Predicting the Fed

The problem with best estimates is two fold.
One, the 'best-ness' criterion is contingent on the information available. So, new information can cause a previous “best” estimate to be a second best or worst estimate. (An extreme example would be, in a non-financial context, American foreign policy on September 10’2001. The next day’s events – led to wildly different prescriptions than most academics/policy wonks had anticipated.) So, the quanta, quality and timing of information is the key.

Second, the estimate itself is a result of some estimating method – an algorithm, a formulae – that econometricians call “estimators”. In essence, it is not just information that is relevant – but the method in which you process the information. It is entirely feasible, and relatively easy to show, that even with the most recent information using a wrong estimator can result in (a) biased estimates (b) unbiased but highly inefficient (c) biased and highly inefficient estimates. By inefficient, one means estimators that contain within itself the possibility of generating widely variant results as the underlying sample increases in size.

As you can imagine, getting oneself tied up in some subtleties is something that many participants on Wall Street have little time for, or worse, just find it plain useless. One of the biggest games is undoubtedly, inspired no doubt by Whack-a-Mole journalism in American media, is watching the Fed’s decisions on rate cuts. (Things are sometimes so absurd that, as Alan Greenspan writes, there are guys dedicated to watching the size of Greenspan’s briefcase!)

One of the well observed predicting markets is the Fed Fund Futures (FFF) market. The FFF is a futures contract written on the “average of the daily effective FF rate”. The FF rate is the rate that the Federal Bank of New York charges to federal fund brokers. The “effective” part in the earlier definition arrives from the fact, for any given day, different brokers who deal with differing transactional sizes, might be charged differently. So, the “effective” is the same as ‘weighted average’. A heuristic reason is that the Fed Funds market participants are likely to take into account all the factors that might affect the path of the interest rates that the fed sets. The rates implied by this market can be thought of as a first-order prediction. There are various issues – as of yesterday, the one month rates are given as below.

7-Oct 95.255
7-Nov 95.495
7-Dec 96.61
8-Jan 95.665
8-Feb 95.785
8-Mar 95.82
8-Apr 95.895
8-May 95.925
8-Jun 95.92

The implied 1-Month rates are given above.

The critical aspect is that the generic expectation is that the Fed will continue to accommodate and allow for a 4% rate over the next six months. i.e., 3/4 of a decrease in rates. Implicit in this expectation is

• Inflation, core or otherwise, will not be a problem. This, despite the clear trends to a 100$ barrel.
  
• The housing conditions will worsen -- i.e., when over 800billion USD worth mortgages are to be reset over the next two months -- expect a lot more defaults.
  
• The weakening dollar is not really something the Fed worries about. (How to reconcile rising import costs with its inflation hawkishness is a tricky question!)

I think, this will be a very difficult time for Bernanke and Co., primarily because with rising inflation (via oil, via imports, via China, via protectionist lobbies) and worsening labor markets -- the short end of the curve will have substantive volatility.

Again, my thoughts are that the demand for non-USD denominated assets will continue.

India -- Some Graphs

Sovereign Wealth Funds -- Behemoths at the DoorStep

With rising US current accounts deficits – resulting in increased demand for foreign denominated assets and foreign currencies, the pressures on the CNY, INR, BRL etc., is well known. Predictably, the sterilization (complete or incomplete) has led to CB intervening in the FX markets – selling their own currencies and buying foreign currencies (typically USD denominated assets). To put this accumulation in perspective, some numbers (in millions) are:

China: 1,334,590

Japan 907,346

Russia 407,495

Taiwan 266,287

Korea 250,667

India 220,223

Central banks (in the emerging markets) control over 5.6 TRILLION dollars of US denominated assets. There are estimates that more than 50% of the US current account deficit was financed by these Emerging Market Treasuries. This financing is slowly declining – because one of the, only (?), benefits of the present credit crises is that the US domestic savings are expected to improve, primarily because they are so far in the hole – there seems to be only one way to go! This financing is also slowly declining because the Central Banks have two primary options – opt for other “major” currencies (Euro, Yen) or opt for more risky ventures (like China investing in BlackStone, Norway’s Global Pension Fund, Dubai in global Ports etc.,) “Sovereign Wealth Funds” are explicitly mandated subsection of foreign Treasury holdings that act on behalf of the domestic Treasuries – and are more likely to invest in non-standard asset classes. i.e., they are likely to be the primary agents that drive the risk premium lower in the coming years across the globe. The size of the numbers being projected is beyond my comprehension (in any meaningful sense). Where are these risky returns like to come from? Potentially innovative financing deals and projects like those done by Macquarie!

