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A theory on China

Looking at credit charts makes you a China bear, and here is the one that usually scares people*.

private credit to gdp4 A theory on China

It is a scary chart! Increases of private credit/GDP of this magnitude has generally meant trouble, EM or DM. An increase of 38.0% since the lows in November 2008 screams ‘crisis’, in fact, as it is hard to imagine that much credit expansion without over-leveraged balance sheets, non-productive investments, and a possible Minsky moment, by which one has to take on debt to cover interest rate expenditures [other credit charts of China are equally scary. Here are two from Goldmanhere is one with EMs ranked, as always data is different from database to database!]

So are we going that way? My bet is no.

I wasn’t always this chipper about China. In fact go back six months and I thought the above mentioned chart spelled ‘doom’. I don’t anymore, and I can explain why with two charts.

First, as anyone who have studied the Asian Crash of 1997-8 will know, what made it close to inevitable was the combination of an overvalued currency (pegged) and huge borrowings in non-local currency denominated debt. Here is what I consider the best paper on that. This left the Tigers with the impossibility of remaining on pegged exchange rates, but if they devalued their corporate and banking systems would collapse (and they did). Can this happen in China, which also does some currency management? No.

external debt1 A theory on China

While short-term external debt has risen in dollars, as a percentage of GDP it has not (red line). This means that it is a very different beast we’re dealing with, insofar as China does not have to decide on its exchange rate on the basis of its banking and corporate balance sheets. Credit is mostly Renminbi denominated. So far so good (and absolutely nothing new here.)

The second graph that has me re-thinking my view on China is the credit/deposit ratio.

credit deposits 3mma1 A theory on China

While credit has expanded enormously since 2008, so has deposits. Why?

My theory (and I’d be very interested in opposite views) is that China’s credit story is different because of its closed capital account. China’s capital account is closed, and has arguably not been opened much since 2008. Here for example is a paper, “[studying] the renminbi (RMB) covered interest differential – an indicator of the effectiveness of capital controls. It is found that the differential is not shrinking over time and, in fact, appears larger after the global financial crisis than before. That is, capital controls in China are still substantial and effective.

In other words This Time Is Different because credit has shown up as deposits elsewhere in the system. This is both good and bad. Good because China is still a, errr, relatively authoritarian country and if the Chinese government decide to pull the plug on credit expansion, the credit can be repaid with deposits elsewhere in the system. Simple bookkeeping and China controls all entries. Bad because, well, where is that money? Is it places like here? Is it with LGFVs, which have just said, “we have done stimulus,” and then just done nothing with the money except depositing them somewhere in the banking system? If that’s the case then credit expansion has probably meant less in real life, and more in debt statistics. 

The crucial thing in my mind is just the fact that, because one cannot easily move money out of China, deposits actually have to show up somewhere when credit is created. This makes it (i) a whole new credit expansion story, and (ii) much more manageable.

This has policy implications, most notably that China should not move too fast liberalising their capital account, at least not before they are done tackling their credit situation. While money has stayed in China so far, it is not so certain that it would if China opened up. If money started to move out in spades, we could move closer to a ‘classic’ credit binge as the liability sides of balance sheets would have to be borrowed elsewhere. Nobody wants that.

[Update: I should add, as George Magnus made me aware, this does not mean that I think China will do great going forward. Their credit expansion will require a tightening cycle, and a big one, and growth will slow. I just think they have way more tools in the box than most any other countries before.]

* This theory is not at all original and you can find this kind of thinking elsewhere. This is just my write-up. Graphs are mine, though. Also again: data differs wildly in China so you can disagree with charts.

How the Bundesbank did not have ‘negative equity’ in the 1970s

Over the years I’ve heard many talk about the story the Bundesbank having ‘negative equity’ in the 1970s. Since that’s not exactly what happened I thought I’d post on this.

What happened was that the Bundesbank had a shortfall of reserves, i.e. they fell below the required level. This would, normally, lead to negative equity. Given, however, that it’s a bit awkward to have one’s central bank being technically insolvent they used a neat accounting trick.

