Daily News Roundup 2012: Tuesday 31 January

It's important to start something new on the last day of the month. So I've been up for a bit, abused my iPad slightly, and I've decided on a hierarchy of news applications:

1. Bloomberg - obviously. However, Bloomberg is quite technical, and assumes a fair amount of pre-knowledge for anyone interested in doing this on their own.
2. CNBC - what a legendary news station. I recommend this one. All the essential stuff is covered. And it's really well-explained.
3. BBC - I've left out. I think Bloomberg and CNBC had it covered.

The Headlines that caught my eye:

Emerging Markets

• Emerging Markets post Bigger Gains than the US so far (CNBC). link: http://www.cnbc.com/id/46191756
• Starbucks to enter India (Reuters via CNBC) link: http://www.cnbc.com/id/46196917
• Tata Global surges after venture with Starbucks (Bloomberg) link: http://www.bloomberg.com/news/2012-01-31/tata-global-surges-after-venture-with-starbucks.html
• Asia Stocks, Oil Rise on Greek Debt Talks (Bloomberg) link: http://www.bloomberg.com/news/2012-01-31/asian-stocks-oil-rise-on-greek-debt-swap-talks-progress-aussie-advances.html

I'm not sure if it's come through, but I'm an emerging markets fan. The media tends to turn all our focus toward the financial woes of Europe and the United States - and we end up forgetting that there is literally a whole New World of investment opportunity. A New World that seems quite capable of sustaining itself (if it had to) without Europe and the US. For example, the trade flows between China and Africa have grown at record pace; and now, China is the biggest trade partner for most African countries (including South Africa I'm told - although I stand to be corrected).

As the US and Europe struggle, we're seeing Emerging Market funds post higher returns and large multinationals driving their products and franchises into the economies of Asia, Africa and Latin America. The Indian Economy, for example, is expected to generate economic growth of around 6.5% in 2012 - during an expected global recession! The thing to point out (in my mind) is that the debt markets of these economies are relatively unsophisticated - and many of these cultures have historical biases against debt and borrowings. This leaves them relatively-hedged in a financial 'world' that is struggling with its debt.

Europe

• EU Nears Confrontation Over Greek Rescue (Bloomberg) link: http://www.bloomberg.com/news/2012-01-30/eu-nears-confrontation-over-greek-rescue-as-portugal-poses-looming-threat.html
• Most Banks Tightening Credit to Europe - Fed Survey (Reuters via CNBC) link: http://www.cnbc.com/id/46192914
• Greek Bondholders May Face 70% 'Haircut': Source (The Associated Press via CNBC) link: http://www.cnbc.com/id/46191869
• Jim Rogers: No One Leaves the Eurozone This Year (CNBC) link: http://www.cnbc.com/id/46186447

I'm just a big fan of Jim Rogers' attitude: "I would love for them to say that OK it's a disaster and for banks and shareholders to say they'll take big losses. Everything would collapse and I would buy all the euros I could and all the stocks I could, but I don't think that is going to happen." Perhaps he's exaggerating to keep off all the speculators.

The key points:

1. Portugal seems to be heading in the same direction as Greece. Its bond issues have a "junk" status credit-rating, and credit-default swap spreads (that is, the cost of insuring the bond issues) imply around a 70% chance of default.
2. As the headline implies, US banks are withholding credit to their European counterparts.
3. 1 and 2 are strong signs that contagion would take place should Greece default.
4. Greek debt negotiations are still continuing - and the EU is increasingly frustrated by Greece's lack of success, and its failure to implement enough fiscal measures (ie. just not austere enough). Apparently, Germany suggesting a fiscal overseer, which basically would have put Greece under curatorship - but it seems that everyone reacted with shock.
5. The EU summit is set to ratify a new Fiscal Treaty (it was agreed on in December last year - but it still needs to be ratified) which is meant to act as a safeguard against further fiscal problems by imposing penalties on governments whose fiscal deficits exceed set limits (I think I read 3% of GDP).
6. EU leaders appear to be admitting that austerity is not enough to take Europe out of the fiscal crisis. This is quite interesting - as it marks a change in stance for a number of the more conservative countries, Germany being the most prominent. And honestly, it just makes sense: if I was facing bankruptcy, slowing my spending would not be enough. I'd probably have to take on a second job. And maybe sell off some assets. 

America (The United States thereof)

• Why Even 20-somethings Are Worried About Retirement (CNBC) link: http://www.cnbc.com/id/46146242

This was interesting because I think it demonstrates why it's necessary to have some kind of formal finance taught in schools. I think this will be a future blog post. 

• Jim Rogers: I Would Not Buy Facebook (CNBC) link: http://www.cnbc.com/id/46186936

Just because Jim Rogers had a lot to say yesterday. But agreed - buying hot stocks has been shown to be a bad buy. Much better to buy underrated stocks with good fundamentals.

• US Treasury Forcing Mortgage Principal Forgiveness (CNBC) link: http://www.cnbc.com/id/46193915

The reason that the US lost its AAA rating was because of its high fiscal deficit (very bad), as well as its bad asset book (after the subprime crisis, the bailout of the mortgage agencies, banks and insurance companies involved the US government taking on their bad assets). Now there is a plan to write these off (this is an election year, after all). I'm just concerned that decisions made during an election year tend to be short-sighted. But we shall see.

