Risk assessment in liquid assets’ pricing

The agenda of a wide array of topics discussed in the World Economic Forum in Davos is an opportunity for political and industrial leaders to deliver messages to public about the good management practises and future expectations on resilient dynamism. However, despite a review of global development trends and panel discussions on human capital, leadership, energy, healthcare, technology, value chain and other topics, I would like to focus on risk management which is an integral part of financial stability and social-economic outlook.

 

The most recent subjects broadly discussed in financial stability context are the increase of the US debt ceiling and amendments of the Basel III. According to the Statement by the Press Secretary released on 18 January, 2013, Barack Obama, a president of the US, expressed an importance of the timely Congress decisions on payments of bills and committed to further deficit reduction in a balanced way. A failure of the US to pay its bills could lead to the national default and meltdown of the financial markets.

Similarly, loser liquidity risk management standards for financial sector those were agreed by the Basel Committee on 6 January, 2013, may cause underestimation of risks. A liquidity coverage ratio measures the requirements for sufficient High Quality Liquid Assets in comparison to the net cash outflows. The minimum LCR requirement for banks in 2015 is 60 percentages which is projected to increase till 100 percentages in 2019, id. est. banks should possess as much High Quality Liquid Assets as it needs to cover a total net cash outflows. Made amendments regarding the definition of HQLA and assets treated as cash outflows enabled banks to increase the numerator of the ratio and reduce the denominator which implies higher percentage of LCR. However, despite the changed requirements of what is allowed, could the Basel Committee publish the guidance of what is more favourable?

In both of these cases the market participants will have to reassess the value of liquid assets and management of liquidity risk. Moreover, assets pricing distortions due to high volatility may also cause difficulties in management of liquidity risks. Risk is a probability of  default. However, according to the Basel III, LCR is defined by the assets’ features to be sold quickly in the markets. In general, all publicly traded securities are liquid and risks arise due to the price they may be sold. The financial stability depends on whether sold assets produce gains or losses.

A distortion in prising is a risk itself. When assets pricing and future values are not clear risks could be hedged with derivative instruments. However, these deals also involve financial obligations, the transfer of money, the gains or losses according to the agreed conditions and markets’ circumstances.  

Thus, I would like to distinguish two drivers of the resilient dynamism: competence and power of negotiations. Both of them are equally important to succeed.

Could increased assets' value through currency devaluation lead to higher returns?

The goal to reverse prolonged deflation and yen appreciation is a declared focus of a newly appointed Japanese Prime Minister Shinzo Abe. However, according to the minutes of the Federal Reserve Board and the Federal Open Market Committee published on January 3, 2013, several members expressed concerns that continuing purchase of mortgage backed securities ($40 billion per month) and purchase of long term Treasury securities ($45 billion per month) would contribute to the maximisation of employment and price stability. Consequently, the suggestions to slow down or stop the programme before the end of 2013 were discussed. Decisions on monetary policies are left to the discretions of the national central banks; however, the opposite policies may contradict the reliability of Japan-US alliance.
 

Shinzo Abe, the leader of Japan's Liberal Democratic Party, together with a new coalition Cabinet, formed on the 26th of December in 2012, committed to revive economy through bold monetary policy measures, flexible public funding policies and growth strategy which encourages private sector investment. The new government also promoted endeavors to accelerate the reconstruction of the Great East Japan Earthquake, restore national security as well as improve education and sustainable social security systems. However, despite the domestic interests, commercial concerns, as usual, go far beyond territorial influence.

According to the statistical data of Bank of Japan published on 10 December, 2012, Japan’s international investment in debt securities amounted 210,574 billion yen in 2011 which comprised 36 percentages of total invested international assets. The liabilities in international debt securities comprised 91,639 billion yen those made 29 percentages of total invested international liabilities in 2011. Thus, falling Japanese yen against major foreign exchange currencies may increase assets' value; however, the increase in incomes depends on the structure of foreign and domestic assets and liabilities.
 

Analysing direct international investment in 2011, the biggest amounts were allocated for wholesale and retail industry as well as finance and insurance industry. According to the statistics, 5,334 billion yen were invested in Central and South American finance and insurance industry; 4,796 billion yen were allocated in North American wholesale and retail industry and 4,700 billion yen in North American finance and insurance industry. The total amount of investment in European finance and insurance sector was 3,131 billion yen. Direct investment in Asian finance and insurance industry comprised 2,714 billion yen and 2,163 billion yen were allocated in Asian wholesale and retail sector. The other significant investments were made in chemicals and pharmaceuticals industry as well as electric machinery and transportation equipments based in US, China, and Europe in 2011. 3,208 billion yen were allocated in US, 2,236 billion yen were invested in Europe and 1,566 billion yen were spent in Asian chemicals and pharmaceuticals industry. Additionally, 2,557 billion yen were invested in Asian electric machinery and 2,810 billion yen were allocated in Asian transportation equipments sector. 1,933 billion yen were invested in North American electric machinery industry and 1,848 billion yen in North American transportation equipments. 1,659 billion yen were allocated in European electric machinery sector and 1,871 billion yen in European transportation equipments. Similarly to international portfolio investment, devaluated domestic currency may increase the value of assets; however, higher returns on direct international investments also depend on structure of incomes and costs.    

