The Second Parchment

On Economics, Finance, Politics and Music

Category: Public Economics

Sovereign Credit Rating Service: A Public Good?

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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.

Indonesia’s Fuel Hike: Eliminating Arbitrage?

The discussion about the impending rise of fuel price as the government schedules on removing subsidies for fuel has turned into a fiery political debate in every part of Indonesia. Despite President Yudhoyono’s coalition not unanimously approving of this proposed policy (I saw supporters of Partai Keadilan Sejahtara demonstrating earlier this afternoon), the probability of it happening is so high that markets have reacted, adjusting to expectations. Just today, Rupiah significantly depreciated against the USD. The price of a dollar reached more than Rp. 10,000, which happened for the first time since 2009 as the world slowly recovers from the 2008 financial meltdown.

Our recently-appointed Finance Minister, Dr. Chatib Basri, commented that the government’s decision to revoke the subsidy will bring about a positive outcome. Most people and economists supporting the government base their support on a classic argument: they argue that subsidies should be channeled towards productive long-run sectors (technology, health, education). But Dr. Basri takes a different angle. Quoting from an interview by the Jakarta Globe, Dr. Basri commented that:

“The biggest deficit in our trade balance is from oil and gas imports,” Chatib said at the State Palace on Wednesday. “If the price increases, the price disparity between the domestic and international fuel price will narrow.”

To elaborate further, Dr. Basri, as paraphrased by the interviewer, said that “the government’s plan to raise the price of subsidized fuel would cut the amount of oil and gas smuggled out of the country.” In the article, the Ministry of Energy and Mineral Resources confirms that Indonesia has indeed been a recurrent victim of rampant fuel smuggling. Subsidized fuel is comparatively less expensive in Indonesia compared to other Southeast Asian countries that those knowing how to circumvent the procedures of Indonesia’s customs have taken advantage of such significant disparity in price. Buy low in Indonesia, sell high overseas. Assuming that all types of transportation costs are removed, this act of fuel smuggling is a form of arbitrage in the fuel market.

However, I believe that price differences between Indonesia’s and foreign fuel markets shouldn’t be a problem if there exists a strong and strict regulative framework within Indonesia’s customs. The argument that the government should let the price of fuel increase so as to eliminate arbitrage opportunities isn’t compelling enough. While it’s very clear that Dr. Basri, one of Indonesia’s esteemed economists, is not advocating for this argument, some important government officials actually are. A solution to Indonesia’s problem in catching profit-making arbitrageurs shouldn’t be raising the cost of fuel. It should be anything other than that i.e. stronger enforcement of export-import laws, better oversight and controlling or cargos.

Regardless, the price of fuel is rising soon. Like it or not, it’s happening, and any Indonesian consumer irrespective of their level of wealth, in the short run, wouldn’t be happy with things getting more expensive. While I believe that taxpayers’ money should be directed at productive sectors (just like most people do), it still somewhat saddens me that an hour ago I was asked to pay for an extra 20% to buy a bottle of a drink I’m currently addicted to. Oh well—what can you do.

Roubini at NYU Abu Dhabi

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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.”

The Euro Debt Graph

Euro

If anyone ever asked me about my favorite graph in economics, I would show them the graph above. My professors once said that the graph is aesthetically beautiful (look at the convergence between 1999 and 2008) but what makes it very special is the amount of information contained in just one graph.

Some have tried to explain what exactly caused the convergence. There’s a lot of economic theories being offered, but I find one particular hypothesis convincing. It’s simply carry-trading. Not the typical currency carry-trading, but government bond (10-year maturity) carry-trading. Private investors in 1999 saw the expected accession of Greece to the Eurozone as a form of risk-minimization: they believed that Greek bonds would just be as valuable as Germany’s risk-free bonds. Since Greece’s interest rates were way higher than Germany’s interest rates, they borrowed money from Germany (with low cost since Germany’s interest rates were comparatively lower than those of Greece) and invest in Greek bonds (with higher return since Greece’s interest rates were comparatively higher than those of Germany). The free market then did it job pretty miraculously: the high demand for Greek bonds increased their price and lowered their yields. Take a look at what happened in 2001-2002. At this point, those who carry-traded since 1999 must have earned tons of money. This act of carry-trading persisted until 2008, when Lehman collapsed, credit rating agencies downgraded Greece, and investors started seeing Greek bonds to be riskier than other bonds in the Eurozone.

The consequence? Private investors started panicking (a legitimate panic, not an irrational one), and each country started having its own interest rate trajectory. In 2012, Greek bonds were perceived as extremely unpredictable in its return to debt investments (notice the double-digit government bond yields), while Germany’s bonds maintained its stability. No wonder why Christine Lagarde wasn’t happy.

On Iceland: Defending Professor Mishkin

Iceland

Many people assail Professor Mishkin of Columbia University for his inconsistent stance on Iceland’s economy before 2008. Especially those who have watched the widely-acclaimed documentary, ‘Inside Job’, in which Professor Mishkin was interviewed regarding his opinions on the 2008 financial crisis and how it was similar to that of Iceland’s. The shrewd interviewer found that Professor Mishkin changed the title of his report, from ‘Financial Stability in Iceland’ to ‘Financial Instability in Iceland,’ as the crisis ensued. The narrator further said that Professor Mishkin had a conflict of interest; that he published his report under the direction of the Icelandic government, to stabilize the market after Fitch downgraded Iceland banks from ‘stable’ to ‘negative.’ I read the report, and as expected, the tone was optimistic. Indeed, in the end, history disproved Professor Mishkin’s claim that “[Iceland’s] financial system remained strong.” (In the report, he did not expect, or mention the potential of, a Lehman’s collapse in 2008, which subsequently led to illiquidity in interbank lending. Which economists correctly predicted the 2008 crisis anyway? There were only a few of them).

He wasn’t completely incorrect, however, and here’s why. In addition to his exceptional analyses of Iceland’s competitive advantage, governmental and educational system, he did implicitly illustrate a hypothetical case of the Icelandic banks failing to finance their liabilities. After skimming the report, I found a chart demonstrating the relationship between CDS (Credit Default Swaps) spreads and the probability of an Icelandic financial instability. (For those not acquainted with the term CDS, Investopedia has a great description of it). CDS is basically an insurance that protects the CDS owner/speculator against a probable default or ‘failure’ of an asset. As commonly known, larger CDS spreads imply that the market perceives the Icelandic banks as having a high probability of possessing bad assets, defaulting, or becoming insolvent. Professor Mishkin did his calculation, and he found that when the spreads reach 500 basis points, there is a 100% probability that Iceland inevitably would experience a financial turmoil.

CDS Spread vs. Probability of Financial Crisis1

The paper was written in 2006. That time, CDS spreads were clearly below 500…

CDS Spreads1

… but as shown in the graph above, CDS spreads soared rapidly until 2008. It even reached above 1000 basis points. Under Professor Mishkin’s calculation, it means that a financial crisis would occur, unavoidably. And it did; the banks were insolvent, capital inflows sharply declined, the Icelandic Krona depreciated, the banks restructured, public debt increased, foreign assets frozen, and unemployment tripled. All of these were triggered by the U.S. subprime mortgage crisis in 2008, which rendered interbank lending freeze. Professor Mishkin was therefore not completely incorrect. His graph shows that he did ‘predict’ a financial instability in Iceland. He didn’t simply change the word ‘stability’ to ‘instability’ out of thin air; he had a basis for doing so.

On Government Deficits

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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.