• Blackrock's Doll says Feds' QE3 is unlikely (Bloomberg) link: http://www.bloomberg.com/news/2012-01-31/blackrock-s-doll-says-fed-s-qe3-is-unlikely-in-contrast-to-pimco-s-gross.html

Quantitative Easing is always of interest to me - it comes back to the Inflation post: Quantitative Easing is just another term for monetizing debt. In measured and managed format, a relaxed monetary policy can stimulate an economy. But then a government walks the very fine edge of perception. Interestingly, the US Fed does not release official money supply data. This does make it hard to form expectations of future inflation - I would guess that's part of the reason for not disclosing those figures.

Post-script

• CEOs of Barclays, HSBC may keep bonuses (Bloomberg) link: http://www.bloomberg.com/news/2012-01-31/barclays-s-diamond-hsbc-s-gulliver-may-escape-hester-s-zero-2011-bonus.html

This is just linked to my post from yesterday. I'm sure Mr Hester will be planning a move soon - to a bank that's not state-backed.

Contagion. And Why Greece is Contagious

So. That last post.

Some people were irritated.

In the aftermath, I was called a wolf in sheep's clothing (amongst other things); and the post was called "a rehash of selective information" "which offers no conclusive suggestions as to how to resolve the situation" and "was lacking in certain fundamental areas".

Which I found to be a bit unfair. Firstly, you're not really discrediting the argument by calling it names. And secondly, you can't attack an argument by attacking the person making it. The debating phrase in my head is "the ad hominem fallacy".

Also, to be frank, if patriotism requires me to be blind and sheeplike, then the wolf accusation is a compliment. After all, wolves and sheepdogs are not so different. Shun me if you wish; but I like to think that it's the wolves, not the sheep, that do well in a crisis.

In any case, I was sent a video link that offered an alternative viewpoint (Peter Economides - "Rebranding Greece"). If anyone is interested, you should youtube it - it's worth seeing a different perspective. Essentially, Mr Economides suggests that Greece has been unfairly singled out in the crisis - and that the Greeks are partly to blame for this. He argues that Greece must rebrand herself if she is to come through this. Mostly, I agree.

But I have some observations:

1. A branding solution unfortunately does not change the underlying fiscal crisis - in the same way that dying my hair dark is unlikely to help if I'm going bankrupt (even if the bank had a prejudice against blonds to begin with). While it may be necessary in the long-run - as a short-term solution, it requires more than just a change in look - we also need an internal dynamic shift to take place.
2. As an alternative to the current view that Greece has the highest default risk (a view based on Greece having the highest public-sector-debt-to-GDP ratio), Mr Economides uses a UBS analyst report on the likelihood of sovereign default. The report incorporates the public-sector-debt ratio, the loans-to-deposits ratio, and the credit-to-GDP ratio to create a quantified index of default likelihood. As a general point, incorporating the "loans-to-deposits" ratio of the private banking sector, whilst interesting, is not that relevant to longterm sustainability - it is the government that is going bankrupt. That ratio simply gives an idea of banking sector stress, which is linked to the level of reserves that the Central Bank/Reserve Bank will have available if the bankruptcy goes down today - not the underlying systemic fiscal crisis that will persist over time. From what I can see, the greatest index weighting has been placed on this variable.
3. In addition, the basis of the alternative viewpoint was a forecast generated by analysts at a bank. Using an analyst forecast to definitively dispute the actual fiscal data can be dangerous. This is not what Mr Economides is doing (he seems to be making a point about statistics and perception); but it is what some people are doing to justify their own views on the crisis.
4. Incidentally, I searched for this UBS report (the Andrew Cates' Aggregate Balance Sheet Risk Index) online - and while there is much reference to it, I could not actually find it. So, in all honesty, I am inferring some reasoning. But that said, every article I read that mentions the index includes the caveat that the index does not take into account all factors that affect the risk of default. 
5. Mr Economides states that after the Olympic Games of 2004, "we [Greece] started consuming like lunatics". This supports my original argument - although I also think that Greece would have been overboard on its spending before this. Olympic Games are not cheap to put on.
6. The human cost of this crisis is undeniable. But sadly, it is also unavoidable. Pragmatically speaking, any solution will limit rather than avoid human cost. Perhaps there is a certain hardness that comes from having lived through a real fiscal crisis - but people will survive, and will emerge stronger and more rooted in community.
7. Finally, I was never, at any point, attempting to imply that the Eurozone debt crisis is purely a Greek Debt crisis. But I do agree that it forms the focus of the media attention.

So I'm going to address that last part: why I think it is the Greek Crisis in the news, and why there is the potential for the rest of the world to interpret the Greek debt crisis as the Global debt crisis.

It is because, fundamentally, Greece has the largest relative public sector debt. We are not talking about the "likelihood of default" here - but the magnitude of the problem. And even if we were to accept the conclusions of the UBS report - that report would still lack a fundamental variable (indeed, it is the variable being pushed by Mr Economides): market perception. Regardless of whether it is justified, public perception considers Greece to be the most immediate default risk.

And that makes it the most immediate default risk. 

Two broad factors drive a share price: company fundamentals, and market perception. Two broad factors drive the cost of sovereign debt: national fundamentals, and market perception. And easily, market perception is the more dominant: because it thrives on emotion, paranoia, and our deeply ingrained animalistic instinct to stick with the herd. 

Given that, the question becomes: what is the market perception concerned with?

Answer: contagion. 

• Contagion is the spread of economic problems from one country into other countries with similar characteristics.

In this situation, a disorderly default in Greece would give rise to a contagion that would spread through the other indebted countries in the Eurozone. 

