Neoliberalism: Oversold?

From the IMF: interesting references to the chilean experience in restricting capital movements, an example of success in combining markets with appropriate regulation.

Hey, China and partners: are your international reserves adequate?

From my post at The Long Room, Financial Times Alphaville

FX Reserves in China decreased by USD 94 b to USD 3,557 b in August, the highest   monthly fall on record, the biggest fall in percentage terms since May 2012. While falling commodity prices, several other emerging market and low income countries have experienced drains in their international reserves too.

Sensational headlines aside, what matters is assessing how adequate FX reserves are as a country insurance against external shocks.

Rules of thumb for measuring FX reserves levels adequacy have been in use for years. Best known among them are:

• the 3-month import minimum as a cushion against foreign trade collapse; 
• the short term one year residual debt, known as the Greenspan-Guidotti rule for mitigating the market access risk; 
• the combination of both above plus the projected current account deficit, intended to reflect the full potential 12-month financing need;
• the, also arbitrary, 20% of broad money (M2) as a proxy for protection against the risk of capital flight.

Some newer approaches include the cost of holding reserves into the picture, therefore changing the question from what is an adequate level to what is an optimal level for a country´s FX reserves. Unfortunately they are very dependent on stylized modeling assumptions and calibrations which jeopardize possibilities for their practical use.

The IMF developed a new methodology (2011, 2013) to assess reserves adequacy which suits the need of practioners very well. It built upon older measures by offering a metric which weights the different sources of FX reserve drains.

As if it were a risk weighted capital ratio for assessing a bank´s solvency, the IMF established a minimum, adequate level of precautionary FX reserves for a given country. Weights are suggested for Short term debt (STD), Portfolio Liabilities (OPL), Broad money (M2) and exports (X).

Since the exchange rate framework matters during an event of FX market pressure, weights are lower for countries under flexible exchange rate regimes.

_______________________________________________________________

IMF international reserves adequacy metric

Minimum expected outflows during exchange market pressure events

Fixed ER:   30% of STD + 15% of OPL + 10% of M2 + 10% of X

Floating ER:   30% of STD + 10% of OPL + 5% of M2 + 5% of X

________________________________________________________________

The IMF suggests that the adequacy requirement is met as long a country’s reserves lie between 100-150% of the metric defined above

When applying the IMF benchmark to China, those now diminished current levels are still 32% above the estimated cushion to cope with exchange market pressure. Minimum adequate FX reserves would be USD 2,702 b.  

The same metric applied to a China-exposed emerging country like Chile results in a similar 30% comfort margin:  IMF-metric, USD 29.3b as compared to USD 38.1b of current international reserves.

Indeed, both China and Chile have access to IMF contingent credit facilities. They both also hold Sovereign Wealth Funds which are in part kept as precautionary reserves for macroeconomic stabilization purposes, so they could eventually provide extra liquidity should that be needed from outside their own central banks.

Here comes the Yuan

From my post at The Long Room, Financial Times Alphaville

Last week our Central Bank in Chile signed a bilateral swap arrangement for RMB 22 billion with the People’s Bank of China (PBOC). This was the 31^stamong similar agreements reached by the PBOC with other central banks - (total over RMB 3.1 trillion) - but it is the first in Latin America which has included a quota   for private qualified locals wanting to invest in RMB.

The PBOC policy of bilateral central bank swap arrangements would allow the building up of Renminbi deposits in foreign central banks. Those swap deposits, according to IMF guidelines, ‘are treated as reserve assets because the exchange provides the central bank with assets that can be used to meet the economy’s balance of payments financing needs and other related purposes’.

That is why countries suffering international reserves stress like Argentina have been active users PBOC facilities, favoring trade ties with China.

Indeed, neighboring Chile is in the financial behavior antipodes of Argentina in regard to FX adequacy and external solvency. Thus, the PBOC strategy has aimed far beyond relying on FX stressed trading partners. Its target is to become an international reserve currency.

So far, it is almost there. The use of the Renminbi in money market instruments in the Bank of International Settlements increased from US$0.9 million in the 3rd quarter of 2010 to 29.56 billion in the 2nd quarter of 2014. The Renminbi is already the seventh largest reserve currency. It ranks 9th in the amount outstanding of international debt securities (East Asia Forum, Feb. 2015).