In the FX markets, this diversification towards other asset classes and non-USD ‘majors’ is inevitably linked to a decline in the USD value. (one number thrown around is that around 1,200 billion USD is likely to move out of the dollar denominated assets!) I would very seriously look into buying global blue chips – since while still being “risky”, these will fit within the SWFs criterion of being “risky enough”. I would look seriously at global real estate – buy property in semi-industrialized nations.

The secret, I suspect, is to ride the coat-tails of the global central bank investment philosophy changes. The unspoken, unheard of elephant-in-the-room is the United States government. Excessive decline of the dollar, with no perceptible change in consumption/savings in the US, might result in, to use a Lou Dobbs phrase, “selling America to foreigners”.

In essence, I would not be surprised if 5 years from now, a Pulitzer prize winning non-fiction entry is solely geared to explaining the complexities and conspiracies that went behind the spectacular but ultimately unsuccessful management of the Dollar slide.

Carry and Roll-Down: back to the basics

Interest Rate Traders and salespeople talk about carry and roll-down all the time. It is useful to remember what they are talking about.

1. Upfront Carry:
1. For a 10-year receive fixed swap, the 1 year carry is the net present value of a 10-year swap less the net present value of a 9-year swap starting 1 year from now.
2. Upfront roll-down:
1. For a 10-year receive fixed swap, the 1 year roll-down is the net present value of a 10-year swap and less net present value of a 9-year swap today.
2. Typical documentation will have carry and roll-down for various swap lengths: 1M, 2M, 3M and so on. So a 1 year carry can be provided as 0.45 $ per 100 $ of notional or some other dollar convention.
3. Running Carry:
1. the Upfront Carry divided by the PV01 of the forward starting 9-year swap.
4. Running roll-down:
1. the Upfront roll-down divided by the 9-year swap starting today.
5. Actual Vol-adjusted Running Carry & Running Roll-down:
1. 1Y Running Carry divided by the actual volatility of the 1Y rate over the past 1 year.

How to Read the Quotes:

6. Notional Neutral Switch:
1. Typically quoted as where one receives fixed for the shorter rate and pays fixed for the longer rate.
2. If the expected carry and roll-down is 180bps on a 5s/30s – one should read this as follows. For an investor, who receives fixed on a 5 year swap 1mn notional and pays fixed on a 30 year swap 1mn notional -- expected profit is 180,000.
7. Duration Neutral Switch:
1. Typically quoted where one receives a short dated swap, and pays a long dated swap.
2. The notionals can vary here – such that the durations cancel out.
8. Butterfly:
1. Quoted as 2bps on a 3s/4s/15s. Read this as expected roll-down and carry as pay fixed on the 3yr and the 15yr, and receive the 4yr fixed rate.
   

Risk Aversion -- a pseudocode!

There has been much talk about risk aversion indices rising – indicating that investors are willing to hold to low yielding savings, cash or cash-equivalents instead of high yielding investments. In essence, as the Mafia says, investors have been hitting the mattresses.

Standard global indicator of risk aversion is the EURCHF – with the CHF being the currency of choice when currency investors are unsure of their immediate next move. So, any R.A.I must be correlated to EURCHF. The biggest puzzle however has been that volatility of the difference in returns between stocks and bonds is greater than the volatilities of consumption or t-bill yields. So, what could explain this? One conjecture has been that risk-aversion is a time-varying factor. i.e., Investors at different times in the business cycle demand different risk premia. This has been the thrust of research since at least Lucas (1978). So how to capture this number for risk aversion?

The generic modeling structure has been as follows:

1. A fictional investor has a utility function with consumption as a variable and risk aversion and discount factor as constants.
2. This investor has intertemporal budge constraint – where delayed gratification is the theme. i.e., decide to consume today or consume tomorrow by investing in risky asset.
3. Maximize the expected utility subject to this constraint and arrive at equilibrium conditions for consumption, S&P 500 returns, t-bills returns and risk aversion parameters.
4. The equilibrium conditions capture a fictitious state where marginal cost from investing today in risky asset is matched by the marginal benefit of consumption tomorrow.
5. Assume t-bill returns and S&P 500 returns are normally distributed.
6. Using market data for returns, using root-finding algorithms, solve for the discount factors and risk aversion.

For times of the year, solve for the risk aversion numbers. So, ideally as risk aversion numbers rise, one should observe the EUR-CHF to decrease (i.e., Swiss franc appreciates).

Microfinance Bonds! - Liberal Goals through Conservative Means!