A simple series of events that we would call "contagion" could be as follows:

1. Greece defaults on its debt, triggering an immediate downgrading of its sovereign debt to junk status, as well as triggering the Credit-Default Swaps written over its bond issuances.
2. The ECB, most of the Eurozone Reserve Banks, and most international banks have Greek Debt exposure (ie. they have investments in Greek bonds). If these bonds default, it would call the credit quality of these institutions into question. There would be further downgrades in their credit ratings, and consequent increases in their cost of borrowing.
3. As the cost of borrowing increases, so the reserve banks come under further liquidity pressure. Any new borrowings will cost more; and some of their current assets would not be paying back expected cash flows (the Greek bonds in default).
4. Given the recent default, borrowers may be unwilling to buy up new debt issuances from countries with similar economic characteristics to Greece and/or they may not have the funds available to invest in them. This would cause liquidity shortfalls, and an inability of the at-risk countries to roll their debt (ie. borrow new money to pay back old loans - thereby keeping the level of debt constant).
5. These liquidity shortfalls could result in more at-risk countries going into default.
6. And so the pressure continues to build as each new country defaults, bringing about further defaults, and spreading the contagion.

So really, we're all concerned about contagion. And everyone is anxiously looking for the country that will kick it off. Which, at the moment, looks to be Greece in March 2012 (a large number of bond repayments fall due at that point - which is why everyone is so desperate for a deal before then). 

The Eurozone solution right now seems to be an orderly Greek default. If the default is orderly (ie. based on the debt negotiations) - expectations can be managed, and hopefully contagion will not spread. A disorderly default, on the other hand, will almost definitely give rise to a free-for-all. Hence the media attention.

And what, in my opinion, is the solution for Greece itself?

A miracle.

Because right now, Greece cannot earn in revenue what she already owes in debt, never mind what she intends to spend. I see one of two things happening:

1. Greece leaves the Euro, undergoes a collapse of her banking sector (bank runs are sure to happen in the period before leaving the Euro), monetizes her debt, and suffers through a period of inflation and/or hyperinflation (it will be her third experience of traditional hyperinflation); or
2. Greece suffers through the austerity program and recession in the hope that she can stay in the Euro.

Either way, there will be suffering. But austerity is controlled, whereas debt monetization is not. And at the very least, austerity may give some relief in the form of external funding from fellow Eurozone countries.

Finally, I am all for the Greek call to community. We should be rising up: rising up to help the Greek elderly. Because if the Zimbabwean experience is anything to go by, it is the elderly who bear the brunt of fiscal crisis. They are fully reliant on the State, because they are no longer in a position to react.

The Greeks must rediscover their community. If the cloud is to have a silver lining, it is the only way.

What is: The Daily News Roundup

I decided that I should probably make an effort to post a little something everyday. While it's awesome to write longer pieces with something specific in mind, a little regularity never hurt anyone.

And as I thought about it while I was running this morning, I realised that the business news is an area that probably needs to be addressed. Every morning, I wake up, check facebook, greet the twitter following (usually with a picture from breakfast - today it was pork sausages), and start checking the news on the BBC app on my phone.

Now the BBC is awesome. But sometimes - sometimes I wonder about the way they decide on business news headlines.

For example, this morning, I read that RBS boss Stephen Hester has rejected a £1 million bonus. Someone important said something like "the game was up". The journalist got to use fun adjectives like "controversial". There were lots of quotes from various politicians about "doing the right thing" and "a sensible and welcome decision" and "now he can focus on getting back billions of pounds for the taxpayer". And then someone in Labour attacked the British Prime Minister for being weak and feeble because he didn't step in earlier.

So not really business news at all then. Just a business background for political saga.

Although sidebar - I think that the British Government's decision to step in was monumentally stupid. Obviously, the decision was populist - and it was made very clear that Mr Hester had bowed to political pressure (I believe the journalist got to use the adjective "enormous"). But why do I think that it's such a problem?

Incentives.

If a bank does not meet the remuneration standard set by the banking industry as a whole, your key personnel will be unhappy, and the good ones will leave. My vote is that Mr Hester will not be focusing on getting back billions of pounds for the taxpayer. If I were Mr Hester, I would be focusing on moving to another bank where I could collect my missing £1 million bonus. Immediately.

That may well be the topic of another post: "Why bonuses should be higher". I'll freely admit that I'm biased...

But getting back to the news: when I think about it, I've always struggled to relate the business news articles back to my day-to-day. News either has to be interesting or relevant. And honestly, business news isn't all that interesting - unless we politicise it (see above), or turn it into the Kardashians (see all news articles relating to the sex scandal of the former head of the IMF). So that means that the good stuff must be relevant.

The Daily News Roundup is going to be a commentary on what I'm finding relevant and interesting on BBC and Bloomberg. Not everyone will be interested - but this is largely for me. Because even with all the background, I still find myself reading about the bonuses and the sex.

After all - good scandal is fun.

Why the Greeks are in Crisis

The world is filled with concern.

Every time I turn on Sky News, a Greek Debt negotiation is stalling. And frankly, no one should be that surprised. Having grown up in a Greek community, I can empirically say that the Hellenes are a fan of two things:

1. Their right to voice their opinion;
2. Their right to storm out when someone opposes it.

This leads to a lot of storming. And a lot of factions, in elevating levels of prejudice: 

• First, and foremost, it's the Greeks against the world. 
• Then, when we're just talking about the Greeks, it's my island against the rest of Greece. 
• Then, when we're just talking about my island, it's my village against the rest of the island. 
• Then, when we're just talking about my village, it's my family against everyone else. 
• Then, when we're just talking about my family, it's me-and-the-family-I'm-currently-speaking-to against the side of the family that I'm not speaking to. 

