Saturday, 2 August 2014

Comments on the PIMCO report for Cyprus

Since the PIMCO report on the Banking System of Cyprus became public information, I've actually noticed much less comments regarding it than when it was still considered confidential. The reason might simply be that it is always much more difficult to speculate on something which is available to everyone than something which is supposed to be a secret. Thus, given the lack of comments on the subject, what follows is my take on the report.

The first thing you notice in the report is that PIMCO did an excellent job in identifying the major features of the Cyprus banking system. The most important of these features are:

1. The prevalence of asset-based lending practices
In essence, Cypriot banks lent out money only if you had some strong collateral to back your loan (in most cases real estate), with less attention given to whether the client had the ability to actually meet payments. If the borrowers got into trouble, they could always sell their property to repay their loans; as real estate prices increased for a very long time, this practice rarely yielded losses for the banks. Most importantly, borrowers who were not able to repay could always pledge more collateral and actually increase the amount of they borrowed.

2. Extended foreclosure and legal resolution timeline
Simply put, if a borrower could not repay his loan, then the whole procedure of obtaining the collateral and making a forced sale of the property ranged between 10 to 12 years. Add this to the previous feature and the reader may easily see that a borrower had no difficulty in pledging more collateral and obtaining more credit as there is almost zero downside on his part. This in its turn artificially increases loans and leads to the concentration of bad loans to few people (see land developers, hoteliers, etc).

3. Different provisioning methodology, impairment recognition and interest income practices
Notably, a fully-secured loan was not considered a non-performing one which makes the value of NPLs depend on the (subjective) valuation of the collateral. In addition, unpaid interest income was also considered to be income as a result of the historically appreciating property prices which made the probability of future losses very few (as also discussed in feature 1).

In addition to these, a high reliance on the the international banking operations for income and non-residents for funding was also reported. These features resulted in high cure rates for NPLs as well as high re-default rates (since extra collateral means a "cured" NPL but does not mean that the borrower's ability to repay has increased) and subsequently in high probabilities of borrower default but low loss-given-default rates due to over-collateralization.

The methodology of the exercise, will not be the subject of this article, yet, just simply comment that even though there has been much speculation, PIMCO does not appear to do anything different than standard procedure. The same holds for the base scenario which does not appear unrealistic given the European Commission (EC) forecast in Autumn 2012. Actually, compared to the -2.3%, -1.7% and -0.7% EC forecast for 2013, 2014 and 2015 respectively, the -3%, -0.6% and 0.8% is cumulatively much rosier. The same holds for the unemployment rate forecast.

The finding which most strikes out in the report is that Cyprus banks were unable to meet their capital needs even in the base scenario. In fact, not only would they need additional capital to meet regulatory needs but they would also end up with negative capital in 2015, making an additional case against the validity of the EBA stress test exercises in 2011. Again, I note that this is simply the base scenario. In the adverse scenario, the capital needs increase by more than 3 billion euros for the whole system.

The PIMCO numbers are supposedly the ones on which the decision on the percentage of the deposits haircut of the Bank of Cyprus  relied on. The 3.9 billion shortfall for the bank was very close to the 3.8bn obtained from the haircut. The problem, however, lies somewhere else: as stated in page 8 of the report "Greek loans represented approximately 40% of the defaulted balances. Moreover, in the adverse scenario [..] Greek loans represent 43% of total expected losses on Cyprus and Greek loans". In numbers, out of the total of 6.6 billion expected losses on loans and advances, around 2.8bn were from Greece. For those who have forgotten, MoU in March 2013 also included the forced sale of the banks' subsidiaries in Greece. This means that the banks were cut off from any potential losses in Greece thus lowering their capital needs. Even if we round the number of the PIMCO report to 2bn euros, the capital needs in the adverse scenario reduce to about 1.9 bn, without even taking into account the reduction in risk-weighted-assets which would further decrease needs.

Hence, the question which arises from the PIMCO report is: since the forecasts were made using the Greek branches as well, why was the amount employed in the haircut the same? In fact, since the Bank of Cyprus actually required a further re-capitalisation of close to 1 bn a few days ago, how low have the PIMCO estimates been? The only major difference which could make the actual outcome worse than the predicted is the fact that unemployment was 16% in 2013 rather than 13.8% in the forecast, while the house price forecast was much more pessimistic than the actual result. The change in the NPL definition does not matter at all, as PIMCO, in page 15, defines a non-performing loan as one which is 90 days past due, regardless of its collateral amount. The good Laiki couldn't have impaired the balance sheet by that much either since most of the losses were absorbed by the bad bank. Even in the worst case scenario of BoC obtaining all loans from Laiki, the exclusion of the Greek branches leaves capital needs for the domestic Laiki at less than 1bn. Strangely, the liquidation of Laiki was said to decrease Cyprus's needs by 4.2 billion which is in contrast to the PIMCO report in which the bank required 3.9 billion in total (including the Greek branches).

