The Second Parchment

On Economics, Finance, Politics and Music

Category: Monetary Economics

Sovereign Credit Rating Service: A Public Good?


It is inevitable that credit rating agencies partially catalyzed the credit crunch the financial system experienced in 2008. Some have attributed the recession to the way Moody’s, S&P, and Fitch Ratings rated fixed income products; one of whom is Annette Heuser of the Bertelsman Foundation. I recently stumbled on her TED talk, and got interested. In her talk, she made a bold statement: “credit rating services, especially sovereign credit ratings, should be a public good.” Watch her TED talk here.

In other words, she wants sovereign credit rating services to be free and transparent for everybody: clients, investors, non-clients, and non-investors. As an effort to realize this, she and her team have been working on a “forward-looking” credit-rating model that they name INCRA. She doesn’t want it to be a business, so operations under the project have been done under the non-profit umbrella and financing of the project has been based on endowments made voluntarily by outside contributors. Read her latest update on INCRA here.

During the talk, she justifies her decision to develop a free sovereign credit-rating model on several fundamental beliefs: i. The downgrading of sovereign credit ratings increases the cost of borrowing for governments–usually emerging countries–that are dependent on the international credit market for their infrastructure financing; ii. The market of credit rating is imperfect–it is an oligopoly–with three key players in it (Moody’s, S&P, Fitch ratings); iii. There is a ‘moral hazard’ in the credit rating business: she believes that credit rating agencies tend to deliberately overestimate the creditworthiness of a particular institution, because that institution is the one paying for the credit rating service. Since fixed-income investors might not know about this, they would trust whatever the credit rating agencies publish on their reports.

I find some of her reasons a little bit too bold. One has something to do with the assumption Ms. Heuser is making on how credit rating agencies always rate in their clients’ favor–the institutions/countries hiring them to rate their institutions/countries (refer to point iv). This might be true in the context of what happened in the 2008 mortgage-backed securities fiasco, but I don’t think the case can be extrapolated to sovereign credit ratings. I still couldn’t find any relevant studies, so here’s a question: do governments pay credit-rating agencies annually, thus making them having a voice when upgrades/downgrades of their countries ratings are being discussed? I know governments hire sell-side/buy-side financial analysts for capital restructuring reasons (i.e. Greece hired BlackRock), but do they also hire credit rating agencies?

Another point is the following (refer to point i): while it is true that a central bank’s policy to increase a country’s interest rates will directly affect the cost of borrowing, there is insufficient evidence demonstrating that the downgrading of a country’s credit rating would do the same. I cannot intuitively see any direct correlation between credit upgrades/downgrades with the central bank’s choice of interest rates. I haven’t done any research on this yet, but I believe that the argument on the correlation between credit rating upgrades and the increase in interest rates is still a matter of academic debate. In the end, American investors invest in Indonesian bonds based on what Bank Indonesia wants Indonesia’s short-term or long-term treasury bonds to be. Indonesia determines its own cost of borrowing–Moody’s, S&P, and Fitch might (potentially) just contribute to an insignificant premium of the bond rates in secondary capital markets.

Ms. Heuser is probably referring to foreign direct investments (FDIs), which are correlated with sovereign credit ratings. Investors would demand higher equity (not bond?) returns when investing in the emerging markets, or countries with ratings just slightly above the investment grade. If this is the case, it makes sense, but then again, the amount of FDI inflow has little correlation with how much the government should allocate its budget for foreign debt payments. Additionally, the central bank also has power to influence FDI. Again, take the case of Indonesia. Ever since former Federal Reserve Chairman Ben Bernanke announced its tapering off of quantitative easing, investors have been pulling out their investments out of Jakarta (Early August 2013). Weeks and months afterwards, Bank Indonesia, increased interest rates by hundreds of basis points (Late August 2013). Since local currency is used to finance local investments, a good proxy for FDI inflows/outflows would be this year’s $-Rupiah exchange rates, which can be seen here. Also since investments are made in equities, the Jakarta Composite Index serves as a good indicator, which can be viewed here. Look at the significant increase and decrease of the rate/index over August-September. This shows that ratings might alter the the outflows/inflows of direct investments, but not foreign investors’ preferences in purchasing government debt. Unless the ratings are incorporated to the calculation of the probability of sovereign debt defaults.

