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That is the end of quite a forgettable year, but with a better than expected ending and probably with a even better outlook for the new year. If I had to choose the ‘one’ thing to look out for in 2010, it would be the ‘Exit Strategy’. With the monetary and fiscal stimulus measures already in place for more than a year now, central banks and governments have now started contemplating about a timely exit.

 

Given that the recession has ended, and that inflationary pressures are showing up along with very high public debt levels (signaling even more inflationary pressures) the argument for an exit is very strong. Countries like Israel, Australia and Norway already started their hiking cycles few months back and the pressure is building amongst others and the obvious question of ‘How and When to Exit’ is going to be the most sought after topic in the coming year. Let me try tackling the above question in parts.

How?

The government can either start consolidating its finances as public deficits and debts continue to blow up or start raising the interest rates as a monetary policy stance. The current as well as projected debt levels are so high for some countries that it might look imperative for the governments to act on the fiscal policy first. And the moment political pressures get built up on the central banks to monetize this debt level, the central banks would keep on consuming (read ‘buy the debt’) thereby adding to further increase in money supply and hence huge inflationary pressures.  

But fiscal policies are sometimes deemed ineffective largely stemming from its lack of flexibility. Fiscal tightening would often hit the roadblock of political compulsions and you would seldom find a government opting for one when its parliament is due for elections soon. Moreover, a change in a fiscal stance, be it curbing expenditure or say a raise in tax would always have to wait till a new budget is due to be placed. Monetary policy on the other hand is far more flexible as central banks have the option of reviewing the state of the economy every month and take a decision. Though it is not fair to believe that monetary policy would not face the similar political roadblock, but central banks in general try to be independent, pursuing their own macroeconomic policy objectives. At this juncture, it is quite reasonable to expect the central banks to act first, as the fiscal stimulus packages would in any case soon expire and is not getting renewed in most of the countries. Fiscal adjustments would happen keeping political compulsions in mind and would come at a much later stage.

When?

This is probably the tougher of the 2 questions. In order to avoid a ‘W’ shaped double-dip recession most countries would want to see the last, and allow for the accommodative monetary and fiscal policy as long as possible. However, a loose monetary stance can translate into inflationary pressures and as well as fuel more asset price bubbles. On the other hand, accommodative fiscal stance would lead to excessively high public debt levels. It is thus going to be very tricky to ‘time’ this exit. Central banks, mostly being inflation targeting, would look out for signs of recovery in the domestic as well as the international market, and eventually start hiking the benchmark rate in 2010, but reaching a political consensus prior to that is probably even more crucial.

Posted by Rajarshi Majumdar at 7:21 AM | Permalink | Comments (0) | TrackBacks (0)

In some of my earlier posts, I talked about how the big banks and institutions continue with their old business practice, royally oblivious of the fallouts of their devious business practices. Why banks, even the rating agencies have also failed to learn the lessons as much. Or maybe they are simply turning a blind eye on the likely impact of the recession and dollops of bailout packages on government finances. Since Greece is passé, here I will discuss about two countries, Spain and Ireland which still enjoy very high rating despite their economy being in shambles.

Spain – A country that grew by leaps and bound aided by the global credit glut and driven by the surging real estate sector to unreal(istic) levels (as has been the case with many countries), Spain experienced its Minsky moment as the world spiraled into a recession. During the 3^rd quarter of 2009, when most of the European Union countries climbed out of recession, Spain’s economy shrank, for the sixth straight quarter. While the latest decline of 0.3% is not too bad as compared to some other economies, but the country is in real big trouble. An unemployment rate of 20% (possibly next only to Latvia) is unbearable. More so, if one considers the fact that at one point in time Spain was one of Europe’s top job creator. As per one estimate, Spain has lost about a million jobs in the real estate sector alone. These are mostly for unskilled workers, and it is highly likely that most of these jobs are lost forever. According to their National Statistics Institute (Nacional de Estadistica), Spanish home mortgage lending dropped 31 percent year-on-year in October, as banks continued to restrict credit.

 

Even its finance is in a mess. According to IMF (World Economic Outlook forecast as of October 2009), Spain’s budget deficit for the current year will be around 12.3%, because of dipping tax revenues and the mounting costs of combating the economic crisis. The government has funded public works projects aimed at reducing joblessness, along with unemployment benefits, car buying incentives and other measures that it hoped will help restart the economy. But things are clearly not working. For 2010, the deficit is expected to rise to 12.5%. Clearly, the deterioration in the public finances, which have swung from a budget surplus in 2007 to a deficit of over 10% of GDP, is forcing retrenchment. As a result, the government has planned to raise taxes. This, I think is going to adversely impact the potential recovery, as domestic demand will start to falter. Hence they would necessarily need to depend more on exports to bring the economy back on track. An analysis of Spanish export destinations show that virtually 75% of their exports are accounted for by the EU. A lot, will, therefore depend on how soon and how fast their trading partners recover. I feel that the recovery would not be strong enough to positively impact the economy to the extent desired.