Concluding, the big question mark here is not if PIMCO over-estimated the capital needs of the banks, but why its numbers when it came to the Cyprus evolution of loans were so far off. If the BoC actually needed 4.8 bn (3.8bn of the haircut plus 1bn from the re-capitalisation) to pass the October stress tests why was the number less than 2 billion (excluding the Greek branches) in the PIMCO report? 

The PIMCO report, even though it did a great job in identifying and analysing the state of the Cyprus banking system did a very peculiar job in forecasting its capital needs. Truth be told, numbers and reports don't really add up.

Saturday, 12 July 2014

A Marriage Made in Hell: Housing and Foreign Demand

In the past couple of years we have seen a surge in the effort to obtain demand from abroad. Current Account negative balances, have provoked many discussions, since in a currency union, in order not to have a Balance of Payments crisis, there is a need for having a stable quantity of money in the economy. The apparent solution of boosting the export sector, as Germany has been doing during the Eurozone crisis, is no solution for the long-run as without strong domestic consumption the country is prone to shifts in foreign demand. Yet, in the short run, this dependence on foreign demand appears to be great if demand keeps going up. 

The problem is that the same principle does not hold for housing. Picture the following scenario: a person from country Y buys a very affordable home in country X. It goes without saying that most probably country Y is richer than country X, or at least house prices in the latter are lower than the former. (The rationale behind this is that it wouldn't be easy for someone to purchase a home in a country where prices are much higher than in his own country - unless he or she is very wealthy which is what has been happening in London nowadays). Now, if the house is really affordable, others will also want a piece of the housing, and from the supply and demand law we know, prices will rise in the country.

Is that necessarily bad? The answer is unfortunately yes, most of the times. If the rise in foreign demand occurs during a relatively short period of time (as it usually manifests), then house prices will rise by much more than national inflation rates. The case of Spain is very enlightening:

Yellow line is the price of housing per square meter while the green one is the inflation rate
The first question which arises is why doesn't the inflation rate rise by as much as foreign demand if that is the main driving force behind the increase. The answer to this is inequality, but not in the Piketty sense: it is not that everyone in Spain benefits from the rise in prices. The "representative" Spanish household has no intention of selling its house and living somewhere else just because prices have gone up (I know that many economists believe that this is what "rational" agents would do, but that is not very realistic). It's the land developers who benefit the most from this expansion of prices, which is followed by an expansion in credit as banks see its profitable to lend to them. Money is still distributed along the economy in the form of credit or increased consumption (the rising trend of inflation in the above graph is indicative of this) but not by as much as the rise in property prices.

The second question is why does it matter that much. What most fail to see at the time is that this expansion in foreign demand hurts the nationals by much more than we believe. If the average price in Spain was around 1000 euros in 1997, and a part of the population could not afford to purchase a house, then who would argue that in 2008, when it nearly tripled many less would really afford it. If someone doubts this then the following graph should remove all doubt:
The increase in wages was less than 70%, when house prices rose by almost 180%. House price in 1997 was approximately 14 times the wage index, while in 2008 it was more than 28 times. Foreign demand for housing has an even nastier side: it assists in the creation of a credit bubble as locals have to borrow more money for property purchasing and land developers borrow more as profit opportunities rise. Spain is again indicative of this behaviour as credit rose by more than 400% since 1998, mostly driven by these developments.

So what makes housing so different?

The simple answer is that housing is immovable. You cannot really take a house or an apartment and leave the country as you can do with other types of goods.That makes all the difference since it means that locals and foreigners compete for the same goods. If a producer can sell a banana at home and the same one abroad, then prices are charged accordingly and, if possible, charges foreigners more, given the extra trouble that is required. In the meantime, the producer cannot really charge the foreign price to the local market because there are many other substitutes: buy from another producer, buy an imported banana or buy some other fruit. In contrast, the house is stuck where it is built and there is no local nor foreign substitute for it. In addition, the developer has a very good alternative for local demand: sell it to a foreigner at an inflated price. Which is more profitable? Obviously the latter, and the locals will just have to meet the price if they want to purchase the property.

Thus, simply put, increased foreign demand for real estate is almost always bad news for the locals. The phenomenon has not just taken place in Spain, housing bubbles have appeared in the Netherlands, Greece, Cyprus and even London as it appears nowadays. So next time you hear about rising foreign demand for real estate in your country be wary, very wary.

Wednesday, 4 June 2014

Does Supply Create Its Own Demand?

