Gary Gorton and his co-authors have produced a large literature on what they calls safe assets (assets whose prices are informationally insensitive). They published two new papers this month on collateral crises and on the constant share of safe assets through the last half century. Their earlier papers on being slapped by the invisible hand and the run on repo are quite well known. The basic argument of this literature is that:
- Safe assets serve an important social function
- Safe assets are in short supply – the demand for these assets exceeds the stock of government securities and other obvious safe assets.
- The shadow banking system is an important source of supply of safe assets
- The shadow banking system and the safe assets that they create must be protected from “runs” in the same way that bank deposits are protected.
A more radical version of this idea can be found in a paper by Morgan Ricks which argues that only licensed money-claim issuers should be permitted to issue short term debt and that all this debt should then be explicitly insured by the government.
Much of what we know about the demand for safe assets come from the work of IMF economist Manmohan Singh (not to be confused with the Indian Prime Minister!). In a series of papers on the use of collateral in OTC derivatives, counterparty risk and central counterparties, collateral velocity, rehypothecation, and the reverse maturity transformation by asset managers, Singh and his co-authors have documented the need for safe assets in derivative markets and asset management.
What emerges from this discussion is that much of the demand for safe assets comes from sophisticated financial institutions and sovereign reserve managers. To my mind, this completely weakens the case for any form of subsidy for the creation of safe assets. The literature on participation in equity markets (which can be regarded as a proxy for risk taking in financial markets) demonstrates that participation is determined to a great extent by intelligence (Grinblatt et al), cognitive ability (Christelis et al), education (Cole and Shastry) and financial literacy (Rooij et al).
Most of the demanders of safe assets are big institutions (according to Manmohan Singh’s work), and one would expect them to possess a sufficient pool of intelligence, cognitive ability, education and financial literacy to be able to invest in risky assets. In some cases, portfolio risk may actually be lower if safe assets are replaced by equities. For example, Manmohan Singh explains how the security lending activities of asset managers creates a reverse maturity transformation – it converts the long term investment portfolio of households into a demand for short term assets (collateral). To the extent to which equities are correlated with each other, it is plausible that collateral in the form of stocks similar to those that are lent out might reduce risk. To the extent to which the borrower of the stocks is engaged in a “pair trade”, a natural supply of such collateral might exist.
I suspect that the demand for safe assets is better explained by a rational tradeoff between the costs and benefits of risk assessment (in a manner that bears some similarities to the rational inattention model of Sims). I therefore look at the huge demand for safe assets as a consequence of the moral hazard engendered by repeated bail outs of the financial sector. Even sophisticated investors may find it optimal not to make a serious risk assessment of any asset which has little idiosyncratic risks and is exposed only to systemic risks if the probability of such an asset (or rather its investors) being bailed out is quite high.
When one reads Gorton carefully, it becomes apparent that that the safe (or informationally insensitive assets) are not risk free – they are only free of idiosyncratic risk. Systemic risk is less subject to information asymmetry and therefore does not pose the problems that Gorton attributes to risky assets in general. But then the ability of the state to insure against systemic risk is highly suspect because if such an insurance is attempted in sufficiently large scale, the result is likely to be a sovereign debt crisis when the systemic risk event materializes. Capitalism to my mind is about accepting and dealing with failure, while the path that Gorton and Ricks are proposing is the path of socialism.
I see a similarity between the desire of the rentier class for safe assets and the desire of the working class for defined benefit pension plans. In both cases, the desire is to shift the risks to the taxpayers and thereby avoid the cognitive burden of making informed choices. In the case of the working class, society has over the last few decades rejected the demand for “informationally insensitive” pensions (defined benefit plans) despite the fact that lower levels of financial education might make the cognitive burden quite high for many of these people. I see no reason why the rentier class should receive a more favourable treatment.