So, due to high international commercial relations it is difficult to measure benefits and loses of devaluation of domestic currency. Moreover, monetary policies may hardly replace structural reforms and aggressive economic growth may end with even higher debt obligations.

Are buybacks suitable gifts for investors and acceptable choice for decision makers?

Everything is fine say whose agree with the new tax regimes imposed to balance sovereign debts. However, those who disagree may find buybacks policies as alternative solutions to satisfy expectations of long term investors. So, are the buybacks appropriate means to ensure markets’ financial stability, suitable to attract investors and acceptable choice for decision makers?

The shares’ buyback policy may be advantageous for long term investors compared to paid dividends if taxes on dividends are higher than taxes on capital gains. The buyback policies may be favourable as well for the postponement effect. Shareholders may keep shares for long term and pay taxes on capital gains only once shares are profitably sold. These trends may sustain equity markets as notices in respect with buyback policies usually lift share prices. But will the buyback of debs has similar effect?

New programme to support Greece was discussed by the Troika during last several weeks. According to the press release of Hellenic Republic announced on 3 December, 2012, the bond holders were invited to exchange Greek debt securities for up to 10 billion euro aggregate principal amount of six-month notes issued by the European Financial Stability Facility. It was reported by Reuters on 3 December, 2012 that the offered prices were higher than Greek bonds eligible under the buyback closed at on 23 November, 2012. So, is such buyback of Greece’s public debt a gift for investors?

The invitation to buyback Greece bonds followed the Eurogoup Statement on Greece released on 27 November, 2012, which set considerations regarding an updated programme of further actions between the Troika and Greece. The goals of the IMF assistance programme till 2016 involve the reduction of Greece debt-to-GDP ratio to 175% in 2016, 124% of GDP in 2020 and lower than 110% of GDP in 2022.  It is expected that graduate buyback of Greece’s public debt will return it to the market financing.  So, Greece was encouraged to reduce debt in exchange of lower interest rates on the loans available from the Greek Loan Facility, lower guarantee fees on the EFSF loans, extended maturities of the bilateral and EFSF loans by 15 years, deferred interest payments of EFSF loans by 10 years and transferred amounts from the national central banks of the euro area Member States to Greece’s segregated account equivalent to the income on the portfolio of the Securities Market Programme used to absorb liquidity. Moreover, after the Member States’ approval of the next EFSF disbursement which amounts 43.7 billion euro, the 23.8 billion euro will be paid for banks recapitalisation in December.

 

Buyback of Greece sovereign bonds is an attempt to absorb risky assets from the markets. However, once favourable buyback conditions are created for investors, what capital structure of decision makers’ balance sheets remains? Only generators of constant revenues may afford such decisions.

 

Will Dodd-Frank Wall Street Reform and Consumer Protection Act save the markets from the collapse?

Thanksgiving Day in the US last Friday, 23 November, opened the Christmas shopping season.  Massive purchase brought confidence in the retail sector’s stocks. However, was the last Friday also the final rally? Historically, December is a weak month for stocks’ performance. Moreover, the ongoing US officials’ talks about the tighter fiscal discipline most likely will lead to the reduced consumption and decreased economic growth.  Going further, the US Securities and Exchange Commission’s statement, published on Monday, 26 November, surprised with Mary Schapiro’s decision to leave the agency on the 14^th of December. So, does it mean that the Chairman of the SEC abandoned started reforms? Then, who will safeguard the markets?

The Dodd- Frank Wall Street Reform and Consumer Protection Act which entered into force in July of 2010, was a response to the financial crisis in 2008. The legislative changes were approved as an economic foundation for job creation through increased investors’ confidence. Mary Schapiro, the former chairman and chief executive officer of the Financial Industry Regulatory Authority and chairman of the Commodity Futures Trading Commission, was appointed to lead the reforms at the SEC by President Barack Obama in January of 2009. The main changes according to the Dodd-Frank Wall Street Reform and Consumer Protection Act involved introduction of a new independent watchdog housed at the Federal Reserve; prevention measures those end bailouts of financial institutions and liquidate failed financial firms; establishment of a council for identification of systemic risks; increased transparency and accountability measures for over-the-counter derivatives, asset-backed securities, hedge funds, mortgage brokers and payday lenders; improvements in corporate governance and enhanced voting rights for executive compensation; improved transparency and accountability requirements of credit rating agencies; strengthened oversight on financial fraud, conflicts of interest and manipulation of accountancy books.

