April 30th, 2010

I'm still paying attention to finance.

Sorry for all of you who thought you were done with my finance posts. :)

Peter Boone and Simon Johnson at the latter's Baseline Scenario blog:
If Mr. Trichet and Mr. Strauss-Kahn were honest, they would admit to Ms. Merkel “we messed up – more than a decade ago, when we were governor of the Banque de France and French finance minister, respectively”. These two founders of the European unity dream helped set rules for the eurozone which, by their nature, have caused small flaws to turn into great dangers.

The underlying problem is the rule for printing money: in the eurozone, any government can finance itself by issuing bonds directly (or indirectly) to commercial banks, and then having those banks “repo” them (i.e., borrow using these bonds as collateral) at the ECB in return for fresh euros. The commercial banks make a profit because the ECB charges them very little for those loans, while the governments get the money – and can thus finance larger budget deficits. The problem is that eventually that government has to pay back its debt or, more modestly, at least stabilize its public debt levels.

This same structure directly distorts the incentives of commercial banks: they have a backstop at the ECB, which is the “lender of last resort”; and the ECB and European Union (EU) put a great deal of pressure on each nation to bail out commercial banks in trouble. When a country joins the eurozone, its banks win access to a large amount of cheap financing, along with the expectation they will be bailed out when they make mistakes. This, in turn, enables the banks to greatly expand their balance sheets, ploughing into domestic real estate, overseas expansion, or crazy junk products issued by Goldman Sachs. Just think of Ireland and Spain, where the banks took on massive loans that are now sinking the country.

Given the eurozone provides easy access to cheap money, it is no wonder that many more nations want to join. No wonder also that it blew up. Nations with profligate governments or weak financial systems had a bonanza. They essentially borrowed funds from the less profligate elsewhere in the eurozone, backed by the ECB. The Germans were relatively austere; the periphery enjoyed the boom. But now we have moved past the boom, and someone in Greece, Portugal, Spain, Ireland and perhaps Italy has to repay something – or at least stop borrowing without constraint. So Mr. Trichet and Mr. Strauss-Kahn go, cap in hand, to ask Germany for further assistance.
In the comments, StatsGuy makes an excellent point:
You are far too kind to Germany here – the Germans were well aware of that the ECB bonds-for-Euro swaps allowed periphery countries to borrow. Indeed, THAT WAS THE IDEA. This way, Germany could continue its export dominance.

Germany is like a company that extends credit to unworthy consumers, and builds up a high net receivables and thus declares high nominal profits (but has lousy cash flow because it can’t collect on receivables). So who do we blame? The borrowers who took advantage, or the creditors who pretended to the world that credible demand for their goods was increasing?
This game of "let's lend people money so they can buy our stuff, even though we know they're not going to be able to pay us back" seems very popular around the world, doesn't it?

Thanks to a link from Felix Salmon's Reuters blog.

China's equity markets.

Michael Pettis, in his most recent blog post:
It seemed to me that the speculative nature of Chinese markets has nothing to do with the Chinese "love of gambling," but rather is caused by the lack of tools available for value investing - macro data is questionable, financial statements are very poor, the corporate governance framework is at best mysterious, and the regulatory and policy framework is constantly shifting, often to achieve government objectives. Even Warren Buffet would give up trying to invest for value if he moved to China and traded A-shares.

On the other hand the market is extremely conducive to speculative activity. Speculators trade on short term changes in supply and demand factors, and in China stocks move rapidly for a number of non-fundamental reasons - changes in liquidity, regulatory and policy changes, insider activity, policy signaling, and so on.

Until the conditions that penalize fundamental investing and encourage speculation change, the Chinese stock market will be purely speculative no matter how many "sophisticated" investors or derivative instruments are available. A lot of people hoped that the introduction of index trading would allow investors to hedge and so somehow because of that would make the markets more fundamentally driven and stable.

This won't happen. It is not because Shanghai lacks the accouterments of the NYSE or LSE that it is an unsophisticated and "speculative" market. It is because the tools value investors need - reliable information, clear corporate governance, a stable regulatory and policy framework, limited government interference - don't exist. Index futures change none of that.