It's complicated. 

But I'm getting distracted, and ahead of myself. I have a bit of a personal fetish for fiscal deficits and fiscal policy. It's a bit bizarre - but thanks to my Zimbabwean heritage (I'm a Zimbabwean-Greek half-breed), I have seen some pretty exciting things happen with Fiscal Policy. And actually - now I'm a bit grateful for it - because the First World is suffering from some serious fiscal crises.

So Greece. Well, my Greek friends on facebook have a lot of theories for the current crisis. My favourites:

1. The Germans are trying to take over
2. The politicians are in the pockets of a subversive Troika
3. Greece is a scapegoat for the United States
4. Turkey wants to replace Greece in the European Union (?)
5. The Aliens are coming

Actually, I may have invented that last one. But regardless, I am constantly amazed by the number of Greeks that comment on these wall posts with "You make it all so clear" and "I see it now". I shake my head, roll the eyes at the sky, and start a facebook fight with:

"I'm sorry - but the Greeks had it coming".

At which point, the argument descends into fierce rhetoric and the casting of genetic aspersions. But I think that I may have the data on my side (always assuming that the data sources aren't also part of the shadowy conspiracy to destroy Greece). So I went on a bit of a data search, and with the help of www.economywatch.com, I have this graph of the Greek National Deficit:

Greek Fiscal Deficit (Billions of Euros)

 A key definition:

• Fiscal Deficit: is the amount by which government spending exceeds government revenue. Or, in individual terms, it would be the amount by which my spending exceeds my salary.

In the popular press, I regularly see the period after Greece entered the Euro described as "a spending spree". Certainly, looking at the above deficit graph, it seems that the deficit was maintained (and even reduced) leading up to 2000 (Greece's entry to the Euro). After that, Greece springboards deep into an ocean of deficit, somersaulting briefly in 2005, and coming out of that nicely into swallow dive. 

And how does one dive into deficit? One of three ways:

1. You get worse at collecting taxes (a salary cut - or you get fired);
2. You start to spend more (there's that spree); or
3. Both 1 and 2.

Now Greece has traditionally had a history of poor tax collection. In fact - that's quite an understatement. The story is that tax evasion became a form of political protest during the 400 years of Ottoman Occupation, and the Greek people have never really abandoned the concept. After all - why pay taxes when you don't support the government in power? Although, I am a bit sceptical, because I think one would be somewhat incentivised to find a reason to complain, and thereby rationalise tax evasion.

Personally, I see this tax evasion tendency in the historical movement in the supply of money (for the pre-2000 data, I have the ECB website to thank):

Greek Money Supply (Money and Quasi Money Stock Outstanding)

If I can refer back to my "What is: Inflation, and why is it a tax" post - where governments stuggle to tax appropriately, and have limited access to further borrowings, a fiscal deficit can be financed by printing money (this process is commonly referred to as "monetising the debt"). The above increase in money supply suggests high/chronic levels of inflation. I then went to look at inflation (thanks to the World Bank for this data):

Greek Inflation/CPI (% Change)

There are high/chronic levels of inflation occurring throughout the 80s and 90s, but being brought down to below 3% by 2000 (one of the requirements for Greece entering the Euro). At this point, Greece enters the monetary union, and the inflation level begins to approximate inflation in the Eurozone as a whole. This certainly suggests that the authorities were printing money to finance their deficit while they still had control of the Greek drachma, and weren't trying to persuade the EU that they wanted in.

And then, as Greece enters the Eurozone, it suddenly has access to all this extra credit - off the back of its recent fiscal success, as well as the stability of the Eurozone. And it loses its mind (it doesn't look that hectic, but we're talking about billions of Euros):

Greek Revenues and Expenditure (Billions of Euros)

The widening gap between revenues and expenditures in the post-2000 era has to be financed somehow. And the real problem? Well, now that Greece is part of the Euro, it can no longer monetize its debt - after all, it has surrendered its monetary autonomy to the Eurozone. So it looks like we're sitting at option 2 - the spending in overdrive (hooray for the extra credit!). And if you consider her inflationary activities as a type of tax collection, Greece has now lost a key source (if not her principal source) of finance. 

Buggery.

And after the spree comes the long dark cold of austerity. And the Greeks are not happy. And I guess that's human - we like to have fun, but it's not fun to pay the cost afterward. 

Can we have a moment for the really scary part of this story? I'm going to plagiarise a projection from the latest IMF Country report (it's officially titled the "Article IV Consultation"). Greece has an aging population coupled with costly State pension plans (for example, Greek pensioners are entitled to 13th and 14th cheques every year). The IMF projection for government expenditure (driven by expected pension or "aging" costs) against revenue is the following graph:

IMF Projection of Greek Government Revenues VS Expenditure through to 2060

My question: HOW is Greece going to pay for it?

And just a small reminder - Primary Expenditure is before the cost of interest. The more Greece borrows, the higher its interest cost. That primary deficit (the gap between Revenue and Primary Expenditure) is going to be magnified by the inclusion of an increasing interest expense - as every year more has to borrowed to pay off the growing primary deficit, as well as the previous year's interest cost.

It's not sounding sustainable.

At all.

Inflation: Yes, It's a Tax

Recently, I was reading an article in the Economist about the potential danger of imminent inflation in the USA. And it occurred to me that, for most people, inflation (the general rise in prices) is just something that happens. It's something that trade unions dislike, and politicians worry about. It also has something to do with the Reserve Bank and interest rates. But it's a bad thing.