Central banks distribute their earnings to the Treasury, where the amount depends on the state of the economy. Rules are different from country to country; sometimes it’s a fixed amount plus a percentage of earnings, sometimes it’s earnings minus operating costs, etc. [The Fed for example pay a 'voluntary transfer' to the Treasury.] This means that central banks have an equity buffer. It also means that if central bank have persistent losses that buffer can disappear. There are different ways to manage that, here for example is how the ECB does it:

In the ECB’s case, losses can be covered by appropriating the monetary income that would otherwise remain with the Eurosystem’s national central banks. This requires a decision of the Governing Council. To date, whenever confronted with such a choice, the Governing Council has always decided to cover the ECB’s losses with the monetary income of the NCBs, even when in some of these years the NCBs have also suffered losses.

That’s one way. What if central banks go through the buffer? Well that’s what happened in Germany in the 1970s. Instead of asking for an equity injection, the Bundesbank booked on the asset side of the balance sheet a reduction in future distributions of earnings. The Fed did the same thing recently:

The Fed has recently clarified that losses that lead to shortfalls in the reserves (the “surplus”) relative to their required level (see footnote 83) would be registered as an asset that represents the amount of the reduction in future transfers to the Treasury that is needed to rebuild reserves. With this practice, which is allowed by US GAAP (on the presumption that future earnings are sufficiently certain that the claimed value of the asset will be realised), accounting equity would not fall in the face of a temporary negative shock to earnings.

That’s what the Bundesbank did in 1970s, too. It’s not available to every central bank because not every central bank can retain earnings, is sure of having a positive income and so on, but there you have the story.

In fact, of  more colourful cases, we have Costa Rica (1980s), Peru (1980s), Thailand (after 1997), Hungary (1990s)* trying the same thing. The result was a little different, though. It’s not a trick for everyone.

Related reading:
What level of financial resources do central banks need? – BIS


* From the BIS: “In these cases, such treatments confused analysis of the underlying economic situation, and contributed directly to a worsening of the central banks’ finances by allowing continued distributions to the government despite significant and growing financial weakness.”

Probability the Danish krone breaks its ERM-II peg

The IMF is out with its review of how the fund did on the whole Greece thing. Joseph Cotterill has a good write up.

I’m still reading through it, but I do want to flack one thing. On page 32 is a proxy for stress in the eurozone:

Screen Shot 2013 06 05 at 9.37.48 PM Probability the Danish krone breaks its ERM II peg

This year’s best Valentine’s cards

First a history of why we celebrate Valentine’s Day. Here’s NPR:

Valentine’s Day is a time to celebrate romance and love and kissy-face fealty. But the origins of this festival of candy and cupids are actually dark, bloody — and a bit muddled.

A drawing depicts the death of St. Valentine — one of them, anyway. The Romans executed two men by that name on Feb. 14 of different years in the 3rd century A.D.

Though no one has pinpointed the exact origin of the holiday, one good place to start is ancient Rome, where men hit on women by, well, hitting them.

From Feb. 13 to 15, the Romans celebrated the feast of Lupercalia. The men sacrificed a goat and a dog, then whipped women with the hides of the animals they had just slain.

The Roman romantics “were drunk. They were naked,” says Noel Lenski, a historian at the University of Colorado at Boulder. Young women would actually line up for the men to hit them, Lenski says. They believed this would make them fertile.

The brutal fete included a matchmaking lottery, in which young men drew the names of women from a jar. The couple would then be, um, coupled up for the duration of the festival – or longer, if the match was right.

The ancient Romans may also be responsible for the name of our modern day of love. Emperor Claudius II executed two men — both named Valentine — on Feb. 14 of different years in the 3rd century A.D. Their martyrdom was honored by the Catholic Church with the celebration of St. Valentine’s Day.

Later, Pope Gelasius I muddled things in the 5th century by combining St. Valentine’s Day with Lupercalia to expel the pagan rituals. But the festival was more of a theatrical interpretation of what it had once been. Lenski adds, “It was a little more of a drunken revel, but the Christians put clothes back on it. That didn’t stop it from being a day of fertility and love.”