So far, INCRA has produced a total of 6 reports, which can be downloaded here. Most of them are produced by political scientists and economists within the academic field. While I doubt that INCRA’s presence will change the landscape of the credit-rating business, I’m still interested in where this project is going.


Basel III: An Update

It has been approximately a semester since I left my internship at the Central Bank of Indonesia’s Monetary Policy Group, in which I worked closely with senior economists on developing a proxy for measuring risk levels of Indonesia’s banking system. The discussion on the developments of Basel III was a ritual every morning, and I am pretty sure it is still today. I remember looking at the following table and wondering what will happen as members of the Bank of International Settlements gradually establishes each of the framework’s regulatory points:


As I perused the financial statements I was assigned to, I would ask myself: “How will banks respond to the increasingly ‘restrictive’ regulation proposed by the central banks involved in the formulation of Basel III?” As the year of 2013 ended, some answers have emerged.

In Indonesia, at least an issue arose due to Bank Indonesia’s minimum Capital Adequacy Ratio rule imposed on several domestic banks. Such particular rule, I believe, is highly influenced by Basel III. This has led to an additional capital injection–or colloquially, a bailout–of Bank Mutiara, after its controversial Century days. Read more here. Internationally, investment banks and regulators have constantly revised the terms of the rule to reach a point where profits and risks balance. Quoting a banking professional in an article, the concession has been a ‘win for the [financial services] industry.’ Read more here.

On Indonesian Funds: Hedging A Fall


A few weeks ago I wrote about how the Indonesian government, through its macroprudential laws, prohibits any shorting activities in the Indonesian stock market. Given this restriction, I was wondering what would Indonesian small and second-level investors (like me) do to partake in potential profit-making situations when the market goes bear.

Just hours ago, a friend of mine (Ilya) recommended to long Exchange Traded Funds (ETFs) or Index Funds whose yields negatively correlate with the Jakarta Composite Index: inverse-exposure stocks/portfolios. So when the market goes down, the fund goes up, vice versa. This is one good idea, but unfortunately, such fund is not commercially sold unless an investor directly manages his/her own portfolio by either: i) being an active trader at the Jakarta Stock Exchange, ii) appointing a broker and actively managing the portfolio, ensuring that its beta coefficient is negative, iii) hiring a personal asset manager at an asset management firm.

I went to a mutual fund yesterday to confirm this. (Yes–the day after I visited the mutual fund to talk about the issue and to open a mutual fund account, Ilya messaged me on Facebook about the exact same issue. What a coincidence). After opening my first mutual fund account (an early birthday present!), I talked to one of the marketing officer about the strategy. As expected, those ETFs don’t exist. The investor needs to construct a replicating portfolio by his or herself, accompanied by an asset manager. I then asked about publicly available Indonesian funds out there, and he gave me a broad list:

  • LQ45: An index consisting 45 blue-chip equities, updated every 6 months, based on the companies’ liquidity levels and market capitalization.
  • Sectoral: A portfolio which comprises companies from 10 different sectors in Indonesia: agriculture, mining, consumption goods, properties, infrastructure, etc.
  • Jakarta Islamic: 30 companies whose stocks fulfill the Sharia criteria. Weightings in the portfolio depends on liquidity levels.
  • Bisnis-27: This one is pretty new–a daily newspaper named Bisnis Indonesia partnered with the stock exchange to list 27 top-performing Indonesian companies (based on fundamental analyses).

Curious about their performance, I tried Bloomberg-ing them against the Jakarta Composite Index. Unfortunately only the LQ45 is listed. But I’m pretty sure the others’ annual performance is similar:


Guessing from its general form, the fund moves together with the Jakarta Composite Index. No way that a trader can use this to bet against a dwindling market. Again, this is only LQ45–but I’m very sure that the others are the same. So what should people like me do?