And it can be a very bad thing indeed, because inflation can be used as a tool. In the past, inflation has been used to keep countries in a state of civil collapse. The worst inflation on record (in Hungary after World War II) was forced upon the Hungarian people by the Soviets (at least, according to a number of economic scholars). Lenin talked about debasing the currency as being the easiest way to overthrow a regime. And the worst part is that inflation inevitably runs out of control, once people start to expect it. The real question: how is inflation generated to those levels that it brings a country to a state of collapse? 

If we're going to ask that question, we should probably back-track and ask "What causes inflation?" Any good economics student should tell you that it happens in one of two ways:

1. Manufacturers have to spend more to produce their goods (say, for example, the oil price goes up - well that increases the cost of manufacturing and distribution across the board); or
2. People want to buy more goods (ie. they wish to spend more).

Generally, inflation-targeting Reserve Banks try to control the second one (they can hardly influence the oil price), and they attempt to do so with interest rates - incentivising people to save with higher interest rates (thereby lowering their demand, and slowing the price rise), or incentivising people to borrow with lower interest rates (thereby increasing investment and economic growth). 

A crucial assumption underlies this process: a consistent and predictable money supply. And that makes sense, because generally, only Reserve Banks are able to print money (they are the "Monetary Authorities") - and they are reasonably independent of the "Fiscal Authorities" (being the government).

Two key definitions then:

1. Monetary Policy: refers to the Reserve Bank's decisions around interest rates (they have the power to set a base interest rate), money supply (they have the power to print money) and exchange rates (they are the central repository of foreign reserves - or money denominated in foreign currency).
2. Fiscal Policy: refers to the Government's decisions around the Budget. That is, what they are going to spend money on, and where they are going to get the money to finance their spending.

What does this have to do with tax?

The "Fiscal Authorities" (the government) safeguard the public good: spending money on defence and national health and schooling and so on. But all this spending needs to be financed somehow - just as I need a job in order to pay my rent. Governments have some choices:

1. Collect taxes (the equivalent of earning a salary - that is, being paid by the public for the service it provides)
2. Borrow (obviously - the equivalent of taking out a loan or buying on credit)
3. Print money (or, more accurately, get the Reserve Bank to print the money)

For number 3, there is no real individual equivalent - I do not have the option of creating money out of nothing. But the monetary authorities are the virtual orchard of money-producing trees. And when the fiscal authorities can't collect taxes properly, or collect enough taxes, and they've run up their debt to the point where they can't borrow any more, compelling the monetary authorities to "create" money begins to look like an attractive option. 

And what happens when you suddenly start creating money? Well, the government spending ripples the new money into the rest of the economy, and more money means that people want to spend more. You have people with the ability to buy more, without a change in what's available to buy. So it's a seller's market, and they put up their prices: inflation.

Which indirectly begins to work like a tax. If you have money in the bank - you may have the same physical amount; but in real terms, you can't buy what you used to. Effectively, your spending power is confiscated and used to fund government spending. Now that's quite handy - rather than having collection agencies, the government can just suspend the independence of the Reserve Bank, and tax everyone immediately by pressing "print" on the presses.

And contrary to popular belief, we're not talking about coins and notes. No - the majority of money creation (these days) is electronic. In effect, you delete the old account balance in the bank records, and type in a new one - only limited by the number of zeros you can type. 

Right now, it's all sounding very efficient. Sod a collection agency. But if you take the process a couple of steps further, what generally happens is:

1. Because people are people, we like to pay as little tax as possible. 
2. And because inflation only affects cash, people attempt to hold as little cash as possible, investing in "real assets" (property, cars, shares on the stock exchange, foreign currency, non-perishables/commodities, etc).
3. Sellers, expecting inflation because of the current monetary policy, increase prices again to compensate for future inflation (in economic terms, this is referred to as "adaptive expectations").
4. Some take the tax avoidance a step further, realising that if they buy real assets with borrowed money, inflation will erode the real value of their debt - and they will, in effect, be taxing their lender.
5. Generally, those in 4 are the wealthy - because they have physical property to stand collateral for their borrowings.
6. The increased demand for real assets drives prices up further.
7. The increased inflation drives up the adapted expectations of sellers, who push prices up still further.
8. Inflation gains its own momentum, and begins to spiral out of control (it's around this time that we start calling it hyperinflation).
9. Civil collapse as everyone panics and no one wants to hold cash.

But the inflation has some interesting implications - particularly given the state of the First World today:

1. As money loses its value, so does anything that has a fixed monetary value.
2. Government Debt has a fixed monetary value. 
3. As time goes on, Government Debt is eroded.

To use an example: let's say that the price of a loaf of bread is $1, and I have a loan from the bank of $10,000. Inflation drives the price of bread up to $100 (and this is not as drastic as it sounds - it was exponentially worse in the recent Zimbabwean Hyperinflation). Initially, I owed the bank 10,000 loaves of bread (in real terms). Post inflation, I owe them 100 loaves. Sure - I pay more for bread - but my salary would also have to increase in response to inflation while my debt remains unchanged.

So, in conclusion, who wins with inflation:

1. The Government - its domestic borrowings are eroded, and it has an efficient taxation system to fund its spending.
2. The Rich - who can borrow and hedge against inflation, as well as profit off it.
3. Borrowers - whose debts are eroded by inflation
4. Manufacturers - who have their largest investments in stock and machinery

And who loses:

1. The Government - as actual taxes are paid in arrears, inflation erodes the real value of taxes. Eventually, the Government loses all sources of revenue other than money creation.
2. The poor - who cannot borrow and therefore cannot hedge themselves against inflation.
3. Pensioners - who collect fixed pensions, which are then eroded by inflation.
4. Savers - whose bank balances are eroded by inflation.
5. Wage-earners - because wage adjustments tend to lag behind inflation, like a dog chasing its tail.