Around the same time, the Normans celebrated Galatin’s Day. Galatin meant “lover of women.” That was likely confused with St. Valentine’s Day at some point, in part because they sound alike.

And, with that image, here are (some of) this year’s best Valentine’s cards [although, to be fair, most are not from this year... they're still cool, though]:

game of thrones valentine cards image 097424987 This years best Valentines cards

Not even a paywall.. This years best Valentines cards

Headline This years best Valentines cards

on the record This years best Valentines cards

Screen shot 2012 02 13 at 4.35.34 PM This years best Valentines cards

Trending love This years best Valentines cards

From Mediabistro and In The Capital.

Here’s last year’s economists’ Valentines. Here are some tips from science. And, if all else fails – copy-paste this into google: (sqrt(cos(x))*cos(400*x)+sqrt(abs(x))-0.4)*(4-x*x)^0.1 (hat tip to David Keo)

When it’s okay to be friends

From Indexed:

Screen Shot 2013 02 08 at 9.43.21 AM When its okay to be friends

Quantum mechanics’ different schools

Here’s a good interview with Sean Carroll on the different interpretations of quantum mechanics. He’s in the Everett (many worlds) camp (the favorite being the Copenhagen).

He gives out a few Sheldon-like punches in it, too.

Here’s the paper mentioned: ‘A Snapshot of Foundational Attitudes Toward Quantum Mechanics‘. The abstract:

Foundational investigations in quantum mechanics, both experimental and theoretical, gave birth to the field of quantum information science. Nevertheless, the foundations of quantum mechanics themselves remain hotly debated in the scientific community, and no consensus on essential questions has been reached. Here, we present the results of a poll carried out among 33 participants of a conference on the foundations of quantum mechanics. The participants completed a questionnaire containing 16 multiple-choice questions probing opinions on quantum-foundational issues. Participants included physicists, philosophers, and mathematicians. We describe our findings, identify commonly held views, and determine strong, medium, and weak correlations between the answers. Our study provides a unique snapshot of current views in the field of quantum foundations, as well as an analysis of the relationships between these views.

It should be said that I don’t have a view nor expertise. Just a fascinating topic. A hat tip to Brad Plumer at Wonkblog for the video.

Related links:
The Most Embarrassing Graph in Modern Physics — Sean Carroll’s blog
Does probability come from quantum physics? — Climateer Investing
How to Teach Quantum Physics to Your Dog — Amazon, book by Chad Orzel

Hey there, credit genius

Matt Levine of Dealbreaker has a hilarious take on the S&P analyst who don’t need investor input to his model (his emphasis):

You don’t believe in reviewing your proposed criteria changes with investors? Why’s that? Is it because you’re so good at evaluating structured credit that investors have nothing to teach you? Then why do you work at S&P?

Hashtag burn.

Matt isn’t too hard on the S&P, though. Yves Smith over at Naked Capitalism, however, thinks the DoJ might have a case. If you want more, here’s Joseph Cotterill, part 1 and part 2. And the US vs. S&P doc itself.

‘The Art Collector’

N+1 Magazine has a story about ‘the Art Collector’. Here’s the intro:

It was 1997, or maybe 1998, when I first heard of the Art Collector. I was working as a research analyst at a large New York investment bank. The broker at our firm whose responsibility was serving the Art Collector told a gathering of the bank’s research analysts that the Art Collector’s hedge fund was now one of the top payers of brokerage commissions to the bank. He may have said the top payer. It was an awakening: a hedge fund, five or six years old at the time, could now pay as much—or more—in commissions than the mutual fund giants that had always been our most important clients. The math, however, was straightforward. The mutual funds had a lot more money. The Art Collector traded many more times.