Many a policy during recent years have been aimed at making things easier for producers. The rationale has been that if producers can create more goods (or make the same goods with less money) then they will have to hire more people, thus boosting employment, consumption and growth. This understanding is based on what has been commonly known as Say's law, which states that "the mere circumstance of creation of one product immediately opens a vent for other products".

Unfortunately, this "law" does not always hold. In fact, at times it appears to be nothing more than a misunderstanding of how the world works and how businessmen think and operate. Let us consider the following example: Company X creates 100 units of good Y which it sells to the public. Demand is good so that there are no excess goods at the end of the day. However, Company X is not the only company in town; there are dozens of others which produce all kinds of goods, some substitutes of good Y, some complementary and some which are completely irrelevant.

One terrible day, some shock (say a financial breakdown) causes demand for all goods to drop by 20%. Given that firms employed as much workers as it was enough to meet demand and earn them a profit, they now begin to lay off people, until they once again meet demand, with a lower cost. For simplicity, let us suppose that there are no frictions in the economy and this correction happens very fast. Obviously, letting workers go will mean a further deterioration of demand, but we will ignore this for now and just assume that there has been a drop of just 20%. 

An additional option would be to cut workers' salaries by 20%. Yet, this is unlikely to happen because some workers would remain idle and not be fully used during their employment hours. Having them all work less is a bit unrealistic, thus a combination of wage reductions and less employment appears to be more likely. Now let's say that the government, instead of doing anything else, subsidizes part of the firm's expenses, making the good less expensive. What does this mean: basically instead of earning €1 euro per item, it now earns €2. Surely, the company's profits rise spectacularly. But does it mean that it helps the economy? Not really.

The issue here is that firms, unlike what many people people believe, hire only when they are trying to meet demand and not when profits are rising. Unless dropping the price by €1 means that there is a surge in demand for their goods enough to hire extra workers, then nothing will occur in the economy. As some goods are price inelastic then we know that reducing prices will not change their demand by much. In addition, the economy's reduced income means that people are more likely to hold off purchases, even if they can afford it, a form of buffer against worst days in the future.

What is more, even if a lower price increases demand, there appears to be a problem similar to what we know as the paradox of thrift or the prisoner's dilemma: what is good for the individual (here the firm) is not necessarily good for the economy as a whole. For instance, the first firm which will hire new workers must be certain that the demand for its goods will be sufficient to cover wages. Yet, only a very small part of those wages will be allocated to the good the worker is producing (think of it this way: an ice cream maker will not just consume ice cream). This, in its turn, benefits the other firms in the economy by much more: by incurring no expenses, they see demand for their products marginally increased. 

It is more than obvious that if a firm starts hiring then others will most likely follow, even though there is a "first mover disadvantage". The disadvantage is mitigated only if demand is persistent and large enough to cover the wages and leave room for profit. This means that Say's law most likely holds if there increased demand for goods. The magic word here is demand: even in Say's world, it takes demand to create supply not vice versa. To what avail are we to fill the market with trillions of goods if nobody wants to purchase them? Nevertheless, this is very hard to know in advance (given the lower income and reduced trust in the economy) and in addition, the cost is high: unless direct subsidies are employed then the effect of other measures such as reduced red tape or other bureaucratic hurdles is infinitesimal.

Then the big question arises: why should we subsidize firms to create cheaper goods, when we know that the outcome is uncertain, or even if the outcome is favourable, the shift will probably take very long? More so, why shouldn't we just target the demand side, which creates more growth faster and tackles issues such as poverty and unemployment much faster, while in addition it is cheaper? If we let ideological barriers such as thinking that assisting the demand side is "Keynesian/Minskian" and the supply side "Liberal/Free Market/Friedmanite", we just reach the conclusion that we are enforcing the same thing through different ways. The only problem lies in choosing wisely which way suits us better.

P.S. This article strictly refers to established firms.l Start-ups usually do create their own demand for their (new) goods, but they are not usually the ones to receive government aid as they are either at infancy level or non-existent during those times. In addition, their "new" demand lies heavily on whether the public has enough funds to purchase innovative goods, something which brings us back to original demand. Assisting in the creation of start-ups (when times are good but especially when times are bad) while simultaneously boosting demand could in fact work wonders for an economy.

Saturday, 3 May 2014

Why Marx was both right and wrong

Note: This article does not include any "capitalism is good/communism is bad" aphorisms and it is not intended for any political discussions. What follows is merely an economic exposition.

When the name of Karl Marx enters a conversation, our minds spring to themes of collective societies, USSR-style governments and hard-headed dictators. What we seldom remember though is that Karl Marx was an economist and one of his most famous contributions (and the one on which he based the Communist Manifesto) was his, interpretation and expansion of the thoughts of David Ricardo and Adam Smith on the Labour Theory of Value.