Effectively, inflation becomes a tax on the poor, the working middle class, the elderly and the financially conservative. 

And what drives this type of inflation? Money creation. Or, in journalistic terms, when Reserve Banks engage in quasi-fiscal activities and/or "quantitative easing".

So when American Economists start to argue that a short burst of inflation might be good for their economy - it's all a bit concerning.

Rating Agencies and the Credit-Rating Downgrade

Last week Friday, S&P announced a credit-rating downgrade of many many Eurozone countries. Although, judging from the BBC news items, you would think that only France was affected. Also - and perhaps more concerning - one of the BBC articles had the following phrase at its tail-end, clearly a tentative bone thrown to the financially confused: "Credit ratings are used by banks and investors to decide how much money to lend to particular borrowers". 

And I had a little "not quite" moment to myself.

So, I came up with a list of definitions that need to be mentioned:

1. Debt (or Sovereign Debt) - is how a government or a large corporation borrows money. You and I would go to the bank and get a loan. Actually, I'd go to my rich uncle and beg. But these guys need a fair amount more than any bank can give, or would be willing to give (after all - given the size of the loans we're talking about - the bank would be effectively throwing all their chickens, and livestock, and their mother, into one giant basket - which sounds a little risky). But when we talk about bond issues, or treasury bills, or commercial paper (CP) - these are basically all different forms of borrowing (as a general rule of thumb - the different names usually denote the time period of the loan: bonds are longer, treasury bills and CP are very short-term). And instead of one large lender, the debt gets parcelled into smaller bonds, or notes, and sold to multiple investors. And when we say "sold", we mean that the investors are buying the rights to receive the future cash-flows of the bond. It's the same as the bank "selling" me a loan - it's "buying" the right to my future repayments.
2. Ratings Agencies - we have more than one of them. Three main ones, in fact: Standard & Poors (or S&P, as I affectionately refer to it on twitter), Moody's, and Fitch. There are others - but those are the three big boys that cause the big uproar when they change anything. Ratings Agencies are meant to be independent third parties that go and do all the background credit checks on the borrower on behalf of the investors. And because borrowers know that investors like knowing that a credit check has been done: they will pay the Ratings Agency to come in and do them, in order to make their bond issuances (loan applications) more appealing to the investing public. This does create a problem with independence, however - who is paying for the rating, and who wants a better rating?
3. A Credit Rating - is the Ratings Agency's opinion of how likely the borrower is to pay back the debt on time. It is affected by two things in general: the terms of the debt issue (how big is the issue, when are the payments due, etc), and the financial status of the borrower (affected by both their internal capabilities and their external environment). The credit rating, from what I understand, reflects how things stand at the date of the rating. Unlike a Credit Outlook:
4. A Credit Outlook - is the Ratings Agency's feeling on what will happen at the next rating review. A negative rating would suggest that the Agency realistically expects to downgrade the rating at the next review.
5. Credit risk - this is the likelihood that the borrower will default on the debt.
6. Default - this does NOT mean that the borrower goes bankrupt (although it can mean that). Generally speaking, default refers to missing a debt repayment. So if Greece is a day late in paying its next installment, it will be in default. Even though it may pay the very next day.

So what does all of this mean? And how does the rating affect anything? Well:

1. A credit rating generally affects the interest rate that the borrower will have to pay. The better the rating, the lower the interest rate. And practically, this means that if I look at two different bonds that I'm going to buy - and one is rated AAA (the least likely to default) and the other is rated AA+ (highly unlikely to default, but more likely than AAA) - and they both offer 3% interest - well then I'm going to buy the AAA! It makes no sense to take on more risk for the same interest rate. So the borrower will have to offer slightly higher interest rates in order to get me to buy the AA+ bond.
2. But more importantly: the biggest investors in bonds are large institutional investors, like pension funds. These large institutional investors are usually required to keep a large percentage of their investments in AAA bonds. And this is for good reason. Most of us invest some of our salaries in pension/provident/retirement funds every month - and those funds have to do something with the money to make it meet our requirements when we eventually retire. Pension and Provident and Retirement funds - they are the giant money-players. And because of this, they're highly-regulated by their national governments. Many of those regulations place restrictions and limits on where they can put their money - precisely because there is such high political risk at play (can you imagine how UNHAPPY a voting public would be if a pension fund crashed? It doesn't bear thinking about). So, as it turns out, the biggest investors are hyper-conservative.
3. Most borrowers are not intending to pay back their full debt any time soon. The debt "rolls" - so each time a repayment is due, more money is borrowed to pay it back. Theoretically, it's very possible for a borrower to operate at a consistent level of debt. But when credit-rating downgrades occur, it becomes more expensive and more challenging to re-finance the debt.

So in conclusion, what are we saying? When a down-grading occurs - you have to pay more (point 1) to borrow less (point 2). And then there is the ripple effect. Because you look at local banks - they take our savings and give out loans. They have to do something with all the savings and call-deposits that they receive - also highly-regulated. And they're also credit-rated so that investors have an idea of where to place their call deposits. So the banks have to be conservative and invest a large percentage in AAA bonds. Those bonds get down-graded to AA+. Well then - the bank's security was sitting in AAA bonds, those have been downgraded, and the bank's downgrade follows within the week.