Moreover, it is known that at least 23 central banks received qualified investor status, hold RMB assets - (and/or CNH, the “off shore RMB” that is) - as part of their international reserves:

The list comprises all geographies:

·                     Australia, Hong Kong, Indonesia, Japan, South Korea, Macau, Malaysia, Nepal, Pakistan, Singapore and Thailand

·                     Austria, Belarus, Norway, France and Lithuania

·                     Bolivia, Chile

·                     Ghana, Kenya, Nigeria, South Africa and Tanzania. 

Ultimately, the RMB should reach the SDR currency status during the IMF review due this year. This after the “freedom of use” criterion as it is comprised in the set of requirements for broadening the SDR basket currencies be met - (i.e. ‘widely used’ and ‘widely traded’ clauses are satisfied).

The RMB admission as a fifth SDR currency would further consolidate current central banks diversification, strengthening demand for RMB with potentially big portfolio reallocations, some RMB appreciation and less USD-RMB correlation over time.

We should welcome the new reserve currency since transactions costs, international trade and capital movements would benefit development from the SDR status. It would be desirable that the PBOC take this new status opportunity to improve transparency on its COFER reporting to the IMF, the currency composition of their own international reserves, that is.

Lending carnival

Public banks in Brazil

 Published at The Long Room, Financial Times Alphaville

A Spanish version available at America Economía

Increasing fiscal deficits and a higher chance of downgrading of its sovereign ratings are main factors behind the recent pledges of austerity on lending plans by public banks in Brazil. Finance Minister Mantega announced a 20% reduction on lending by BNDES next year, shortly after the IMF warned Brazil on the rapid expansion by its three major state owned banks.

BNDES (long term financing of development projects), Caixa (housing loans) and Banco do Brasil (rural credit) boosted their lending 25% per annum on average in 2011 and 2012, compared to 10% of private banks (domestic and foreign). They enlarged their books further this year, overtaking private lenders participation, reaching 50.7% share of the USD 1.09tr market.

As reported by the IMF´s mission last October: 

 “The substantial credit expansion in recent years by public banks has been financed significantly with transfers from the Treasury. Since the global financial crisis, the Treasury has provided subsidized direct lending to public banks, mostly to BNDES"

“The fiscal cost of government lending has also increased as the long term interest rate the rate public banks pay on obligations to the Treasury was reduced by 100 bps to 5 percent during 2012, with the lower rate applying to all outstanding loans”.

For those so called Sustainable investment loans, nominal rates are still as low as 3.5% while 12 month inflation is a higher 5.8%.

Government and IMF concerns added to earlier action by Moody´s when it lowered BNDES and Caxias’s ratings by two notches, to Baa2 last March. The deterioration of core capital indicators was a key factor in the downgrading decisions; however public banks were still in compliance with minimum regulatory Tier 1 requirement of 5.5% of capital adequacy, reflecting the usually healthy performance of a fairly young portfolio in its rapid growth phase. 

Brazil´s case illustrates very well the typical tension the development banks are subjected to: even if loans were not subsidized and fiscal costs were negligible- (often not the case, indeed) - the pressure to use lending as a development policy tool conflicts with banking supervision standards and prudential rules. This is especially so when government-promoted loans would perpetuate beyond what either counter-cyclical or market-failure motives would justify.

For the sake of financial soundness, Brazil is rightly signaling the need to curb public lending expansion. However, still needs to address implicit subsidies in government funded loans at negative real interest rates. The latter harms the efficiency of investments- (e.g. projects developed on the grounds of artificially cheap funding). 

As stated in the recent OECD recent country report when suggesting a desirable phasing out of BNDES lending to large corporations:   

“The development of private credit markets has much potential to relieve credit constraints and improve the allocation of credit”

As important as allocation efficiency, below market interest rates in public lending are also unfair - (e.g. the more you manage to borrow, the more you gain). Interestingly enough, 69 % of BNDES loan portfolio is concentrated in the 60 nation´s biggest corporations.

As much as financial crisis may burn tax payers’ money when rescue formulas are implemented to bail out private financial entities, public banks represent a potential fiscal destabilizer as well. Several developing countries have suffered from the fiscal burden of bad lending with honorable purposes, most notably by public but poorly regulated development banks and agencies. 

A case in point we learned first-hand in Chile: when the Chilean CORFO shut down its direct lending operations in the nineties, the best bid received in the auction of its old portfolio was a meager 12.8% of the face value. 

