Volatility may be provoked

The Governing Council of the ECB decided to increase the key interest rates by 25 basis points to 1.5% on the 7th of July due to the high inflation in euro area. The annual HICP inflation was 2.7% in June 2011 that is inconsistent with the primary objective of the ECB’s monetary policy to maintain inflation rates below, but close to, 2% over the medium term. According to the introductory statement to the press conference such anchoring is a prerequisite condition to the economic growth in euro area. However, the ECB’s attempts to strengthen euro by increased key interest rates may evoke even higher volatility. The results of the EU wide stress test will be announced on Friday, 15 July. Moreover, participants of the financial markets are sensitive to news those increase burden of the “peripheral” countries to manage their debts.


According to the EU wide stress test scenario based on the ongoing EU sovereign debt crisis, the domestic demand of the euro area will decline affecting consumption and investment. It is assumed that the long-term interest rates will go up by 75 basis points, stock prices will fall by 15%, house prices will decline, tensions regarding the European money market will renew and contribute to an increase in short-term interest inter-bank rates by125 basis points. Considering the scenario which involves global negative effect of the US policy and a USD depreciation vis-à-vis all currencies, the private consumption and investment will be getting worse; however, it is assumed that both oil and non-oil commodities will be unaffected and the monetary policy will be unchanged. Considering the circumstances mentioned above it is anticipated that the overall effect of the EU-specific and external environment shocks will reduce the GDP growth by around 2% in both 2011 and 2012 and HICP will be lower by 0.5 and 1.1 percentage points for the euro area.

Although the ECB expects that the increased interest rates will reduce inflation and contribute to enhance economic growth, higher energy and commodity prices those are the main reason of the increased HICP little can be changed by such decision. Moreover, when the increased interest rates are used to reduce monetary liquidity and at the same time the opposite actions such as emergency liquidity to assist banking system in the event of crisis are considered it leads to higher volatility in the financial markets. Thus, I wish the ECB was able to identify though was not following the anticipated negative scenarios of the EU wide stress test.

Could the fixed balance sheets restore financial stability?

The OECD’s Economic Outlook published on the 25th of May and the BIS’s 81st Annual Report brought out on the 26th of June characterize the global recovery as self-sustained. It is projected that the US economy will grow by 2.6% in 2011 and 3.1% in 2012, the GDP in Euro area will rise by 2% in each of upcoming two years and the Japan’s GDP increase by 0.9 % and by 2.2% in 2011 and 2012 accordingly. Consequently, the safeguards of financial stability recommend withdrawing fiscal and monetary stimulus due to the rising inflation. However, these suggestions bear a strong resemblance to the decisions how to fix balance sheets instead of restoring foundations of financial stability.

From my point of view, the described economy recovery of the advanced countries in the OECD’s and the BIS’s reports is lack of structural analyses. Once the pressure of the inflation is taking under considerations I would rather like to know whose industrial sectors are overheated and why their development requires suppression. Moreover, has anybody estimated how the imposed extra costs associated with the suggested growth of interest rates would affect other fragile industries?

Additionally, increased capital (10.5% - total capital requirements that involves minimum capital plus conservation buffer), leverage and liquidity standards for banks according to the Basel III requirements and other endeavours such as accepted “ringfence” concept – the British initiative that intends to protect essential banks’ operations (deposit taking and payment systems) in big diverse banks; regulators agreement on extra capital charges of 1% to 2.5% of risk-adjusted assets on the 30 global systematically important institutions as well as suggestions of the BIS and the BCBS to apply supplementary countercyclical capital buffers are attempts to absorb losses in bad times and keep clean balance sheets of financial institutions after the banks’ bail outs started in 2008. However, those achievements do not mean that losses of the Financial Crisis are vanished. In most cases, they are just transferred to the governments’ balance sheets and the particular focus is required to recover the fragile economies of advanced regions.

However, according to the BIS's Annual Report “very low interest rates in major advanced economies delay the necessary balance sheet adjustments of households and financial institutions”. Thus, it may imply that encouragement to increase interest rates is aimed to restore price stability rather that the soundness of the whole financial system.

Trends of voluntary aid

A meeting of Eurozone finance ministers in Luxemburg today, on 20 June, ended without approval to lend €12bn  ($17bn) to Greece until the country’s parliament passes new spending cuts and economic reforms worth of €28bn. The matter is time sensitive as Greece needs the €12bn by July to avoid defaulting on its debt. The Eurozone finance ministers require further austerity measures; however, Greece may also relay on some EU countries’ voluntary aid.

French President Nicolas Sarkozy and German Chancellor Angela Merkel announced on last Friday that they will support Greece by purchasing new Greek bonds when existing bonds mature and encouraged others to follow their suggestion on voluntary basis. Such decision may not be acceptable in regard to taxpayers of Germany and France but when the possible decline of euro is directly related to the worth of governed assets, a voluntary aid is fully understandable.

However, looking to the long term perspective sound investment programmes, but not just austerity measures, should be the main focus for the Eurozone finance ministers as long as European Investment Bank, European Investment Funds and European Bank for Reconstruction and Development were established for the purpose to make a long-term finance available.

Similarly, analysing the outlook of the US economy state, id.est accomplished QE2 programme, increasing debt obligations and additional borrowing needs; the raise of yields of US long term treasury bonds and depreciation of US dollar should be expected in short term perspective. Consequently, countries those use US dollar as reserve currency and possess trade surpluses most likely will suggest their voluntary aid and buy US long term treasury bonds so that the worth of their governed assets were preserved.