Following the mortgage backed securities which ended up as the underlying payment stream against whose stream of payments commercial paper was issued – prior to the credit crunch – there is a generic aversion today to getting deeply involved in that whole rigmarole again. But, innovation and profits are the life-blood and élan-vital of modern finance. So, bonds backed by microfinance lending are here to stay. Famous CLOs backed by loans to microfinance institutions who in turn lend to thousands of really poor individuals. For eg., see BlueOrchard. The exact fate of such CLOs, in wake of the credit crises, is unclear. Nevertheless, I suspect, this is an instrument that is here to stay.

A key issue here is what are the risks involved in such a setup. i.e., when does repayment risk amongst the really poor kick in. By and large, those individuals who qualify for microfinance are those whose income patterns are only marginally affected by business cycle fluctuations, unlike the middle class. In contrast, the real risk comes from weather extremes, failure in governmental subsidy programs etc., So the crash of the NASDAQ or the Sensex barely affects the villagers in Guntur, Andhra Pradesh – but the increase in rationed rice and sugar prices due to governmental policies will affect their income and repayment abilities. So, the bonds/CLOs issued by Wall Street can be a useful market mechanism tool with governmental subsidies to alleviate poverty!

However, one interesting observation is that many of the borrowers borrow from various lenders. i.e., they might borrow from the microfinance initiative offered by ICICI Bank, by World Bank, by Bill & Melinda Gates Foundation etc. Naturally, this raises the issue of what are the likelihood of payments being made out. One my friend from college, Karuna Krishnaswamy, has written a pretty interesting paper on this phenomenon. He argues that those who end up borrowing from various sources – actually end up having a better payment record as opposed to the single source borrowers. The exact reason is conjectural, and I suspect, untraceable to a single factor.

For those who will eventually model these things, the level of complexity has been increased by an order of magnitude. Typical prepayment structures in the Mortgage world grapple with the issue of a single stream being pre-paid. In contrast, in the MFI backed bonds – any single borrower can decide to prepay one stream over the other!

Awesomely technical challenge!

Revaluation of the Yuan...

Given the generic consensus at the G7, US Congress, Rest of the World barring for Sudan and Myanmar that the Yuan is under-valued against all global majors, particularly the USD – it is a question of when, rather than if at all, the Yuan will be revalued. Given the smooth change of guard at the Communist party meeting – it seems fairly certain that the Yuan will be revalued, perhaps not as much as the Treasury officials deem necessary, but in the “right” direction. What does this do to global trade flows?

Some preliminary conclusions/thoughts/conjectures are:

1. The econometric evidence on the contributions exchange rates make on competitiveness, productivity investments and thus, trade surplus in China is too varied to really be of much use in a week-on-week assessment.

2. One estimate is that the Yuan is undervalued anywhere from 0-50%! Assuming it is 50%, and all other costs remain constant, a 50% revaluation (entirely unlike) will affect varying sectors of the economy differently. So, prices observed in the imports will change according to the demand elasticity for given price change. So, in the countries that import low-complexity Chinese commodities -- pencils, mousepads etc., -- there will be a substitution effect in display.

3. Standard trade theory predicts that as Yuan is revalued, the level and growth rate of the Chinese exports should decline. However, it is important to note that most international trade contracts are 6-12 months set in advance. So a container of toothpaste to be delivered at Seattle port set at 1USD, will make the Chinese exporter temporarily better off. In contrast, US exporters of products invoiced in Yuan, will be worse off given the new USD-Yuan rate. The trade deficit numbers will do exactly the opposite as Washington expects in the two-three month period. (The opposite of a J-Curve observed during a devaluation.)

4. What a Yuan revaluation does to non-USD currency majors – is very much contingent on the competition for products in domestic markets and in third-party markets.

5. The supply change management in place for goods to and from China is a well-oiled machine, and changing trade flows will take longer than perhaps one anticipates. There are economies of scale in place and productivity gaining measures in place – that the willingness to abandon China as a primary sourcing place is unlikely to change all that much. Of course, the trade deficit numbers will seem more palatable for political purposes, but whether a substantive quanta of imports declines is unlikely.

6. All of the above assumes the Chinese will continue to produce as always. Then the improvements in the Yuan will provide the results Washington wants. But, all that is unrealistic. If the pricing pressures increase on Chinese products, then it is silly to not expect them to improve their productivity.

7. The most understudied aspect is that when the Chinese exports decline (and thus their income declines) – the effect on goods imported to China. It is easily conceivable that services from India and Europe can replace services and goods offered by the US. The elasticity of Chinese imports to income changes is perhaps the most important, and unclear, aspect of this whole issue.