Several options available:

  • Form your own bear portfolio by pooling stocks with negative betas. The thing is, it might be challenging to find a platform to get such list of stocks (not sure, once one have a trading account I think it’s readily available). However, I’m still pessimistic about the liquidity level of these equities considering Indonesia’s top 45 liquid & fundamentally sound stocks have positive betas.
  • Invest in derivatives: buy put options or sell call options. This idea is viable–we do trade options in Indonesia, despite the fact that there’s a policy of automatic exercise. In Indonesia, options will be automatically exercised once prices are below or above the threshold (strike price) by 10%.
  • Work hard and smart and get that first $20,000 to be eligible to short here.
  • Learn Cantonese and go to Hongkong. Alright I’m kidding about this one.

Relevant side note: The efficient market hypothesis doesn’t really apply here in Indonesia. Mutual funds do beat the market, though of course not always. [Paper in Bahasa Indonesia].

Irrelevant side note: In response to a significant Rupiah depreciation and an increasing trend in inflation and capital outflows, our interest rate was raised by 50 basis points just two days ago. My floor at the Central Bank of Indonesia was full of people midnight before the governor announced it. It was amazing to be in the same floor with the economists and central bankers who actually contributed to making the decision. [Article in English].

Short Selling in Indonesia


…is allowed but strictly regulated, thanks to the 2008 subprime mortgage crisis. A customer needs to have a minimum of IDR 200,000,000 (approximately USD 20,000) in their stock account to have the privilege of hedging their stock investments when the market plunges. Download the regulation here: Short Selling in Indonesia (in Bahasa Indonesia).

Most active, technical traders I’ve talked to play the one and only strategy to gain profit: capital gains from buying low and selling high. What do they do when the stock declines as Chairman Bernanke recently announced his plan to decelerate the Fed’s quantitative easing program and as the country is in a political turmoil as the price of fuel increases? Simply hope that the market would bounce back again.

Relevant update: Greece is planning on lifting its short-selling ban. [Article].

Roubini at NYU


Professor Nouriel Roubini is in town! (Yes, this Roubini). A group of us just had a two-hour lunch with him. Our discussion mainly revolved around the global economy and international trade, both his areas of expertise, but he also touched on several current domestic economic issues. His talk wasn’t really highlighted by value judgments (academics are often very careful about the opinions they assert, which I value very highly). He did, however, made some statements that I think are interesting: a) China should consider lowering its 40-50% savings rate, despite him acknowledging that this behavior has been partially stimulated by the ‘fear’ that the Chinese future will be dominated by the elderly not qualified for employment opportunities that boost the Chinese economy, b) there is a decline of hegemonic political power within the G-7 countries, and the global economy has been shaped by the G-20 countries instead, c) there would have been a massive collateral damage had the U.S. government not provided extra liquidity to its failing banks in 2007-2008, d) current U.S. zero-bound interest rate policy has caused a spillover over other monetary policies pursued in other countries.

He briefly talked about the Euro crisis, and I was curious as to his opinion on the European Central Bank’s role in the eurozone. Unlike the Bank of Japan and the Federal Reserve, the ECB has no privilege or prerogative to conduct quantitative easings (QEs) to lower spreads with respect to the German bunds. The Lisbon Treaty regulates this. I asked his opinion on this, considering that spreads in 7 eurozone countries have been very large over the past 3-4 years. This is a paraphrased, simplified version of what he said:

“The monetary policy objective in the Eurozone is discrepant from that of Japan or the United States. In the United States, the Federal Reserve is constitutionally mandated to focus on improving the following two variables: price stability in unemployment rates. The ECB has no similar mandate; in fact, it places a small emphasis on the latter variable. It aims to maintain price stability within the eurozone more than reducing unemployment rates of its member countries.”

