WHAT’S ON YOUR MIND? Thoughts From EconoMonitor’s Dolan, Hugh, and Deliveli

Numbers Manipulation – Motive, Means and Opportunity
-Ed Dolan (Ed Dolan’s Econ Blog)

I have been thinking about some important parallels between the Libor scandal and the failure of ratings for structured securities. The parallels arise from the existence, in both cases, of the motive, means, and opportunity to manipulate the numbers for private gain.

The means and opportunity arise from the fact that neither Libor nor ratings are objective reports of past events. Compare them, in that respect, to numbers like exchange rates or the outcome of T-bill auctions. The latter are reports of transactions that someone actually carried out. Libor and ratings, instead, are reports of transactions that someone thinks could possibly take place—borrowing that a bank could undertake if it wanted to in the case of Libor or future fulfillment of a financial obligations in the case of ratings. If someone says that something could happen, is that what they really think, or not? There is no way to check.

The motive for manipulation comes from two sources. One is the fact that the values of many financial instruments are pegged to these numbers. For example, the value of an interest rate swap changes as Libor changes, and the value of a credit default swap changes as ratings change. The other motive comes from regulatory reliance on the numbers. Banks (Barclays in particular) thought they could relieve regulatory pressure if they reported an ability to borrow cheaply. In other cases, financial institutions knowingly bought overrated securities so that they could indulge their appetite for risk while minimizing regulatory capital requirements.

With motive, means, and opportunity aligned in so tidy a fashion, is there any wonder that fraud took place?

All this makes one wonder about a different category of numbers that move markets, numbers like unemployment and inflation rates. Those, in principle, are objective reports of past events, unlike Libor or securities ratings. However, unlike exchange rates or T-bill prices, outsiders cannot easily verify them. The raw data are not easily accessible; and even if the raw data could be verified, the methodology of deriving the final numbers could be subject to manipulation.

Observers of emerging market economies, such as Argentina or China, frequently express doubts about reported inflation rates and other data. So do many people in the United States. Anyone who has ever blogged about inflation or unemployment rates is used to a hailstorm of comments along the lines of “Gummint lyin’ to us again!”

So far, though, most economists think our government number crunchers are doing an honest job, as best they can, given the inherent methodological difficulties and the budget constraints they face. (In support of that view, check out various bits of Congressional testimony Keith Hall, posted here. Hall was Chief Economist of the Council of Economic Advisers from 2005 to 2008 and Commissioner of Labor Statistics from 2008 until earlier this year.)

I hope this professionalism lasts. If we learned from some whistleblower that the BLS had falsified a jobs report on the eve of an election, we would have a scandal that would make the Libor manipulation look like a tempest in a teapot.


Deposit Flaw
-Edward Hugh (Don’t Shoot the Messenger)

According to ECB Governing Council member Josef Bonnici, speaking on Thursday, the recent central bank decision to reduce the deposit rate to zero is a good move since it offers an additional incentive for the banking system to look for alternatives to stashing money at the ECB in order to improve their earnings. “This may lead to greater borrowing, especially in some member states,” he said.

I have spent the weekend wondering whether he is right, and if he is what form the additional lending will take.

Certainly bank deposits at the ECB sank on Wednesday when the new rate became effective, falling by nearly half from the 808.516 billion euros deposited Tuesday to 324.931 billion euros one day later, before recovering slightly to the 366.18 billion euros reported on Thursday. But before we get too excited about a major sea change in interbank lending patterns we should note that in many cases banks just shuffled funds from the deposit facility to their current accounts with the ECB, since these shot up from just under 74 billion euros to nearly 540 billion euros by the end of the week.

On the other hand, much of this money may simply have been placed in the current account while the banks decide what to do with it. It is what happens next that matters, and there are good reasons to expect at least some of the money now lying in the current accounts will be put to work, especially now that Mario Draghi has made it clear he has no fear of taking Euro Area monetary policy deep into ZIRP territory.