 

Despite such huge economic imbalance, Spain’s sovereign rating is still AA+, with a negative outlook.

 

Ireland – The Celtic tiger is hobbling and how. The high growth rate (at times at 10%) that the economy experienced from 1995 till 2007 has transformed Ireland from being one of Europe’s poorer countries to one of the wealthiest. As the economy grew stronger on the back of fast rising exports, wealth increased manifold. And then, as has been the case with most of the countries, real estate boomed as if there was no tomorrow, and propelled the economy even higher. And then the crisis hit the economy big time and the energy of the tiger was sapped. The economy entered into a recession. Starting from Q1 2008, the economy shrank in 5 out of 6 quarters (QoQ). During the last quarter the trend has been reversed, but only just. In YoY terms, however, the economy shrank the 7^th straight quarter. For the year as a whole, the Irish GDP is expected to shrink by 6.4%, while the GNP is likely to go down by as much as 10.4%. Their current unemployment rate is as high as 12.5%.

Even if Ireland emerges out of recession, the growth will be so slow that it might not look like any recovery at all. And, to put it mildly, government finances are in tatters. IMF’s forecast of Ireland’s budget deficit for the year is 12.1%, which will grow to 13.3%. However, the country has recently announced certain steps that can bring down the deficit by about a couple of percentage points. This includes a saving Euro 4 billion in this month's budget for 2010 by drastically reducing public spending, even going to the extent of reducing salaries of the employees in the public sector. Despite this, the deficit will be well above the cap of 3% that every EU member must necessarily adhere to.

 

A country that was given up as a no hoper enjoys very high rating for the high growth recorded only during the 12 year period. Despite the current financial vulnerability, Ireland still enjoys a long term rating of ‘AA’, though with a negative outlook. Not even China enjoys this luxury despite their high growth for more than two decades.

Posted by Kunal Kumar Kundu at 2:26 PM | Permalink | Comments (0) | TrackBacks (0)

Today there was a news article in the paper, which quoted the Chinese commerce minister boasting about China overtaking Germany as the biggest exporter in the world. Latest available data do confirm that and this indeed is a great achievement. A closer look at the data reveals that China actually overtook Germany middle of last year (2008) and has been exporting consistently higher except for a single month in February 2009, a time when each country in the world was competing against each other on negative YoY export growth reeling from a slump in external demand. Infact China posted the 13^th consecutive monthly negative YoY growth in exports last month. This year China is expected to end at a world export share of more than 10%, meaning that on a comparative scale the fall in China’s exports is far less than the others. The emergence of China as a global exporting goliath has been a much watched and anticipated phenomena and there have been wide criticism about the Yuan peg and how undervalued the currency is. However, I have a couple of questions corollary to this.

1)      What about Imports? The answer is even more striking. China has surpassed Germany here too emerging as the 2^nd highest importing country in the world, with a share of around 7.5%. This is still less than that of US, which accounts for more than 12% of what the world imports. But, while the difference in the import shares between China and US was 11.2pp during October 2005, it now stands at 2.7pp in July 2009. In the year 2009 alone, China’s share in world imports have multiplied from 5.5% in Jan 09 to 9.3% in July 09. All of a sudden, China is showing tremendous appetite in consuming world exports and is managing the slack in external demand, contributing significantly towards the developed country’s recent trade balance improvement. But Chinese imports too were falling for the past 12 months, but saw a huge jump in November (27.4%YoY), again meaning that on a comparative scale the fall in Chinese imports were much lesser than that of the world.

2)      And then China’s trade balance? That is going to be tricky as both exports and imports have fallen commensurate to each other.  The data too shows haphazard movement and the trend in unclear, though little bit skewed towards a fall in trade surplus.

But then the argument on the peg on Yuan probably is a little weaker now. So far the developed countries cried foul as cheap Chinese goods continued to flood their market but if China’s such appetite for imports continue to remain strong that would be in the favor of developed countries.

Posted by Rajarshi Majumdar at 8:53 AM | Permalink | Comments (0) | TrackBacks (0)

A financial risk model by definition is required to measure and manage risk as per its defined objectives. Due to churn in business and employees taking more roles and responsibilities, sometimes the poorly documented model create problems for its new owner. The problem gets magnified during its validation as mandated by the system.