What is the problem? These Ratings Agency guys - they can cause a serious liquidity problem if they get it wrong. And they do get it wrong. A lot. They managed to let the entire Subprime Crisis pass them by until it was too late. Those downgrades were spectacular when they happened. 

If I'm honest - it feels a little to me like the Ratings Agencies are extremely gung-ho about not letting the Subprime crisis repeat itself. I'm not saying that they're wrong (if you read the IMF's 2009 Article IV Consultation on Greece, for example - it's clear that them kids are properly in trouble - and the deficit projections based on an aging population and a public pension plan that includes 13th and 14th cheques are terrifying). But I am saying that they seem to be a little over-eager to downgrade wherever possible. Rather be wrong on the negative side, I guess. But still - people tend to overreact. And that can exacerbate the problem far worse than erring on the side of optimism.


And in answer to the BBC - I see what you're saying. But I think that credit-ratings are more about the interest rate the borrower has to pay, and whether an investor is legally permitted it in his portfolio, rather than the investor decision about whether he wants to lend or not. 

A Friday 13th of credit-rating downgrades.

It just happened.

Why Buy Gold?! Buy Oil.

Whenever investors get jittery, they search for a store of value. And generally, that means that they all flock to buy gold. In the flocking, the gold price rockets through the roof; and all the gold-mining companies float around with excess cash, investing in more projects and more mines.

As a South African, I rejoice.

But in general, I get confused. What, exactly, is the gold allure? And why do we flock to it?

I have been told that most of these gold-mining companies have large research departments that search for alternative uses for gold.

My question is: “Alternative to what?”

And the answer, roughly: “Well – decoration”.

Incidentally, many of those departments are at risk of being shut down, having almost nothing to show for their years of research.

So I did a Google search, and the answer does not seem to change. Everyone seems to agree though that the fundamental use is adornment. There are some other applications in dentistry, electronics and satellite technology. I read a dire warning about potential gold shortages since every cellphone contains about 50c worth of gold (forgive me – but unlikely in my lifetime). And I do get a little concerned when one of the important uses of gold mentioned is “in tooth-fillings”. 

So are we saying that the very basic reason for gold being a good store of value is our need to self-decorate? Is it all based on a fad?? Because let me tell you – I’m part of the age group that is rapidly investing in rings. And there is not a girl amongst them that doesn’t do a little nose turn-up at, God-forbid, yellow gold. It all seems a bit flimsy to me.

And interestingly, the only other major “use” that gets bandied about is as a store of value: so it’s a store of value because it’s a store of value. Profound.

To sum up, it seems that gold is valuable because:

1. People like to wear gold; and
2. We all agree that it’s quite valuable.

Is anyone else concerned? Mr Buffett – any warnings to give?

Because, at the risk of sounding trite, I get highly sceptical when the thing that is so valuable in times of crisis is, in fact, a luxury good.

I reckon we should all be buying oil futures. THAT we need: I dare you to spend five minutes trying not to touch anything plastic. And how do we get plastic? From oil. Never mind the fact that everything has to be transported.

Oil is the new black gold.

Get economically empowered today.

Credit-Default Swaps: the real issue with the Greek Debt Crisis

Recently, the Universe smiled at me. I walked into a small second-hand bookstore, and found a signed, annotated, mint condition, first edition copy of Nelson Mandela’s autobiography “Long Walk to Freedom”. I rushed off to change the limit on my bank-card, and half an hour later, it was mine. And really, I cannot deny that the purchase was motivated by the prospect of making a return post Madiba’s mortem. In fact, in those 30 minutes that it took to change the card limit, I was plagued by the real fear that news of his death might break before I could get back to the store and seal the deal.

So it seems that I now have a vested interest in Mandela’s death. Is that a pleasant thought? Perhaps not. But then, I like to be pragmatic about these things. Investments are investments.

But despite my vested interest, would I go so far as to act on it? Well, no. That sounds like a lot of effort. And I’m sure it would cost more than any gain that I could make. Pragmatically speaking, of course.

Now what does this have to do with the Greek Debt Crisis? Well – it comes down to a question of vested interest. Up and until around 2005, the aim of investing was to reap gains when the market goes up, and limit losses when the market goes down. The market rewards you with gains when you make the right call on the market improving; and it rewards you with no losses when you make the right call on the market crashing.

Evidently, at some point, someone began to notice the logical inconsistency there. Essentially, you bet on the market going up, you stand to make money; you bet on the market going down, you sell off your investments, and you make no money at all (but you don’t lose anything either). And someone says “you know what, I also want to be able to make money when I call, correctly, that the market is going to crash”.

That desire sounds a lot like wanting to buy an insurance policy. For example, when I insure my car, I pay my insurance company monthly premiums, and in the event that I crash the car, they pay for the repairs or the replacement. That is: I am betting on my car getting damaged in an accident; and the insurer takes the other side of the bet, saying that I won’t. Or, at least, they say that with enough people paying car insurance premiums, it is statistically unlikely that enough cars will be damaged in order to make them make a loss.

So someone takes this idea and says, “You know what – that guy over there with the drinking habit – I reckon that he’s quite likely to have a car accident. Can I take out insurance on his car? I’ll pay you monthly premiums, and in the event that he crashes, you pay me the value of his car”. What is the problem here? We’re removing the requirement of ownership. In that situation, there is no limit to the number of insurance policies that can taken out on that car, other than the insurer’s willingness to write them.

And that, more or less, is a Credit-Default Swap (CDS). I take out insurance against losses on someone else’s investment.