I guess this makes sense—no German citizens would like to see their price of commodities being volatile in exchange for more Greek college graduates having higher level of employment (is this true?). QEs sometimes involve fiscal transfers as well, which is highly unpopular among constituents. This extrapolation is very tenuous though, one can argue that this is true if there’s actually relevant supporting polls on this particular issue.

Now, if we take Professor Roubini’s statement as granted, we can conjecture what will the ECB’s Taylor Rule look like. Since the ECB focuses on price stability more than unemployment, the parameter assigned to the former variable is expected to be much greater compared to the coefficient assigned to the latter variable. This would be an exciting econometrics project for anybody out there interested in monetary economics.

Update: Yesterday’s FT article (March 5th) indirectly corroborated Professor Roubini’s comment on ECB’s main role. “…the ECB has no formal role in managing unemployment. Its one purpose in life is to guarantee price stability by keeping inflation “close to, but below” 2 per cent over a deliberately unspecified medium term.”

A Short Note on the U.S.’ Quantitative Easing

I feel the urgency to write this post after I watched this misleading animated clip on the Federal Reserve’s quantitative easing policy. I think most economics students or current affairs aficionados can refute nearly most of the things mentioned in the clip, but I’d like to point out one good thing about Chairman Bernanke’s successful in his pursuit of purchasing what most of us would consider junk assets.

Read this post from the Economist. The Fed’s large-scale asset purchases have been profitable so far. Secretary Geithner literally received a total of $89 billion dollars in profits from the subprime assets the Fed’s purchased after QE1, QE2, and QE3. Chairman Bernanke did use Americans’ tax revenues and did utilize it capacity to print money in the beginning, but in the end, the citizens’ money have been incrementally restored.

Anti-Feds, the two fluffy bears in the clip included, would then argue that the Fed’s money printing would lead to inflation. Printing money means inflation, they’d say, disregarding the fact that the U.S. economy’s money velocity has shown a negative trend and that its GDP growth has demonstrated a positive trajectory since the 2008 financial crisis. But as shown from the graph below (quarterly), The Fed’s quantitative easing policies have not, and will not, lead to a Zimbabwean inflation that most anti-Fed zealots have claimed.


Though one can argue that mild inflation is bad, it has some positive features as well. Borrowing becomes cheaper as debt becomes less valuable as prices are expected to increase. One’s debt decreases in real terms. One last thing. It’s widely known that quantitative easings lower interest rates on selective assets (an important feature that’s not mentioned at all in the clip). Take a look at this graph showing how real investments have increased post-2008.

I acknowledge that in elaborating my arguments above I might have oversimplified some data. Furthermore, I haven’t actually done proper academic research on this. But in general, one can be positive about the Fed’s unconventional monetary policy. The unjustifiable detestation towards the Fed and Chairman Bernanke is often fueled by irrational preconceived notions and a strict adherence to an anti-government ideology. If we really want to learn or refuse to be indoctrinated, I personally think that we should refrain from committing this error.

Update: The NYTimes recently reports that the U.S. economy contracted in late 2012. This had nothing to do with the Fed’s action though. It’s mainly attributable to the significant decrease in military spending. 

On Government Deficits


I am currently working on a project about formulating appropriate policies in response to the impending U.S. fiscal restraint, also colloquially known as the fiscal cliff. To avoid any form of partiality, the first paper I read was the one written by the Congressional Budget Office, a non-partisan federal agency whose specialty is in providing analysis of the federal budget of the U.S. government.

CBO’s paper reinforces my belief that Rand Paul was not simply vocalizing his Republican predecessors’ political ideology when expressing his detestation towards budget deficits. Indeed, macroeconomic models in our economic textbooks are correct in showing that deficit spending is favorable in the short run–when nobody spends, the government, in a purely economic perspective, has the authority to be the ‘spender of last resort’ by increasing spending or extending tax cuts. (Note that I am discussing this issue from a purely economic perspective without taking into account the concept of government legitimacy in welfare-redistribution. If you are a libertarian, you might disagree that boosting aggregate demand through taxing or government spending is one of the roles of the government). In the short run, no economic agents living in the present cares about the existence of public debt—none of them is concerned about the significance of the rapid ticking of the debt clock located on Manhattan’s 6th avenue.