Thus, for those who follow short term trends, summer time should be an important period to observe. Most likely the capital flows will be based on a voluntary aid.

The shift of the US monetary policy and the OPEC's disagreement on oil production

Ben S. Bernanke, a chairman of Federal Reserve announced further course of the US monetary policy at the International Monetary Conference held in Atlanta, Georgia on 7 June. He told that the Federal Open Market Committee decided to complete its purchases of $600 billion of Treasury securities by the end of June and will keep low levels for the federal funds rate for an extended period as economic recovery in the US is proceeding in the moderate pace. However, financial strategies those were designed for the Federal Reserve’s extended QE programme were realized successfully as well.

The US dollar declined against the major peer currencies on 8 June, the price of WTI Crude Oil jumped more than $3 from $98.15 to $101.65 over four hours, Brent Crude Oil raised more than $2 from $116.00 to $118.40 at the same time due to the disagreement between the members of OPEC regarding the oil production. The 159th Meeting of the OPEC held in Vienna, Austria, on 8 June was closed with no formal decision according to mismatched official data about oil demand and supply that triggered instability in the international oil markets.

The 160th Meeting of the OPEC will take place in Vienna, Austria on 14 December 2011; however, if nobody consider about the clear methodology and improved data management the circumstances to predict market trends remain the same - two plus two is not equal to four and clearly identified square tends to be circle.

Captured media attention - the opportunity to introduce the Greece’s potential

The Greece’s €110bn joint EU-IMF bailout package approved last year won't be enough to stabilize Greek economy. The country needs to find another €60bn to cover its deficit, repay long-term loans and support banks through 2013. However, the S&P downgraded Greece’s credit ratings to B and increased over 16% ten year government bond yields force Greece to negotiate on another rescue package alongside with considerations on debt restructuring. Thus, what else can Greece do to help itself?

According to the decision of the Greece Interministerial Committee for Asset Restructuring and Privatisations which was made on December 15, 2010, the Real Estate and Asset Privatization programme involves government intentions to transfer operational management of the country’s strategic communications: airports, railways, motorways, marinas and ports through concession agreements, search for the best available privatization options for its stake in energy and natural resources supply and operations such as natural gas suppliers and natural gas network operations, water suppliers and nickel mining operational improvements as well as the selection and privatization of major real estate assets. The estimated incomes from the Asset Management and Privatization programme amount €7bn within the 2011-2013 period and that is not sufficient to meet outstanding Greece debt obligations.

The privatization programme may be more successful if assets were sold according to the potential increase of its values after assets’ restructure and operational improvements. Thus, the country would benefit more by suggesting investment opportunities rather than sales of its real estate assets. Moreover, when media capture attention to Greece, it is the right time for the country to take the opportunity and present the guidelines of its economy development trends, advantageous of produced domestic products and provided services as well as to promote investment opportunities in private sector.

Get out from the systematic dependence

According to the article “Bank caves in over PPI mis-selling” published in the Financial Times on the 9th of May, the customers of the Lloyds Banking Group, Barclays, HSBC and Royal Bank of Scotland massively require compensation for mis-sold loan insurance. Some analysts estimated that the compensation may reach £ 8 bn and that this mis-selling case may be the biggest in the UK. It also may imply that customer protection instruments are used in full scale and the tendency to back up financial decisions by insurance is prevailing.

Financial safety nets that involve liquidity support, deposit insurance, investor and policyholder protection schemes and crisis management policies are designed to maintain customers’ confidence and protect them from the financial institutions failure. However, it seems that those risk minimization measures work well only to soften temporary disturbance and illiquidity. Managers may be encouraged by insurance to take excessive risks and increased liquidity may boost inflation. Moreover, in case of the exaggerated instability the higher insurance premiums are imposed to adjust risk to the sectors’ interconnectivity and additional costs are experienced due to tighter supervision.

So, while integrity of financial institutions supports the economy development, the same interconnections may be treated as a cause of systematic risks. The inter relations, like a chain of separate elements, create domino effect. Once the significant part of the system becomes weak, it pulls dawn the other elements.

The possible solution to manage systematic risks efficiently could be the release of connections between financial institutions that facilitate a pull back from the systematic dependence. The way, when participants do not depend on the destructive circumstances, flexibly allocate assets and hedge market risks from high volatility.

Interest rates versus inflation

What is the right interest rate for the low growth and high inflation regions? This is the main issue to consider for the central banks in Europe and US. Moreover, is the increased nominal interest rate an appropriate measure to manage inflation when financial stability is rebuilt by the increased money supply?

According to the Federal Reserve Board’s and Federal Open Market Committee’s press release in April 27, the FOMC decided to maintain the Federal Fund Target Rate at 0.25 %. Similarly, according to the press conference held in May 5, the Governing Council of the ECB agreed to keep the key ECB interest rates at 1.25 % after the 25-basis point increase on 7 April 2011. The governors of central banks promised to monitor the inflation and commodities' prices closely and respond to arisen inflationary pressure respectively.

Considering the current US’s and Europe’s economic outlook somebody may interpret that a slight, 1-3 % annual GDP growth of the region is a signal of the modest recovery while determined nominal interest rates are lower than the growth of GDP. However, from my point of view, if the projected capital flows of the state were discounted by the adjusted rate for inflation, it might appear that the current costs of output exceed the future benefits and the net present value is negative.