Wed, 25 Jan 2012
Almost a year ago, I wrote a paper on finance teaching and research after the global financial crisis (see this blog post). A revised version of this paper has been published in the latest issue of Vikalpa. The only significant change in the published version is that the portion dealing with learning from related disciplines has been expanded and rewritten. Most of the other changes were only to improve readability and clarity. As always, comments and suggestions are welcome.
Thu, 19 Jan 2012
In recent decades, economists have been increasingly focused on the de facto exchange rate regime using the ideas developed by Reinhart and Rogoff (2004) and by Frankel and Wei (1994). This approach of looking at the actual data is of course a huge advance over the naive approach of relying on official pronouncements. Intermediate approaches are also possible as exemplified in the IMF’s De Facto Classification of Exchange Rate Regimes and Monetary Policy Framework.
Obsessive contemplation of currency breakups (see my blog post last month) has made me more sensitive to the legal nuances of a fixed exchange rate regime, and I am beginning to think that looking only at the statistical properties of the exchange rate time series is not sufficient.
I have been thinking of three small but rich and highly successful jurisdictions which have today adopted a fixed exchange rate regime – Switzerland, Hong Kong and Luxembourg. The statistical properties of recent exchange rate behaviour in these three countries might be very similar, but the legal and institutional underpinnings are very different. A de-pegging event would play out very differently in these three cases.
Switzerland has temporarily pegged its currency (the Swiss franc) to the euro through an executive decision of its central bank. There is no statutory basis for this peg. Technically, the Swiss have put a floor (and not a peg) on the EUR/CHF exchange rate (Swiss francs per euro); but given the massive upward pressure on the franc, the floor is a de facto peg.
Exiting this peg would be very easy through another executive decision of the central bank. The only real costs would be (i) the exchange losses on the euros bought by the Swiss central bank, and (ii) probably a modest loss of credibility of the central bank. I would imagine that a significant uptick in the inflation rate in Switzerland would be sufficient to cause the central bank to drop the peg and accept these costs.
Hong Kong’s peg to the US dollar is much stronger and longer. It has lasted a whole generation and is enshrined in a formal currency board system. Having survived the Asian crisis, the peg is regarded as highly credible. Yet, it would be very easy to change the peg or even to remove the peg completely. In fact, my reading of the statutes is that this could happen through an executive decision of the government without any changes in the law.
Indeed, there is a significant probability that over the course of the next decade, the HK dollar would be unpegged from the US dollar and repegged to the Chinese renminbi. This change could happen quite painlessly and without any legal complications.
Luxembourg has adopted the euro as its currency. This means that leaving the euro and recreating its own currency would be a legal nightmare. The doctrine of lex monitae asserts that each country exercises sovereign power over its own currency, and that it is the law of that country which determines what happens when a currency is changed. This might appear to give enough leeway to the Luxembourg government to do whatever it wants.
However, in a cross border contract, the other party would argue that the term “euro” in the contract did not refer to the currency of Luxembourg at all, but to the currency of the euro area as governed by various EU treaties. This argument may not help if the contract is governed by Luxembourg law because the local courts are likely to interpret lex monitae very broadly. But if the contract were governed by English law (as is quite common in international contracts), it is quite likely that the English courts would take the EU interpretation. Assuming that the UK remains a member of the EU, its courts might not have any other choice.
I am beginning to think that we tend to focus too much on the role of money as a medium of exchange or as a store of value. If we do this, it appears that all the three countries have surrendered their monetary sovereignty to an equal extent. But the role of money as a unit of account is extremely important. Of the three countries described above, only Luxembourg has (arguably) surrendered its sovereignty on the unit of account. This loss of sovereignty is the most damaging of all.
An alternate way of constructing the euro way back in 1999 might have been for Luxembourg to adopt its own new currency (say the Luxembourg euro) of which no notes would be printed, peg this currency to the euro issued by the ECB (the ECB euro) at 1:1, and declare the ECB euro to be the only legal tender in the country. From a medium of exchange or store of value point of view, this arrangement would be identical to what exists today because only ECB notes would circulate. But in Luxembourg law, under this alternate approach the ECB notes would just happen to be the legal tender for the Luxembourg euro which would just happen to be equal to the ECB euro. The Luxembourg euro would then be capable of being unpegged from the ECB euro at any time under the doctrine of lex monitae.
