiang spoke recently of plans to remove controls on capital outflows. Any such action could release a wave of savings seeking real foreign assets. This would devalue the yuan and cushion the rebalancing of the economy away from excessive capital spending. But it would also drain away bank deposits, threatening a major domestic asset sell-off as well as bank insolvency. 
[Emphasis added.]
I am most worried about a spiral of: flight of savings away from Chinese banks, rising interest rates, a property crash, and household and bank insolvencies.

2. Nigeria's banking system has recovered. To me, not following the Nigerian economy closely, it was news that the country suffered a banking crisis in 2009. In any case, the IMF has published a report that says that banks have recovered just fine, although (of course), substantial risks remain. Selected paragraphs from the executive summary:
1. The Nigerian economy has experienced domestic and external shocks in recent years, which resulted in the 2009 banking crisis. However, the economy has continued to grow rapidly, achieving over 7 percent growth each year since 2009. The performance of financial institutions has begun to improve, though some of the emergency anti-crisis measures continue to be in place. The success in maintaining financial stability after the crisis, and in the face of major external threats, reflects the decisive and broad-based policy response by the government and the Central Bank of Nigeria (CBN).  
2. Following the crisis, the authorities took a comprehensive set of remedial measures. Substantial liquidity was injected; a blanket guarantee for depositors, as well as for interbank and foreign credit lines of banks, was provided; the Asset Management Company of Nigeria (AMCON) was established to purchase banks’ nonperforming loans (NPLs) in exchange for zero coupon bonds and inject funds to bring capital to zero; regulations and supervision were strengthened and corporate governance enhanced; and the universal banking model was abandoned and banks instructed to establish holding companies or divest their nonbank activities.  
3. As a result, Nigeria avoided economic collapse and economic growth resumed. The challenge now is to build on these achievements, so that vulnerabilities can be mitigated and growth placed on a sustainable and enduring path. 
5. The financial system continues to suffer from weak governance, including some non-transparent ownership structures, deficiencies in financial reporting, and endemic perceptions of corruption. These weaknesses were highlighted by failures and severe undercapitalization of several banks, contributing to banking sector consolidation from 89 banks in 2005 to 20 in 2012. The federal government’s fight against corruption has resulted in an improvement in perception of the extent of corruption as indicated, for instance, by Transparency International in 2011. However, corruption continues to be a significant problem, including in the court system and other public authorities.  
6. Despite significant progress in recent years, the regulatory and supervisory framework has gaps and weaknesses: (i) Nigerian financial institutions operate under a framework of laws, regulations, circulars, and guidelines that are not all well-understood, and do not seem to provide a coherent overall framework; (ii) further enhancements are still needed in bank supervision and resolution, particularly with regards to at least one weak bank, and to cross-border supervisory practices; and (iii) the extensive agenda ahead for supervisors and regulators will pose serious capacity challenges.  
7. The development and regulation of non-bank financial institutions require further reforms. The insurance sector needs better enforcement of compulsory insurance; improvements in product disclosure standards; and resolution of small unprofitable companies. The 2004 pension sector reform was helpful, but coverage remains low. Legacy funds’ assets are yet to be transferred to Pension Fund Administrators. Although the Nigerian Securities and Exchange Commission (SEC) has made progress, more reforms are needed to further enhance oversight of the capital markets. The SEC has been without a Board since June 2012, jeopardizing its proper governance and functioning.  
9. Access to finance is an important constraint to Nigeria’s development. There is negligible intermediation to small and medium-sized enterprises (SMEs) by the formal financial sector. While the microfinance sector has undergone significant changes, it remains characterized by numerous small, financially weak and ineffective institutions. 
3. Bringing perspective to QE. David Beckworth points out that the Fed, yes, bought a lot of government debt in 2010-11, but they also allowed their share of Treasury debt balances to drop in 2008-09. In his view, the Fed is indirectly responsible for the ultra-low interest rates. If I understand him correctly, the Fed did not respond adequately to the spike in demand for money balances in 2008-09, and that that failure is behind the low interest rates.