As Deutsche Bank’s George Saravelos put it, “We think the cut in the deposit rate to zero is very significant for foreign exchange markets. This implicitly signals a greater ECB easing bias and a desire for a lower euro.”

The immediate impact has been twofold as far as I can see. In the first place core sovereign bond yields have been driven further into negative territory, pushing out the curve in the German case all the way through to 2015.  But it wasn’t only bunds which became more popular; Austrian, French, Belgian and Finnish two-year yields all fell to all-time lows this week and those on similar-maturity Dutch debt dropped below zero for the first time.

Commerzbank’s Marcel Bros put it like this: “Bund spreads of (semi-)core issuers compressed to the tightest levels YTD amid a massive run on everything with pick-up and ‘reasonable’ credit quality as investors are forced to move out the Bund and/or credit curve to generate (positive) returns. While the ECB’s ZIRP may have even more important (and mixed) implications for money and repo markets, it has ‘succeeded’, for now, in forcing investors to take more (credit/duration) risk or having to pay for buying time and waiting in the safest assets”.

Secondly, we should note that the euro itself dropped to its lowest weekly level versus the dollar in more than two years. Many analysts are putting a “risk averse” flight-to-safe-havens interpretation on both of these developments, but I think they may be missing the main point – EU banks are being driven into looking for yield, and they are finding it where they can. Buying negative yield Austrian bonds may not seem like a search for returns, but if you imagine the yield can fall further and hence the market value of the bond rise, then in fact you may well get a reasonable bang for your buck.

The fall in the Euro can also be seen in this light, as banks practice “carry” in the search for higher yield elsewhere. Sebastien Galy, a senior foreign- exchange strategist at Societe Generale in New York puts it like this, “The euro is now the main funding currency, and everyone wants to be short euro……The dollar is no longer the main funding currency.”

As we saw in the Japanese case between 2003 and 2008, having the role of funding currency means having a substantially undervalued currency – people borrow in the currency and then sell to invest elsewhere, forcing it down – and this will be mighty good for Euro Area exports both in Germany and along the periphery. The one thing it won’t do is stimulate credit expansion on the periphery itself, since the low credit quality of the institutions there and the absence of underlying solvent demand for credit makes that particular counterparty just tooooooo risky. So Mr Bonnici may well turn out to be right, there will be more lending, with the nuance that the new lending won’t be taking place exactly where he (and the rest of the ECB Governing Council) thought it would.

Will Central Bank of Turkey cut rates?
-Emre Deliveli (The Kapalı Çarşı: Emre Deliveli’s blog on the Turkish economy)

The Central Bank of Turkey (CBT) meets on Thursday. Of course, the big question is whether it will cut rates.

To answer this question, we must first define what interest rate we are talking about. Almost everyone agrees the Bank will leave the one-week repo, which is the rate formerly known as the policy rate, constant at 5.75 percent.

There is less consensus on whether the CBT will cut the upper bound of the interest rate corridor, which is currently at 11.50 percent.

In last week’s Hürriyet Daily News column, I argued that economic conditions do not warrant easing. The data that were released since then support my call, at least IMHO. On the other hand, Özlem Derici of Erste Securities expects a 1 percent cut in the upper bound. Her reasoning is the benign inflation reading in the last two months as well as the downward move in inflation expectations.

Click to enlarge

She concedes that there will be some pressure on the lira, but she argues that since inflation looks tame, that won’t be a big problem. She adds that since the upper bound is not binding, it won’t make a big difference anyway (see picture above). Then why cut it in the first place? “To reduce uncertainty”, she reasons.

I’d beg to disagree. Such a cut would have quite a bit signaling effect. As for her inflation argument, I’d counter that the Bank has been emphasizing that the lower-than-expected inflation figures of the last two months are mainly due to temporary factors. In other words, they are sounding prudent on inflation. Besides, Governor Erdem Başçı was recently very keen to emphasize that scaling back the Bank’s year-end inflation forecast should not lead to easing.

But the Bank has been known to surprise in the past. We’ll just have to wait and see.