Now what? When revaluation happens, for a short while the USD will rise, Euro will fall against the USD and the Yen will rise as well (if the USDJPY tracking of 6M USDCNY forwards are to be trusted!).

But, in the intermediate term after the revaluation we will be back here -- singing the same tune.

USD vs Other Major Trading Currencies

In the picture above, I have plotted three weighted indices against the US$. (The weights and their calculations are given here.)

• Major Currencies: The indices in pink are a weighted average of Euro, CAD, YEN, GBP, CHF, AUD, SKK.
• Other Important Trading Partners: The indices in yellow are a weighted average of China, Mexico, Korea, Taiwan, HK, Malaysia, Singapore, BRL, Thai, India, Philippines, Israel, Indonesia, Russia, Saudi Arabia, Chile, Argentina, Colombia, Venezuela.
• Broad: The indices in blue are the entire basket of the two.

These countries have been selected as those that have more than ½ % in 2003 in either exports or imports. The first group (pink) is those currencies that are traded extensively outside their domicile. The second group isn’t traded extensively outside their own markets.

What is most amazing in these numbers is the presence of clear volatility regimes in place. The daily standard deviation of these indices are given here:

Dates	Broad Index	Major Currencies	OITP
2nd Jan ’07 to 16th Mar ‘07	0.357%	0.612%	0.230%
19th Mar ’07 to 19th Jun ‘07	0.766%	0.933%	0.646%
20th Jun’07 to 19th Oct ‘07	1.261%	1.853%	0.792%

Some conclusions:

1. The credit-induced crises of confidence have led to increased volatility in the FX markets.
2. The broad reaction has been – flight to safety. i.e., with respect to the Major currencies, the USD has been a “risky” holding. However with respect to the OITP, the USD depreciation has been lesser than expected – partly because the USD continues to be seen, on average, as a “safe” currency.
3. The OITP depreciation masks wide variation – where Venezuela has done substantially differently than India against USD.
4. Coupled with G7 consensus that Asian currencies should be “allowed” to get stronger – the OITP will be where the most diverse kind of action will be.

What does this portend for the future? My guess is that till the US economy picks up – the dollar slide against the Majors will continue. This is further aided by the Treasury’s policy of letting the dollar slide. The coming revaluation of the yuan will make this a really interesting group to think about. Need to think about this a bit more.

Rethinking portfolio allocation at El Paso, Texas.

This is a season of the “immigrant” as a piñata for the sons of the soil.

In an interesting summary of how silly some of the statistics being touted around in the immigration debate is, Christopher Caldwell has furthered my suspicion at publicly bandied about numbers. This following Marc Faber’s report filled with his own suspicions on the meaningfulness of government statistics – I must confess, I am more pessimistic than last week about “key figures” quoted. Watching the US politicians debate for the Presidential primaries convinces me in the sagacity of the old Benjamin Disraeli line, “there are three kinds of lies: lies, damn lies and statistics”.

Although I didn’t agree with Caldwell’s argument that when talking about immigrants, one must concentrate on their contributions to GDP per capita – the underlying message that one ought to debate the utility of immigrants in any society within an economic framework, as opposed to a cultural, is a wise remark. This is so, because other aspects like cultural compatibility, understanding of ‘core-values’ etc., are provably true or false – depending on who is mining the data.

With regards to illegal immigrants, research has been sparse -- although an exceedingly elegant summary of the complexities is here. The key issues that any study must answer vis-à-vis immigrants are:

• The effect of immigrants on wages – the average and the marginal labor.
• The distributional impact – i.e., does the wage distribution tilt asymmetrically.
• The tax contributions the immigrants make.
• The impact of immigrants on resources within a society (hospitals, schools etc.,)
• The relocation centers of immigrants. i.e., do they choose Virginia over Montgomery?