The problem as I see it is that technocrats always have a temptation to try and build something that cannot fail. The technocrats who created the euro therefore set out to create something irreversible and permanent. I think it is better to approach the matter with greater humility, and endeavour to build something that would fail gracefully rather than not fail at all.
Finally, there is a fourth small, rich and highly successful country – Singapore – which is also an important financial centre like the other three and has gotten by quite well without pegged exchange rates.
Mon, 09 Jan 2012
Last month, the McKinsey Global Institute (MGI) published a 95 page report (The emerging equity gap: Growth and stability in the new investor landscape) arguing that over the next decade, there is likely to be a shortage of equity investors globally. This is based on two arguments:
- Demographics and the regulatory aftermath of the financial crisis are reducing the demand for equities from investors in developed markets.
- Global wealth is shifting to emerging market investors who have historically had less appetite for equity investment.
The second prong of this argument is clearly debatable. Had there been a think tank examining such questions in the nineteenth century, it too would have worried about the shifting of wealth from the UK (which was then the dominant source of risk capital for the world) to newer rivals. We do know with hindsight that with increasing wealth, the rising powers of the nineteenth century went on to become major sources of risk capital to the rest of the world. That could well happen again, but it will not happen unless today’s emerging markets create the preconditions for a vibrant equity market.
MGI is therefore on much stronger ground when it discusses the policy steps that emerging markets should take to develop their equity markets – strengthen the legal and regulatory foundations of equity markets; expand channels for households to access equity markets; and enable the growth of institutional investors. (pages 55-56).
All of this is of great relevance to India which has thrived during the last two decades on foreign risk capital. India has a large domestic savings pool and could perhaps at a crunch get by on only these savings. But two-third of household financial savings go into risk free assets like currency, deposits and small savings. Most of the remaining third goes into insurance and retirement funds which in turn invest a very large part of their resources in government bonds and other safe assets. Only around 1% of household savings go into equities. India may have nearly enough aggregate savings, but there is an acute shortage of risk capital.
Foreign portfolio capital has bridged this gap during the last two decades. Since these capital inflows exceed the aggregate savings shortfall, a part of the capital flows ends up as foreign exchange reserves which finance profligate governments in the developed world (and post 2008, this lending is far from being risk free).
Without foreign risk capital, it would have been impossible for the Indian private sector to come anywhere near the growth rates that it has achieved in the last two decades. But we must recognize that the reliance on foreign risk capital is a short term fix to the shortage of domestic risk capital. As we saw in 1998 and again in 2008, this dependence creates serious vulnerabilities. When foreign portfolio flows reverse, risk capital disappears and weak balance sheets cannot raise money at all. (Strong balance sheets can perhaps raise debt locally). Secondly, capital inflows can ignite asset price bubbles and outflows can prick the bubbles. Asset prices in India often depend on global risk aversion even more than on domestic sentiment.
It is true that Indian equity markets have been one of the great success stories of financial sector reforms (the contrast with the dismal state of the corporate bond market is particularly glaring). But we must not forget that even this success consists principally in the fact that foreign equity risk capital is largely intermediated through Indian markets (by contrast, the Indian corporate debt market moved offshore because of poor regulatory choices).
Creating a pool of domestic risk capital will take a long time and that is all the more reason why we must start soon. We will need a lot of things to get there – well developed and liquid markets, institutional support to facilitate easy access, sound regulatory regimes to provide investor protection and confidence, and finally investor education and awareness.
India would need to do all this in its own interest. What MGI is saying is that India (and other emerging markets) might be forced to do this even faster because the foreign pool of risk capital may be about to dry up.