Let’s take, for example, a 10 billion euro bond issue by the Government of Greece. I look at the fundamentals of the Greek fiscal situation, and I say to myself “you know, they’re probably not going to be able to sustain the schedule of repayments”. So I approach a financial institution, and enter into a CDS over those bonds. In terms of our arrangement, I pay an annual premium; and should the Greek Government fail to meet its schedule of repayments, the financial institution will pay me the full value of the bond issue. The key points:

1. I never have to buy the bonds.
2. I just pay an annual premium (a percentage of the value of the bonds issued – say 0.025%, or 2.5 million Euros) in return for the potential payoff of the entire bond issue (10 billion Euros).
3. Any failure to meet the schedule of repayments (even if, for example, the Greek Government is a day late for one of its quarterly repayments) will result in the payout (these situations are known as “default events”).
4. There is no limit to the number of CDS instruments over that bond issue, other than the financial institution’s willingness to grant them.
5. I now have a vested interest in Greece’s default.

Now this seems to be a raw deal for the insurer. Why would any financial institution enter into these contracts? Well, for starters, governments almost never default on their debt, so the statistical risk of a default event is empirically low. Secondly, the gentleman doing the deal at the financial institution is probably going to be in line for a bonus every year – a bonus based on the volume of business he does, or the value of the premiums he brings in. Is he incentivised to avoid CDS transactions? Not at all. They result in a constant inflow of premiums, with very little historical outflow.

But this justification is flawed. The historical evidence for government defaults includes a time before Credit-Default Swaps. That is, a time without a vested interest in any one country’s default. CDSs were only created in around 2005, by investors wanting to bet on the failure of America’s mortgage-backed securities (investors who reaped their rewards in the Subprime Crisis). There is therefore a mismatch between the risk, and the justification for taking it on.

But now it is too late for that realisation to help. The CDSs were written. And now we find ourselves in a situation where an unknown number of investors hold an unknown number of credit-default swaps. All these people stand to gain in the event of default. It has been suggested that the number of CDSs written, if cashed in, could exceed the value of the world’s money supply.

It’s theoretically possible that Greece’s default could trigger the collapse of the entire world’s financial system. The Subprime crisis almost did – but that was before most investors saw the potential gains inherent in credit-default swaps.

The CDS may well be the beast that brings Financial Armageddon.

Someone needs to ban it indefinitely.

Once I’ve sold mine. 

(As an aside, the practice of short-selling was and is a way of making money when the market crashes – but the potential gain is limited by the number of stocks available to be short-sold. In other words, there is a physical limit – the number of shares – to the potential gain).

What is: rollingalpha.com

Not so long ago, I facilitated a week-long graduate recruitment programme for my employer (Ernst & Young Inc.). Mostly, this was because I got to eat free lunches, avoid the boring work, and finish early on Friday. The programme is ostensibly intended to promote the firm, but these programmes are also a form of social experiment. Prospective employees are placed into teams and given a number of tasks to complete every day. Each task is designed to give the facilitator insight into the individual personalities; identifying strengths, weaknesses and the level of “fit”.

During the week, one of the activities that we ran was a quiz. This served three functions:

1. It was quite time-consuming (a week is far too long a time to shamelessly self-promote – we were running out of things to say);
2. It was relatively entertaining; and
3. We very quickly get an idea of how up-to-date our potential employees were.

Sadly, the answer to that question is “not very”. In fact, “not at all” may be more accurate. And this got me thinking: because recently, I have found myself having to translate the business world for my friends and family. And it’s both amusing and terrifying to think that, for most of the world:

1. America’s debt ceiling is something on a graph;
2. Mortgage-backed securities are something to do with buying a house;
3. Sub-prime mortgages are ones with lower interest rates than normal;
4. Credit-Default Swaps are a blurred haze of words; and
5. The Greek debt crisis is baffling, with the fuss even more so.

This – this is madness.

At the risk of sounding pessimistic, I would suggest that the prospect of a financial Armageddon in the immediate future is a concrete possibility. The speed with which financial systems evolve is often beyond the reach of legislation: and the world’s political systems tend to be reactive rather than proactive in their regulation. And when financial systems are driven by wildly fluctuating waves of greed and fear, current forms of regulation seem somewhat futile.

If I can use a metaphor, the current climate feels like hurricane season. The alternating currents of hot air (greed) and cold air (fear) create high and low pressure zones. As time passes, the pressures build into storming vortices of increasing force and frequency. Inevitably, hurricanes begin to come ashore; each one different, but each one seemingly linked to the one that came before it.

And in the face of these storms, people should be aware that the thunder is not just a loud sound in the sky; that the wind is not just a breeze; and that the first raindrops are not simply a light summer shower. In my opinion, looking to the political systems to change the status quo… Well, it’s a little like expecting the forces of nature to quiet down because we’re introducing a legal limit on wind speed. Human nature on a globalised scale appears to be outside of our control.

The solution then, on an individual level, is not to berate the clouds. The solution should be to look for signs of the storm coming, to batten down the hatches, store up the tinned food and board the windows. Or the solution may be to move out of the path of the storm. For the truly entrepreneurial, it’s probably time to invest in large underground battery banks and a windfarm. After all, the electricity is the first thing to go in a hurricane. In the aftermath, the owner of batteries is king.

And that, in many ways, is the point of this blog. Economics and finance have the greatest day-to-day impact of all fields of knowledge. We use it constantly. But we need to be aware of how it works. To be unaware is to be caught offguard. And that awareness can be the difference between being a victim and being a survivor.

Also, it's fun to talk in metaphors.