All this said, one could say “show me the money”. i.e., how does all this enable one to think about where to invest? I have great faith in the intrinsic ability of masses to weed out irrelevant information and identify that what matters at the end. Survival! Surviving today for yet another day. Illegal immigrants in the United States are perhaps the starkest example of that. Undereducated, without documentation and limited employment opportunities. Their choices of locations and industries are directly connected to the amount of food they consume, the anticipated monies they expect to earn and the growth potential in monetary terms. Not withstanding the legitimate concerns about security and income dynamics -- I think, one must have the humility to learn from their survival skills. Like migratory patterns of birds can predict the deterioration in quality of their homing grounds, the migratory flow of illegal immigrants can enable investors to learn more about “unsexy” industries like construction, fruits and vegetables, waste disposal amongst others. For those seeking to diversify, and find value in firms in these sectors -- I believe, thinking about illegal immigrant movements might be a useful indicator. Illegal immigrants predict, I believe,

1. The changing contours of growth-patterns in non-tradeable American goods and services industries.
2. The areas of US where economic decline is anticipated. So, for eg., short industries with sales focused in say, Alabama and Georgia, and go long on industries with sales in Washington and Oregon.
3. Given the fact that illegal immigrants ear 2 to 30 time their home wages in the US, an obvious ‘wealth effect’ is to be observed. Thus, invest in industries that cater to their needs: cola, beer, gambling, wire transfers, auto parts manufacturers, super-stores etc., In the coming years, it is fairly clear, that one is likely to see more illegal and legal immigrants in the US – with the tacit consent of various industries – despite the goose-stepping propagandists on the Right and the Left. These industries thus have a growing consumer base with growing needs.

So, perhaps we'll soon see labor economists being hired on Wall Street!

Contract types and Financial Cycles.

Weekends, like war, are filled with long stretches of the mundane and brief moments of the unexpected. That said, there are few moments of fun as well. Like this blog entry about arranged marriage that I stumbled upon. In her own charming way, she writes about the razor’s edge that arranged marriages can be. The stolidity of this type of marital institution is an historical fact; but perhaps the material conditions in which such a marriage flourished are changing. I don't know. Perhaps, the uneasiness lies in the modern belief that love and marriage can be found within the same institution. If not this marriage, then Hallmark and Cosmpolitan promises you it in the next one. The irony is that I spent this weekend reading about securitization (particularly about asset back commercial paper market) by Vinod Kothari. One of the early remarks he makes is that marriage is one of the oldest relationship contracts, as opposed to innumerable “friendships” that we find in modern society that can be thought of as transactional contracts. The degree of replaceability of buyers-and-sellers of contracts, the sunk costs involved in arriving at a trading decision etc., distinguish such contracts. While for humans I am convinced that ‘relationship contracts’ are better; for financial markets ‘transactional contracts’ have been a stupendous blessing. These market mechanisms allow you and I to buy and sell stocks, participate in the fortunes of publicly traded companies etc., without necessarily being privy to a specific information or part of some restricted group of people. However, the flip side has been that ‘transactional contracts’ (exemplified by the securitization) business has led to innovation, and with innovation comes possibility of excessive profits. Lured by this specter of excessive profit comes easy credit. Soon, entrepreneurs, con-artists and revolutionaries all agree on one sole idea – this time it’s different. Thereafter, human, all too human sentiments follow like clockwork: greed, hype, irresponsibility, disaster and finally despair. Till yet another cycle begins, perpetuates and finally dies out. The best read on the inevitability of such bubbles and busts is still the one by the late J.K. Galbraith.

Ahab and Sea Freight Prices...

In the past few weeks, there has been a surge in the number of commentators claiming that recession is near, including Julian Robertson. The primary reason is ostensibly the credit crises – with data from the ABX (credit quality indices that track housing mortgages) tranches of the lower most quality trading at their historical lows. Funds that presently are long on the lowest-quality tranches and have exposure to the underlying, the housing market, via CDOs will basically have to incur serious capital losses – or just fold. Fair enough, big banks will have to buckle their belts and spending on corporate jets will fall.

But, is this portentous for a coming recession or decline? Or worse, does it matter that the US might be hit – if you hold an emerging markets portfolio? The Baltic Index (for shipping) has been a chartbuster and over the past few days the tonnage has shot through the roof, measured by freight forward agreements. The Baltic Indices have hit their historical highs – with indices tracking grain, sugar, coal and other iron ores. (See Reuters – story code QnL 19672363) The underlying theme is that demand for commodities, minerals and other long-dated shipping containers continues to be pushed up by China, India and other emerging behemoths. The increase in demand means: (a) demand for US dollar increases while making payments (b) demand for domestic currencies increases while making international trade payment for value-added exports. Which will dominate? Can India create and sell to the world value added products that result in a net increase in the demand for rupees? Therein lies the rub, as the bard says.

The decoupling of global demand, vis-à-vis, the US economy is here to stay. (To wit, read this. )And the generic trend is towards appreciation of emerging market currencies. Three key factors will contribute to short term reversals and volatility:

• Political trouble resulting in a flight-to-safety!
• Correlation spikes between thickly traded emerging market countries – resulting in portfolio reallocation en-masse.
• Ham-handed policy response in response to FX appreciation. (Participatory notes, anybody!)