But in the long run, as most economists and conservative politicians like Paul Ryan would argue, debt is an issue.

a. The increase in debt or the constant implementation of deficit spending, without being followed by an appropriate expansionary measure in monetary policy,  would increase interest rates and thus discourage investments in at least two ways. First, as national saving decreases, the fund available for private-investment purposes will be limited; hence it increases interest rates and disincentives investors to invest in capital-intensive projects. Second, the increase in government spending will drive the economy to produce above its natural rate, increases output, but will then crowd-out investment as interest rates rise. The private investment sector will  therefore have less share of  the country’s economic output, as short-run GDP growth is attributable to government spending, not to private investments.

b. Even in a circumstance in which expansionary monetary policy took place, debt would still be a problem. Endogenous growth models–derived from the world-famous Solow growth model–predict that the decrease in savings would lead to the decrease in capital, an input essential to long-term growth. It is not the increase of demand for goods stemming from deficit spending that promotes long-run growth. Capital accumulation, in addition to growth of worker’s productivity and technological progress, is the key to increasing an economy’s real growth rate.

c. As the paper indicates, having debt would restrict “policy makers to use [fiscal policy] to respond to unexpected challenges.” It should be noted that the ability for government to spend under debt is subject to investors willingness to purchase treasury securities during open market operations. During ‘unexpected challenges’, which I assume to be unpredicted financial crises or events that lead to a decrease in investor/consumer confidence (such as the 9/11 attacks), it is not impossible that investors would be reluctant to lend to the federal government as its government bonds or treasury securities would no longer be perceived as risk-free. This shows that excessive debt would hinder the federal government’s effort in altering its fiscal policy appropriately.

Deficit spending is therefore a temporary panacea for the business cycle. This however, does not mean that the government should not consider spending under debt at all, because the significance of the impact of the ‘panacea’ is not something that is predetermined. Additionally, some might argue that the economy is not a simple disjuncture between Keynesian and neo-classical economics: deficit spending that would bring the economy out of short-term recession would not necessarily afflict the economy in the long run. A single removal of economic disturbance in the short run, by increasing debt, might result in a positive compounding effect in the future.

Note: IMF predicts that U.S.’ debt to GDP ratio is around 70-102%, while Indonesia’s is around 24.5-25%. Imagine how massive an economic boom Indonesia would experience if President Yudhoyono were to be successful in persuading DPR to spend more. 

Irrelevant note: I honestly think Nick Jonas did great in the 25th anniversary of Les Miserables. It is indeed difficult to detach yourself from the preconception that Nick is affiliated with the Jonas Brothers when you first watch it, but once you are over it, you would realize that his voice and character fit Marius Pontmercy’s.

A (Strict) Monetarist Analysis on Ron Paul’s Policy

Former candidate for U.S. President Ron Paul is popular among right-wing conservatives especially for his stance on the existence of the Federal Reserve of the United States, also known as the Fed. He pledged that if he were to be inaugurated as President, he would eliminate the Fed and abolish the monetary system that the U.S. has adopted since 1913. He proposed a return to the gold standard, a monetary concept not a single country has relied on since 1999, to maintain an absolute supply of dollars. His speeches reverberated around university hallways, his sentences were and are still quoted on Youtube videos starring the Democrats, his book entitled ‘End the Fed’ was displayed on the New York Times’ bestselling bookshelf. Yet, just like any other books on economic and political issues, not everybody agrees with every single point he presents. Economists adhering to Keynesianism, and disciples of Milton Friedman have outlined their core differences with the Republican nominee.