While developing or inheriting a new or existing model, it is a good idea to first understand the purpose of the model and the key metrics it is suppose to drive. Primary questions to ask - when were original metrics set and what were the guidelines for its calibration. Do not confuse with model calibration here. What we are discussing here is model performance metrics calibration.  For example in online fraud detection model, we may have a model calibration done quarterly for setting a score cutoff (say <450) for flagging a transaction for review. On the other hand, in model metrics calibration, we would expect the risk manager discussing about addition of new key metrics or calibration of existing metrics or a combination of both.  However do note that model calibration does impact the model performance metrics which are monitored regularly.

Another aspect is the clearly defined frequency when each performance metrics is to be calibrated. Some metrics gets obsolete with changing nature of the business hence derived metrics should be looked at. For example, typical metrics for an Online Fraud Detection Model are False Positive Ratio (20:1, meaning 20 alerts investigated to catch one fraud), Number of frauds caught per month, and Dollar averted per month. These metrics can further be enhanced to track other relevant metrics such as:

1. Cost of fraud detection per case

2. Top 10 riskiest customer activity by dollar loss

3. Ratio of Actual Loss / Potential Loss. This may require defining the underlying attributes for Actual loss and Potential Loss. For example, Actual Loss can be correlated with Gross Loss and Potential Loss can be correlated with:

• Risk Ranking of each customer activity based on risk associated with each category of activity being derived from historical data (volume and value)

• Asset value of each relationship customer attacked and detected/undetected by the model

The key is to define the model performance metrics with calibration and frequency guidelines in place during model development. The guidelines get updated along with model components. However the risk manager needs to be careful while stretching the model metrics as the existing model may not support the new set of metrics hinting that it is probably time to enhance the model.

Posted by Manoj Pandey at 6:04 AM | Permalink | Comments (0) | TrackBacks (0)

Foreign Exchange Reserves, though primarily serves the purpose of stabilization of a country’s exchange rates, is now increasing seen as a messiah to overcome a global crisis like the recent one. Various empirical evidences show that countries with higher level of reserves are better able to withstand panics in global financial markets and sudden reversal of capital flows. Anecdotal evidences even suggest that the countries with very high reserve base (viz. India and China) would actually wither the recession faster than any others. During periods of extreme uncertainty, reserves can be used to pay off short-term debt obligations or for that matter even purchase of essential imports.

Today, foreign exchange reserves accumulated by the developing nations (especially Asia) is at a all time high (albeit lower in the past few months, as countries have increasingly used it to stop any further depreciation of its currency). The 8 Asian countries (China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan and Thailand) have witnessed meteoric rise in their holdings of reserves in the past 25 years and currently (end Nov 2009) holds a cumulative amount of USD3.4trn, same as that of the size of the German economy. The amount is much higher than each of the country’s short-term debt amortization and 6 months of imports.

The obvious question is why? More because, most of these reserves are invested into risk free instruments with sovereign guarantees, which yields almost nothing and thus comes with a huge opportunity cost attached with it. People argue that this is because of the self-insurance that the country wants to subscribe to, during recessionary times.

I concur. And I take you back to the 1997 Asian crisis in support of this.

During the month of July 1997, when the asset prices started crashing, there was a sudden reversal of capital flows and all the domestic Fx markets were flooded with local currencies thereby hugely depreciating it. During H2-97, the currency depreciations were Indonesia – 83%, Thailand – 53%, Korea – 46%, Malaysia – 45%, Philippines 32% and Singapore – 19%. All the central banks thus had to intervene in order to provide emergency support to their currencies. 

The cumulative reserves for the worst affected countries during the month of July 1997 was around USD250bn, and in the succeeding 3 months, the total drop in reserves were by USD50bn (nearly 20% of total). This shows the desperation from the countries to help stop their currencies get devalued further. Not to forget that intervention in the Fx market was not the only instrument the central banks had used, they had also simultaneously raised their interest rate to very high levels. Bank of Indonesia maintained its benchmark rate at around 60-70% during this time. Such interest levels actually added to the woes and the impact on growth were severe. The heavy depreciation of the currencies also meant a huge rise in the foreign liabilities of these countries, when expressed in domestic currency terms causing bankruptcies and further deepening of the crisis.

Figure 2: % drop in the immediate 3 months

The important thing to note is that such huge depreciations happened in spite of the huge reserve outgo. Obviously there seems to be room for more dilution of reserves as hardly around 40% were used in the worst cases (Philippines and Korea), but reason why the central bank stopped any further fall was the level of short-term debt and amount of essential imports during that time. The below table would prove this.