In essence, two years from now -- the present set of emerging market exchange rates will seem comically undervalued against the dollar!

TIPSy on Inflation

The TIPS (Treasury Inflation Protection Securities) , like Canada's Real Interest Bond, has a constant coupon declared at issuance -- but over the life of the bond, the principal is upward/downward adjusted as per the inflation numbers. An interesting point of comparison between numbers is the following:
On the run TIPS bonds -- a 5 year issue has a coupon of 2% while a 10 year issue has a coupon of 2 5/8 %. On the run Treasury Notes -- a 5 year issue has a coupon of 4% while 10 year issue has a coupon of 4.25%. Why does the TIPS offer a difference of 62.5 bp as opposed to 25 bp offered by the Treasury Notes?
One conjecture is that perhaps 5 years from now, the bond market is pricing in a reduction in inflation (thus decreased adjustment in the principal component) and thus decreased demand -- resulting in an increased inflation premium to hold onto the 6Bn., dollars worth TIPS issued. If indeed China is expected to increasingly export its inflation, then over the next two-three auctions the 10 yr TIPS must trade at a smaller coupon. Concurrently, the demand for the off-the-run TIPS must increase and the present holders should lockin a nice capital gains!

Chronicle of a Capital Control Foretold?

In India today, there seems to be a cloak-and-dagger game at hand between the export lobby (“real” economy) and the financial markets (“monetary” economy) – in so far as capital controls are concerned. The appreciation of the rupee against the USD has threatened to bite seriously into the profits of the Indian exporters. This is particularly true of the small manufacturers, as it is, compete tooth and nail with the Chinese, Malays etc., in the manufacturing sector. Predictably, this interest group wants the government to “do” something to stem the dollar slide. Predictably, a throwback to the eras gone by, one hamhanded response has been to force FIIs to register with the SEBI – this is an old Indian (bureaucratic?) trick. If in doubt, drown them in paperwork. Given the obvious daftness of this effort to control global capital surges and retreats, the next best thing seems to be issue “capital controls”. i.e., devise mechanisms by which FIIs can participate in the Indian equity markets only through very limited, thus rationed (thus corrupt) schemes.

The financial markets are very much against this – and they claim that capital controls is completely the wrong way to go. The rupee appreciation is a reflection of the increased exporting strength of India – and the appreciation is a self-correcting way to correct for emerging imbalances. No doubt, the appreciation affects the Indian exporter – but profit and loss in an industry is hardly the place for governments to intervene. Further, the Indian exporter is hardly the constituency that needs to be salvaged by government programs like NREGA. On the contrary, the government must create programs/schemes to incentivise productivity improving mechanisms. Exchange rate appreciation is perhaps a blessing in form a curse – at least in parts. The government should use this "faith" imposed by global financial markets -- to make radical changes.

All this said, the Indian government is on a back-foot (note, cricketing term!) and after the nuclear debacle and the Communist party’s rhetoric about alternative “development paths” – one shouldn’t be surprised against imposition of moderate to weak capital controls over the next two months. In essence, prepare for a convulsive fortnight in the equity markets, take your profits and hit the mattresses.

An excellent interview with Dr. Ajay Shah here.
(There might be an advertisement early on.)

CDS on Sri Lanka!!

Last week, Sri Lanka issued its first international bond for $500 million. Predictably, a CDS market has evolved – with the 5 yr CDS trading at 360 b.p. I am not sure if there has been any study that decomposes this spread into: (a) Sri Lanka’s abilities to repay given increased hikes in domestic rates and decline in economic growth locally (b) sustained international risk-appetite? Theoretically, CDS is equivalent to a bond financed with an hedge on it -- thus making it an unfunded deal (can you see that?). Thus, CDS premium is compared to a asset swap -- and not to a bond's spread on the treasuries. More loosely, in cases like Sri Lanka where an asset swap market are not known to trade actively, CDS premiums tend to lead Bond premiums – and given the highly volatile political and economic climate – there can be substantial divergence in the intermediate term spreads quoted in the CDS and the Bond market. Typically, the CDS premia are on average higher over time than the Bond risk-premia. This CDS Basis (i.e., strictly speaking CDS Basis = CDS spreads - Asset Swap Spreads) can fluctuate substantially -- and Sri Lanka should be no different.
Things that make the CDS Basis tighter:

• Other Credit Products launched on Sri Lanka. (Pretty Unlikely)
• Decline in Civil War (Unlikely)
• If Credit Quality improves and Sri Lanka has any reduced coupon clauses. (Unclear)

More thought is required, but if Sri Lanka is met with success -- one could see a rising increasing in issues/CDS from "really small open economies".