I do not intend to write (and rewrite) real and hypothetical cases against Ron Paul’s idea, because there have been a plethora of books, online op-ed pieces, and magazine articles that coherently challenge Paul’s contention already. Writings whose authors are vehement supporters of the Fed are everywhere. Their arguments range from the notion that having a lender of last resort to ensure liquidity is important to the belief that the price and supply of gold fluctuate.

Recently, I have been trying to think in Paul’s shoes and been attempting at finding loopholes within his propositions apart from those already stated. I found that even concepts within (strict) monetarism whose proponents demand for a very limited involvement of the Fed oppose Paul’s proposition. (I put the word ‘strict’ inside a bracket since Wikipedia claims that the concept has been reinvigorated ever since Keynesians, not Libertarians like Ron Paul, challenged it). Quoting from a book written by Professor Case, Fair and Oster, (strict) monetarists:

“…put an emphasis on the velocity of money, which is defined as the number of times a (currency) changes hands, on average, during the course of a year.”

Calculating this velocity is simply an algebraic problem. Intuitively, the velocity is equal to the aggregate value all domestic goods is worth (GDP) divided by the supply of money available in the market: V= GDP/M. Since GDP is composed of the average price (P) per unit and real aggregate output (Y), we can then form the identity that MxV=PxY. (Let us assume that Paul still believes in the importance of mathematizing economics in a fundamental level). Now, according to Wikipedia, in 1956, Milton Friedman restated a claim that the velocity of money, in the short and long run is constant. Due to proportionality, this suggests that whenever variables in the right side of the equation (P or/and V) change, the variable M should change. Friedman’s restated theory thus implies that the Federal Reserve should (and only should) increase or decrease the money supply whenever there is a significant change in price level (P) or amount of real aggregate output (Y). If price level is stationary and sustainable, this means that (strict) monetarists only allow the involvement of the Fed as long as there is a real increase in productivity.

Let us assume that Obama decided not to re-run, Ron Paul received more funding and made Mitt Romney lost his emotions during the Republican primary debates. His ascension to presidency would then allow him to induce Congress to make Professor Bernanke return to Princeton. Without the Fed, Paul would not be able to alter the money supply in strict monetarist term (not Keynesian), which I think is troublesome. As stated previously, since the velocity of money is constant, any increase in price level and/or real aggregate output mandate Fed’s injection of dollars into the market. However, Paul’s return to the gold standard turns money demand ‘M’ to a constant. Furthermore, Paul claims that the abolishment of the Fed will stabilize price level in a way that excessive inflation would not exist at all. Under this claim, we can then turn ‘price level’ (P) into a constant, leaving one variable only, which is the real aggregate output (Y). Hence, during Ron Paul’s presidency, Friedman’s equation would become something that would put a huge burden on the sole variable, because constant(1)*constant(2)=constant(3)*Y.

This means that, with everything constant, Y should be maintained–growth would or must not occur in the economy. Since this is unimaginable, another hypothetical condition is proposed: what if an increase in Y (real output) is inevitable due to U.S.’ rapid development of technology, increase in human capital, or lenient laws on free trade benefiting the country? Since the Fed no longer supplies money and price level is stable because interest rate is controlled by the free market or because there is no (excessive) inflation, the velocity of money is forced to be increased. Of course, under Friedman’s theory, the velocity is constant, but even if it is not, there must be external factors that force people to transfer the dollars they possess to other people in exchange for goods and services. But if the velocity of money remains the same (or worse, decreases), economic growth would be suppressed, banks will become insolvent, and liquidity traps would be ubiquitous.

Note that such a conclusion is reached based on multiple assumptions and exclusions of essential components affecting the economy. Researches show that the velocity of money is not stagnant (the trend shows that it is decreasing, which exacerbates Paul’s condition). That is one of the reasons why I call the monetarist view ‘strict.’ I also have not discussed the economic (especially fiscal) policies Ron Paul would have proposed in conjunction with removing the Fed if he had been appointed as President. With his other economic policies, ending the Fed might work. Or, as what most economists believe, it might backfire.