	End 1996		End 2008
	STD/Res	Import Cover	STD/Res	Import Cover
China	0.1	9.1	0.1	20.6
Korea	2.3	2.6	0.8	5.5
Malaysia	0.4	4.0	0.3	6.5
Philippines	73.1	0.1	7.1	0.2
Thailand	1.3	6.2	0.2	7.3
Indonesia	1.9	5.0	0.02	4.6

Source: IMF, BIS and central banks

It is evident that for a country like Philippines, whose short-term debt obligations (maturing within 1 year) was 70 times the reserve it had at that time, and there was no way it could have used its reserves than the 40% it already did. Leaving aside China, for all the others, even before the crisis stepped in, the short-term external debt was much higher than what they have in reserves with their central banks. The scenario is completely different now though. Unprecedented rise in reserves has now given a much needed ‘feel-good factor’ to these countries and accordingly they are better prepared for any such repetition of a crisis.

It is evident that these countries have piled up their reserves just to insulate themselves from any external shocks and the earlier theory of maintaining a level to account for the short-term debt repayments or essential imports (or current account transactions) doesn’t hold good anymore. The above table confirms a much better scenario for these countries, though the level of reserves is far too high, than the threshold/comfort level, but central banks would still like to enjoy the luxury as well as security, albeit paying a price. They still enjoy an insurance cover, can raise the sovereign credit ratings, provide higher stability to their currencies, and above all have a self sustained bailout package, which can avoid a repeat of the 1997 crisis.

The Asian Tigers have every reason to roar!

Posted by Rajarshi Majumdar at 4:37 AM | Permalink | Comments (0) | TrackBacks (0)

India's Q2 FY'10 GDP number released some time back surprised me on the upside. However, I was not quite convinced about the data.

Firstly, the government appeared to be too optimistic about the agricultural sector,  strangely assuming that the agriculture growth rate in the quarter will be about 0.9%. However, in a year when the monsoon deficit has been 23%, the highest since 1972, and when drought has been declared in 299 districts during the monsoon itself (a record by itself), there seems to be an anomaly. Let’s look at what history has to say with regard to how the foodgrain production in particular and the agriculture sector in general was affected when monsoon played truant with India.

For this I looked at the agricultural performance data from 1970-71 till date and looked at how the performance panned out during periods of deficit rainfall. It is important to note that prior to the deficient rainfall experienced this year, there were 4 years when the rainfall was deificent by about 20% and above. Virtually during all these years, there was a massive drop in agricultural performance.

Period	Gr. rate in agri	Gr. rate in foodgrain pdn	Rainfall deficit
1970-71	7.1%	9.0%
1971-72	-1.9%	-3.0%
1972-73	-5.0%	-7.7%	24%
1973-74	7.2%	7.9%
1974-75	-1.5%	-4.6%
1975-76	12.9%	21.2%
1976-77	-5.8%	-8.1%
1977-78	10.0%	13.7%
1978-79	2.3%	4.3%
1979-80	-12.8%	-16.8%	19%
1980-81	12.9%	18.1%
1981-82	4.6%	2.9%
1982-83	-0.3%	-2.8%
1983-84	10.1%	17.6%
1984-85	1.6%	-4.5%
1985-86	0.3%	3.4%
1986-87	-0.4%	-4.7%
1987-88	-1.6%	-2.1%	19%
1988-89	15.6%	21.1%
1989-90	1.2%	0.7%
1990-91	4.0%	3.1%
1991-92	-2.0%	-4.5%
1992-93	6.7%	6.6%
1993-94	3.3%	2.7%
1994-95	4.7%	3.9%
1995-96	-0.7%	-5.8%
1996-97

Posted by Kunal Kumar Kundu at 1:34 PM | Permalink | Comments (0) | TrackBacks (0)

Try Austria.

 

Immediately after the Dubai incident, I mentioned in my blog that while the incident in itself is not as important, it does reflect the deeper malaise afflicting the global financial market and is merely a tip of the iceberg. Immediately thereafter, Greece and Portugal were put under rating watch due to severe financial strain and Greece was downgraded, for the second time during the year by S&P, from A- (which incidentally was a downgrade from A in January 2009) to BBB+. Even the new rating can be downgraded further.  

 

With forecast for fiscal deficit being doubled from 6% (as given the previous government) to 12.7% of of the GDP, and a debt to GDP ratio expected to hit 126% by 2010, the downgrade is a no brainer. Not surprisingly, it’s Credit Default Swap (CDS) spread increased from a low of 100.27 basis points (BPs) to 267.72 BPs. What is even more disturbing is that their banking sector has huge exposure to Eastern Europe, which is a highly vulnerable region. The Greek banks have close to USD 57bn exposure this region out of total exposure of USD 101 bn (source: BIS). Not surprisingly, the ratings of their major banks have also been downgraded.