Does FII sway Domestic Equity Markets?

Yes. No. Maybe... says IMF. Using high-frequency data, some of the conclusions are:

• FII inflows into a domestic markets (16 emerging markets) has no statistical significance on domestic equity prices.
• Herding (measured by autocorrelation) is observed on longer terms (around 20 days) as opposed to short term (around 1 week). i.e., Investors chase returns in cases where there is a clearly observed profit taking opportunity. Is this because large investors actively influence opinions -- on Bloomberg chats or other trading information circuits.
• Causality is difficult to determine. i.e., Does inflow volatility cause returns volatility? Or is it the other way around?

Participatory Notes... an Introduction.

Yesterday, the Indian equity markets had a over 7% decline. The ostenible reason has that the SEBI (Securities and Exchange Board of India) issued a recommendation (position paper) to the Finance Ministry that Foreign Institutional/semi-Institutional Investors, or their sub-accounts, shouldn't be allowed to issue participatory notes where (a) derivatives are the underlying (b) the notional value of the participatory note is greater than 40% of assets under custody. It is useful to recap what participatory notes are in this context. (From the Hindu Business Line)

Participatory notes are like contract notes. These are issued by FIIs to
entities that want to invest in the Indian stock market but do not want to
register themselves with the SEBI. FIIs registered with the SEBI and their
sub-accounts can issue, deal, or hold P-Notes. The underlying security against
these notes would be listed or proposed-to-be-listed securities on any Indian
stock exchange. FIIs issue these notes to investors abroad with details of
scrips that can be bought and expected returns over specific periods of time. If
the client agrees, they deposit the funds with the overseas branch of the FII.
Then, the Indian arm of the FII proceeds with the transaction, buying the
scrips in the Indian market and settling it on its own account. The details of
the ultimate investor are not revealed at all in the Indian market or to the
SEBI. The SEBI rule, however, says that P-Notes can be issued only to
regulated entities (in any country). Further transfer of these can also be made
only to other regulated entities. FIIs are not allowed to issue P-Notes to
Indian nationals, persons of Indian origin or overseas corporate bodies (which
are majority owned or controlled by NRIs). This is done to ensure that the P-Note route is not used for money laundering purposes. FIIs are required to
report to the SEBI on a monthly basis if they issue, renew, cancel, or redeem
P-Notes. The SEBI also seeks some quarterly reports about investing in
P-Notes.

It is unclear whether re-routing of laundered money is that big a concern to warrant this move? According to Arun Kejriwal, it is! and as per Tushar Poddar of Goldman Sachs (India Views, October 17 2007. Available at https://portal.gs.com/), it is not.

Sources of China's Inflation... A Menu

Chinese aggregate output distortions has lead to a disequilibrium in the food sector which has thus affected the core-CPI measures. From a proverbial "bigger picture", there are three categories into which one can source these fluctuations into: Bio-environmental, Structural and Monetary.

1. Bio-Environmental: Whether this be the massive dust-storm or porcine disease or avian flu or environmental degradation -- the chain of events are fairly similar. In the short term, there is a spike in demand by consumers, anticipating a decline in supply (thus worsening the actual shortfall) -- coupled with hoarding and supply chain mismanagement --. (See pictures.)
2. Structural: The intervention of the State-planners in financing and investment decision (the prototypical infinite horizon, infinitely lived Planner at work) results in suboptimal allocations. Given this mismatch between agricultural output, capital expenditure and urban agglomeration -- over the intermediate to long term, the decline in productive usage of resources is inevitable.
3. Monetary: This is perhaps the most obvious and easiest to "fool around" with to induce distorted outputs. See this, for a basic example -- and the temptation to increase output is particularly relevant when the size of the sacrifice ratio (loss in output to obtain a permanent reduction of 1% inflation) is high.

Policy makers can most easily affect #3. To affect #2, it involves a substantial change in the political climate -- and to affect #1, a societal commitment is required. To varying degrees of satisfaction, China has predictably decided to tackle #1, #2 and #3 simultaneously. The flip side to this multi-pronged tackle is that the cost of getting things wrong is a rise in the number of events characterized by disequilibriums. (Bubbles in Food, Asset, Housing etc.,)

Politically Calibrated Chinese Overheating?