Since suffering from such an adverse policies, many development banks have moved from direct to on-lending. Chile pioneered on-lending schemes : long term funding was auctioned to, and then channeled through, private commercial banks, the latter absorbing the credit risks while the public bank or agency might provide some partial collateral to certain small commercial borrowers. As reported for Latin America, these reforms, together with the public provision of advisory and other services to small-medium scale borrowers have resulted in better performance of commercial loans in recent years. That is why, credit boosting through public direct lending as reported in the Brazilian case, represents not only a fiscal threat but a step back in improving development banks´ good practices.

As an analyst phrased when commenting the OECD report: “Brazil's wasteful state bank can learn from Chile”.

www.juanfoxley.com

Nobel laureates, market timers and pension funds in Chile

Published at The Long Room, Financial Times Alphaville
A Spanish version available at America Economía

A quick riddle: which of the following quotes corresponds to a strong believer on market efficiency, someone who thinks asset prices are always right (and if they were not, who are you to tell). – Or, if you will, which one comes from an efficiency skeptic, one who found that price volatility cannot be explained by fundamentals alone and bubbles are around the corner.

Nobel laureate #1:

“It’s not easy to make a lot of money fast, and that you can go for years losing money, even if you’re a very smart person”

Nobel laureate #2:

“If they know – (how bad the market is in setting absolute prices) - they should be rich men. What better way to make money than to know exactly about the absolute level of prices”.

“The problem is that, almost surely, expected returns vary through time because of risk aversion, wealth, everything else varies through time. But measuring that requires that you have a good variable for tracking (risk aversion) or good models for tracking it. We don’t have that”.

If understandably, you have not figured out yet, the additional quote would give you the answer:

Nobel laureate #1:

 “Well, Gene and I have a lot in common, more than you might think”.

Indeed, Eugene Fama and Robert Shiller may disagree on the need for the authorities to monitor asset valuations and regulate aggregate risk exposures. - However, they share a common view: regardless of how efficient the market is, nobody can systematically beat it, especially in the short run. So, no room for gurus within the bounds of licit information rules and practices. Just a tiny room for, both hard working and lucky, alpha seekers.

The case for active management is the main casualty of the above mentioned consensus. -  The paragraphs below offer a brief illustration using the Chilean pension fund system as a fresh case of the futility in advising active portfolio management.

The defined contribution´s pension system in Chile features five possible portfolios to choose from for both compulsory and voluntary savings of future pensioners. - Each portfolio allows for a different asset class composition: the riskiest, 80% max. held in stocks; the safest, 95% min. held  in money market, fixed income.- Although there are some restrictions to move into the riskiest funds to those near the age of retirement, the majority is free to move from one portfolio to another at a negligible fee.

Since 2012, concerns rise that an increasing number of contributors start to follow cheap advice from non-regulated investor counselors, the result being a boost in portfolio shifts and some subsequent disruptions in both stock and fixed income markets. 

As it turned out, the number of savers shifting to and from the riskiest pension portfolio peaked just during the days after specific recommendations were issued by a local ´guru´. Eventually, the authority issued further regulations to discourage market timing. 

Most interestingly, it was found out that six out of the eleven recommendations delivered by the referred ´expert´, proved wrong. - Indeed, that is slightly worse an outcome than failure chances when flipping a coin.

Others results came from research on pension affiliates’ moves from one fund to another between 2012-2013. - They did poorly. 

• Almost two thirds individuals ended up gaining less than the least profitable of the five existing funds (bought high, sold cheap).   
• As for the rest,  21% performed as well as one of the original portfolios and; 
•  Only 13% outperformed the most profitable among the five existing portfolios. 

Chile: effective annual returns to market timers in pension funds

(Real rates; ap. 2012-mar. 2013)

Real return bracket	Percentage of those who shift
Above the best existing passive portfolio	13.5%
Within range of existing portfolios [2.5%-4.1%]	21.6%
Below the worst existing passive portfolios	64.9%

Source: Superintendencia de Pensiones

Moreover, when following up on each individual original position, 77% of those who decided to move ended up worse off than not doing so.

Indeed, nowadays there is no need to be a Nobel disciple to learn that market timing is generally naïve, usually self-destructing.                                                     

www.juanfoxley.com