Recently the Austrian government has nationalized the insolvent bank Hypo Group Alpe Adria (HGAA). The financial institution, which has 40 billion Euros in assets, is the country’s sixth largest bank. The announcement came after a deal was reached for HGAA's owners – Bavaria's BayernLB bank, Austrian mutual insurer Grazer Wechselseitige and the province of Carinthia – to contribute over a billion Euros (1.46 billion dollars) to the troubled bank. Last month, the group announced that massive risk provisions (more than € 1bn) would wipe out the capital injections it received from the Austrian state and shareholders over the past 12 months.

 

“Increased risk provisions and the expected impairment at HGAA will weigh significantly on… earnings in the fourth quarter. It is not yet possible to quantify it exactly, but it can be expected that as a result of these effects, the group will report a loss of well over €1bn,” BayernLB said in a statement.

 

According to the Austrian Finance Minister Josef Pröll said the move was necessary to save the country’s sixth largest bank from bankruptcy. "The risk situation of this bank has created an enormous threat for the Republic of Austria, Austria as a financial centre and the entire economic area in the past days and weeks," said Pröll

 

And why not? The Austrian banking sector has now become quite vulnerable, given its huge exposure to the Eastern European economies, whose purely credit driven scorching pace of growth resulted in disastrous consequence during the current recession.

The total exposure of the banking sector to the Eastern European economies (at about US$ 224bn, as per BIS or Bank for International Settlements data) is more than 60% of the GDP. And the exposure in all developing economies taken together, it is around 65%. Clearly we have not heard the last about rescue act carried out on the Austrian banks.

 

Austria’s budget deficit is likely to clock 4.3% of GDP this year, and is expected to go upto 5.5% in next (2010) and 5.8% in 2011, as per OECD estimate. With an external debt that is more than 200% of the GDP, the Austrian economy remains susceptible to downgrade. Not surprisingly, the CDS spread of Austria’s sovereign bonds are moving up quite fast. Currently it is as 85.3, more than 30 basis points above its September low of 54 basis points.

Posted by Kunal Kumar Kundu at 11:53 AM | Permalink | Comments (0) | TrackBacks (0)

Savour these:

1) In the third quarter of 2009, delinquencies hit 6.25% of mortgages in the US – about three times the historical norm

2) A recent study McKinsey research found that the recession has changed the US consumer behaviour as more and more of them are opting for cheaper products

3) Retail sales for November actually fell from the month before, according to the International Council of Shopping Centers. The drop of 0.3% is a far cry from the minimum 5% growth the experts expected. Four out of five retailers missed their forecasts, including Macy’s (down 6%), Abercrombie & Fitch (17%) and Saks (26%)

4) Last weekend, another six US banks failed. This brings the yearly total to 130. This will cost another USD 2.3 billion to FDIC’s - a coffer that’s been empty for months now

3) Bernanke has put a spanner of all hopes of a strong economic recovery by stating that despite the recently released better unemployment numbers, the recovery would be painfully slow and he does not foresee any change in their interest rate stance

4) Given the experience of earlier recessions, the unemployment rate in US is unlikely to have peaked (refer to refer to my recently published article in Dalal Street Journal). It might take several months before it peaks and then start to decline as jobs start getting created. Not surprisingly, Bernanke said the U.S. economy still faced headwinds and unemployment could stay high for some time, playing down the impact of last Friday's stronger-than-expected jobs report

5) The global economic and financial crises may be close to an end but the fiscal crisis in a number of top-rated countries could last for "several years," ratings agency Moody's Investors Service said today. Moody’s Investors Service said its top debt ratings on the U.S. and the U.K. may “test the Aaa boundaries” because their public finances are worsening in the wake of the global financial crisis

6) Fitch Ratings cut Greece's debt rating to BBB+ from A- with a negative outlook, the first time in 10 years a major ratings agency has put Greece below an A grade, citing fiscal deterioration in the euro zone's weakest member. The cut followed a Standard & Poor's report that Greek banks faced the highest risks in Western Europe

7) Recently, S&P's has decided to put both Greece and Portugal on negative watch. Coming in the backdrop of the Dubai crisis, this lends credence to the belief that the crisis is far from being over and has the potential to implode elsewhere in the globe

Reads like some sequel of exorcist, eh?

Posted by Kunal Kumar Kundu at 9:33 AM | Permalink | Comments (0) | TrackBacks (0)