Even if I had heard of the Art Collector’s hedge fund before then, I still would have been surprised by the salesman’s purpose that day. The Art Collector’s firm, we were told, would happily continue to generate huge revenue for the bank. It was asking for only one thing in return. It was not for us to do better research on companies or their stocks, or to do the research more quickly, or in greater quantities. That would be too literal. Or figurative. The Art Collector wanted something more abstract: not better information, just early information. When we interpreted an event in the life of a company, we distributed a note to all of the bank’s clients. We also called the more important ones to provide context difficult to fire as bullet points. We had to call one client first. Why shouldn’t it be the one that paid us the most?

Guess who? Steven Cohen of course. Great read.

However — if you read on:

I don’t think the Art Collector buys a painting of a flag for $110 million because it matches his couch.

Really, Steve? The Flag?

Flag JJ The Art Collector Oh… please let me advice you the next time you want to buy something of Jasper Johns’ and get you this:Map JJ The Art Collector

In Time as a proximation for our monetary system

Last night I watched In Time. If you haven’t, you really should. It’s a great movie, even if you think what I’m about to write is BS.

There are so many great analogies that I don’t know where to start.

The movie takes place in the future in which money is time. Everyone is born with a clock with one year on it, which starts at age 25. If you’re poor, you’ve probably borrowed before that (because food/housing/services cost time) so as soon as you hit 25, you live day-to-day. If you’re rich, then your parents will likely give you a lot.

The world is divided into zones. There is Zone 12 — where Will (Justin Timberlake) is from — where everyone is poor. If you have a month on your clock, you’re rich. In the other end of the world, you have Zone 4 (Greenwich) where a meal costs 5 weeks time. Indeed, it cost a month just to get into the zone (to keep poor people away). In between there are (supposedly) more average lives.

In the rich zone, everyone has more time than they will ever need. Meaning — they can live forever, since one doesn’t age after one turns 25. It’s a fancy, boring life where the only danger is getting one’s time stolen. The line in the movie, “why do today what you can postpone it?” captures the sentiment well.

In short, money is time. A couple of interesting features. The ‘time keepers’ are like the central banks. They regulate the time supply. If there is too much money in one timezone (the poor ones), then they’ll notice because they are likely to spend that time. Also, there is inflation. One day a cup of coffee costs 3 minutes. The next day it costs 4 minutes. Prices are set exogenously (presumably by the time keepers or the government/Zone 4 kinda people). The “dream of escaping” is there all over timezone 12, although completely unrealistic (they pay is something like 12-24 hours, so how is one going to get years worth to get to Greenwich?).

The movie tells a fascinating story, because it tells us why base money ≠ money supply. Why? Everyone in Zone 4 has an abundance of time — and of everything. The villain, a banker of course, has more than a million years, while Zone 12 lives day-by-day.

So let’s say that the economy is in trouble, and one would like people to spend more. The central bank (time keepers) inject more time into the economy. But how can they do that? Well, let’s say that they flush Zone 4 with money (ie the banks in our real world). Where does the money end up? In Zone 4 of course where nobody needs it and it will never leave the Zone — that is pretty much what has happened with base money that ends up at the central bank deposit accounts. If money is to leave the central bank accounts (Zone 4), then people must take it out of the system and give it away, as they don’t need it.

Base money is thus not equal to money supply, because the money supply that matters is the availability of time for the ones who need it. Now, an increase in money supply would create inflation (if everyone has 50 years, then why not spend a day on food?) while base money does not, since it doesn’t leave the Zone (central bank reserves).

Could the time keepers (central banks) and governments (those who control everything) change the world for the better? Yes, but they have a monopoly on earnings and power and won’t. Instead, they charge 20 % on loans making sure there will never be an uprising, but not enough to kill all. Supposedly to “keep the system running efficiently and for the good of the poor”. They don’t know what they want, anyway.

There is much more stuff in this movie, such as what is credit and money; collateral backed money (with your life); the idea of abundance in a world where many can’t feed themselves; monopoly power and patents for already-rich people/companies. Go watch it.

Further reading:
In Time — the Long Room (Izzy)

Merry Christmas!

Since I won’t make a video (yes, you’re welcome, World) — here’s FT Alphaville’s since they were a pretty big part of my year (and it’s awesome!):

Merry Christmas!