Is there a coincidence that the quinquennial Chinese Communist party meetings are underway this year -- and concurrently over the past six months -- one has observed the decline in the sterilization ratio by the Chinese central banks? (As per Tim Bond of BarCap (no link available), this ratio has fallen to around 34%. i.e., sterilization ratio = balance of payment surplus less outstanding governmental bond sales). As Krugman and Obstfeld tell us, increased pressure on the currency to appreciate can be met by selling more domestic currency and thus accumulate foreign reserves. The rise in domestic currency must be met with sale of government bonds -- resulting in reduction in outstanding monies in the hands of the "real" economy. The incomplete sterilization that Tim Bond reports on starkly has contributed to increased growth, albeit from a monetary side and ignoring Professor Bob Lucas's writings, which has in turn led to a creeping inflation.

Following Professors Alesina & Summers -- see page 4 of following link -- it must come as no surprise that we have seen a gradual relaxation of the monetary conditions given the pressures in the year of the Communist convention. Given the obvious conflicts between varying factions (globalizers, isolationists, Hu Jintao type communists, old fashioned Communists etc etc., ) -- it is imperative that the political powers that be must have a "vibrant" economy to push through their candidates over those proposed by other factions within the power struggle!

Lowered US wages & Current Account

Counterfactual exercises are fun.

In an interesting what-if paper, the authors ask what are the effects of a zero Current Account balance on some key variables of interest (nominal, real and relative wages, share of manufacturing, exchange rates etc.,)

To achieve a Current Account balance, their primary "adjustment mechanism" is the Manufacturing Trade Balances(ceteris paribus). Using an iterative root-finding algorithm, they arrive at the numbers required for Manufacturing Balances to fall or rise which would cause the CA = 0. Then, they ask what does this rise or fall in Manufacturing balances mean for real and relative wages, as well as share of manufacturing. All of this is done using (a) a variant of the Dornbusch-Fischer-Samuelson within a General Equilibrium model (b) parameter estimates from rest of the literature.

The results are interesting. Other than the US, all the other Major countries end up needing an increase in nominal wages. The US in contrast must have a 7% decline in wages in order for the current account balances to go to nill. Reasonable, but different, parameters lead to a nominal decline around 17% -20%. In contrast, if wages are held constant -- the a USD depreciation of around 10% is required for the Current Account balances to hit zero.

From the looks of it, this is a work in progress -- and perhaps Professors Dekle, Eaton and Kortum will be modifying it further. A self-admitted critique is that they perform a standard comparative static exercise, i.e., adjust one variable holding all other variables constant and then measure impact -- so caveat lector.

Given the stickiness of wages, the only perceivable channel through which current accounts hit nill are through the exchange rates. Given Washington's "talk strong and let it slide" approach to the USD -- any month on month improvements in the US current account deficits must come through the dollar's slide. However, since current account deficits reflect other mid-to-long term trends (political uncertainty, productivity etc.,) -- changes in CA deficits, I suspect, predict the intermediate and longer trends of the USD (attributable to "real" factors like exports and imports) -- over and beyond the daily ups-and-downs (attributable to speculative capital flows).

It would be interesting to test if lagged changes in current account have any predictive power on the realized exchange rates.

A subtle critique of the above hypothesis is: whether the current account changes can be trusted to predict the trend in the dollar's movement. This is primarily because the USD has a very low (compared to other OECD) exchange rate passthrough (% change in import prices in response to a 1% change in exchange rate) of around 0.42 (with the 1975-2003 data) . Resultantly, a declining dollar might still not affect the net balances of the current account observed.

Failure of Expected Current Account Moves...

A depreciation of the dollar should, at least theoretically, to decline in imports. However, it might not be borne out by reality. The primary reason has to do with the fact that the US has a lower exchange rate passthrough (percentage change in import prices to a 1 percentage change in exchange rates) than most OECD countries. The key issue is why does the US have an e.r.p (around 0.42 with the 1975-2003 data) that is lower than most other OECD countries. Two reasons, amongst others:

1. By choosing the USD as a "vehicle" currency to invoice -- i.e., the sale price is fixed in USD for the importing country -- when the dollar depreciates, the sale price remains fixed in the US currency and the depreciation eats into the producer's domestic profits. Thus, this doesn't necessarily result in a decline in imports via the price mechanism.


2. Given the assymmetric position that the US holds in the global economy (and popular imagination), when it comes to the US the producers may willingly accept lower profits. Also, given the presence of widespread substitutes available -- the exporters to USD prefer to have lower profits today than give that market share away.

Of course, in recent months -- the USD imports have declined -- but, it is useful to read this and keep the generic case argued here in mind.