Quoting another blogger, the labour theory of value simply states that "... the "value" of a commodity is determined by the "socially necessary labour time" embodied in it ("socially necessary" to avoid the nonsensical idea that somebody who makes something slowly will contribute more value than somebody who makes the same thing, but faster)." It should be noted here, that this theory has never been a theory of prices as (under Marx's explanation) even though prices might fluctuate, the overall value in the economy will remain the same. Deriving from this, Marx expounded the notion of the "tendency of the rate of profit to fall", again building on the work of previous economists, who noticed that the rate of return of capital invested in industrial production declined over time.

Marx concluded that in order for the rate of profit to continue to be as high as before, "capitalists" had to employ other approaches, notably to exploit the labour force under their employment. This, in Marx's opinion, led to frequent crises in the capitalist system, which were caused by labourer's revolting against the low wages brought on by employers who tried to earn more.

As already stated two paragraphs ago, what makes a product more valuable is the "socially necessary labour time" embodied in it. This simply means that the reason why air conditioners are more expensive than simple pens is that it takes longer to manufacture them. I doubt anyone could actually disagree with that; yet, what is more interesting is what comes next. In order to see where the exploitation of labour comes in, we have to distinguish between two points of view: one where the labourer is his own master and whatever he produces he can sell and another where the labourer is an employee. If what the labourer can possibly earn in the first case can be more than the amount earned in the second, the we can say that we have exploitation.

Let's start with the following scenario: average Joe can produce X amount of good G, with an estimated value of V (notice we are not talking about prices here). This amount is what Joe is contributing to the economy. Now suppose that capitalist C offers Joe the following plan: he will work the same time as before and earn the same amount of income, but the capitalist will offer Joe some capital (think of it as a machine assisting in the creation of good G), and Joe will be expected to produce amount Y (Y>X). The difference between Y and X, multiplied by the price, is the capitalist's profit (we will consider that the rate of capital here is constant*).

Given that Joe's job is rather unstable (just like any other self-employed person in the world he does not know whether he will be able to sell all the goods he manufactures), having a stable income is much more preferable (the fact that his wage will be the same as before means that he is not losing any purchasing power). Now, since less effort than before is given into making the same amount of goods, according to the labour theory of value, the value of a unit of good would decline. Yet, would the overall value of goods also decline? The answer here is that it depends: if Y*V2>X*V1 (with V1 indicating the original value and V2 the value after the capitalist offered some capital) then it would not. Thus, if the increase in amount of production, induced by the addition of capital multiplied by the new (reduced) individual value is greater than the original then the economy is better off than before.

Why should the capitalist care about increasing value in the economy one might ask. The simple answer is because it increases his profit. His profit is Y*V2-W (with W being the wage he pays Joe), meaning that the higher the value, the higher his profits, given that Joe's wages are constant. This is simply increased return on labour and not on capital (we considered that to be constant before). How would the capitalist, in real life, know that it is good to perform that action: simply, trial and error. If the price more than expected and he cannot make a profit then he just shuts things down, or reduces wages.

Obviously, the rate of return on capital cannot be same, not through time and neither through sectors. For example, the rate of return was huge in the DVD rental industry in the early 2000's, and has taken a nosedive since. Yet, it had nothing to do with labour nor capital. It had everything to do with shifting preferences (from DVDs to pirated movies or Video on Demand). In addition, diminishing returns also imply that adding more and more capital cannot really help you to increase your rate of profit; most of the time they actually decrease it.

Returning to our discussion, Marx was right: wages might fall and capitalists do earn of what their employees produce. Yet, Marx was wrong on that capitalists have to make misers off their employees to earn a constant rate of return (we, of course, do not argue that regulation is very useful in protecting some form of worker exploitation): they just have to find new ways of being more productive or, even better, generating more demand for their goods. 

The falling rate of profit actually has a meaning of its own: it shows you whether people are actually enjoying your product or if you are going to have a full-blown disaster. If we consider the falling rate of profit then we have to define what it stands for: just commenting that it falls means nothing. It falls either because you are doing something wrong or because you are obsolete. In either case, shutting down a business is much preferable to continuing its operation just for the sake of keeping some people employed at a lower wage. It is also better for the employees, even though earnings new skills to keep them marketable may be hard.

*A little bit of math: A production function of the Y=K^(1-a) means that we have constant returns to capital of the rate r=(1-a)*K^(-a). Then, if we add labour, we have the Y=L^a*K^(1-a) form, meaning that we add a*L^(a-1) return to the previous, without the return from capital changing. What the capitalist offers is a wage equal to the marginal product of labour, i.e. w=a*L^(a-1). Yet, if the worker's earnings from before were less than w, then the capitalist can profit from that as well.