David asks "Why are interest rates so low?"
The most obvious answer is that the monetary policy of the Federal Reserve is keeping them low. Many observers point to the Fed’s large-scale asset-purchase programs as the reason for the low interest rates. Others point to the Fed’s forward guidance on interest rates that says the target federal-funds rate will remain in the exceptionally low 0–0.25 percent range for some time. These observations have led some to conclude that the Fed is not only creating a drag on the economy with its low-interest-rate policies, but is also making it easier for Congress and the president to avoid tough budget choices and enabling large government deficits by reducing the Treasury Department’s financing costs. 
This understanding, however, runs up against three inconvenient facts. First, the Fed has not been dominating the Treasury market. At the end of 2012, the Fed held only 15 percent of all marketable Treasury securities, roughly the same share it has held over the past decade. This means that the largest-ever run-up of public debt was financed mostly by individual investors, their financial intermediaries, and foreigners. Second, the Fed’s forward guidance on interest rates is itself shaped by the Fed’s forecast of the economy. The Fed, then, is not independently shaping the future path of interest rates, but is responding to what it thinks will happen to the economy in the future. Finally, long-term interest rates on safe government debt across the world have fallen: Very similar sustained declines in government-bond yields have occurred over the past four years in the United States, the United Kingdom, Germany, and Japan, as the graph below shows. It is far easier to explain these declines as a function of a weak global economy than to attribute them to an overactive, all-powerful Fed.
David moves on to say that

The proximate reason, then, for the low-interest-rate environment is that the ongoing weak economy has stirred investors’ appetite for safe and liquid assets. Households, for example, continue to hold an inordinately high share of money-like assets, including Treasuries, in their portfolio of assets.
Households’ high share of safe assets should not be surprising given the spate of bad economic developments over the past five years: the Great Recession, the euro-zone crisis, concerns about a China slowdown, the debt-ceiling dispute of 2011, and the more recent fiscal-cliff talks. The immediate effect of these developments was to create uncertainty about future economic growth and raise the demand for money-like assets. This elevated broad money demand not only has kept interest rates low, but also has prevented a robust recovery from taking hold.
While this absolves the Fed of direct responsibility for the low-interest-rate environment, it does not absolve it for its indirect influence. Through its control of the monetary base, the Fed can shape expectations of the future path of current-dollar or nominal spending. Thus, for every spike in broad money demand, the Fed could have responded in a systematic manner to prevent the spike from depressing both spending and interest rates. In other words, the Fed could have adopted a monetary-policy rule that would have committed it to maintaining stable growth of total-dollar spending no matter what happened to money demand. A promise from the Fed to do “whatever it takes” to maintain stable nominal-spending growth would have done much by itself to prevent the money-demand spikes from emerging at all. Why hold a greater number of safe, liquid assets if you believe the Fed will keep the dollar value of the economy stable?

Simplifying, the two opposing views implicit in David's discussion are: 1. The Fed bough a lot of Treasury debt, thus keeping their prices high and yields low; 2. There was an independent rise in the demand for money, motivated by expectations of slow growth and by increased risk, and the Fed failed to counter expectations of depressed nominal spending.

I admit that I have not articulated a full-fledged response to David's views, but here hare a few thoughts:

1. The Fed's balances of Treasury debt do not matter for the determination of interest rates as much as the marginal purchases of treasuries, and the announcement of (possible, not even actual) future purchases.

2. Risk perceptions and risk aversion probably played a big part in the surge of money demand in 2008-09. The Fed did step in to assuage the markets. Although the Fed did fall short of targeting nominal spending, it is not clear to me how NGDP targeting would have been more effective than the policies that the Fed actually followed in regards to mitigating the rise in risk perception and risk aversion.

3. The Fed's policies in 2008-11 did probably suffer from the "pessimism problem," and it was not until 2012 when they got around it by targeting the unemployment rate. And it might have been better if they figured that out sooner. But can the Fed, really, steer the real economy one way or another, by buying more treasuries? Why would it make any difference if the Fed targeted NGDP instead of targeting the unemployment rate? In my opinion, the announcement of an intention to keep interest rates low for a long period of time had an effect on the prices of financial assets, but it made a difference on the real economy mostly by removing some uncertainty and instilling a bit of confidence. Having an objective, well-defined target was important, but the choice of target (NGDP, unemployment, employment creation, output growth, what have you) was secondary.

Here's David's blog post, and here is his recent piece on the National Review.

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