It was expected that imposed consumer protection measures will prevent from another financial crisis, but do the reforms include prevention measures from contracting economy? It may appear that shrinking economic growth will undermine stability of financial institutions and commitments to end the bailouts may lead to the increase of interest rates or the liquidation of an array of systemically failed financial firms.

Isn’t it too late to concern about the financial stability of the US banks?

2013 is going to be a challenging year for the global economy. Set US obligations to reduce the growth of budget deficit during 2013 and 2021 years and termination of the reduced taxes from 2013 may weaken consumption and cause double dip recession in the US with the contingency effect on global economy. Moreover, isn’t it too late to concern about the financial stability of the US banks due to approaching fiscal cliff?

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 which was passed by the US Congress and signed by President Barack Obama on December in 2010 terminates a two year extension of reduced income taxes known as the “Bush tax cut” in 2013. It also terminates extension of several other measures such as unemployment benefits and reduction of social security and medical care taxes. Moreover, according to the approved Budget Control Act of 2011, US was able to increase debt ceiling to $16.4 trillion in exchange for mandatory $1.2 trillion cuts of budget expenditures during the period from 2013 till 2021.

According to the analysis of the Congressional Budget Office – Fiscal Tightening in 2013 and Its Economic Consequences, published on August 22, 2012, a sharp reduction in the federal budget deficit will cause economy to contract but also put federal debt on more sustainable way. If current laws remain unchanged those lead to the tax increase and spending cuts the federal budget deficit will be reduced by $487 billion in 2013 and federal budget deficit will be $ 641 billion in 2013. According to this scenario it is expected that economic growth will contract to -0.5 % in the 4^th quarter of 2013 compared to the 4^th quarter of 2012. In case the lawmakers extend most tax cuts and other forms of tax relief and prevent automatic certain spending reductions, the federal budget deficit may be reduced by $91 billion in 2013 and federal budget deficit is projected to be $1,037 billion in 2013. According to the alternative fiscal scenario, it is expected the economy to growth by 1.7% in the 4^th quarter of 2013 compared to the 4^th quarter of 2012.
 

It is likely that in the anticipation of the worst case scenario and sharp economic contraction in 2013, the Federal Open Market Committee (FOMC) of the US Federal Reserve decided to continue monetary stimulus with third round of large-scale asset purchases. According to the statement of the FOMC meeting released in September 13, 2012 the Committee agreed to purchase additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also decided to continue through the end of the year its programme to extend the average maturity of its holdings of securities and to maintain its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. It was expected to increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year and put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

The continued monetary stimulus programme lifted equity markets; however, will capital gains from the equity price increase be substantial to meet investors’ in the US markets expectations related to the increased taxes on capital gains in 2013. Additionally, will the future economic environment promise more business growth opportunities and policies of higher dividends, so that gains from the dividends were substantial to meet investors’ expectations including increased taxes on dividends in 2013? Moreover, the fiscal policy of higher taxes creates more incentives for corporations to fund development through borrowing due to tax shield which leads to more lending opportunities for banks and increased financial risks related to higher leverage of corporations.

Sold gold reserves held in the IMF may realise frozen capital for economic development

The annual meetings of the World Bank Group and the International Monetary Fund hosted in Tokyo, October 9-14, once again engaged high level representatives from financial organizations and academic communities into the economic growth and financial stability issues. The events started with a brief presentation of the World Economic Outlook (WEO) which emphasised threats of high debts and sluggish economic growth mainly due to weaker demands in advanced economies. Similarly, the press briefing on Global Financial Stability Report (GFSR) highlighted actions restoring market confidence through monetary interventions and financial system reforms related to financial buffers, high-quality capital and sufficient liquidity in advanced economies as well as fiscal discipline in Europe, Japan and the United States. So are there particular circumstances those affect the future economic outlook?

Several events during the last and upcoming month have set more challenges and uncertainties regarding the future economic development. Slowing global economic growth and upcoming leadership changes encourage aggressive economic growth strategies and implementation of short term financial stability measures such as monetary easing measures to relieve credit crunch and market pressure. Approaching the US presidential elections in November 6 may change public debt management policies and measures for reduction of fiscal cliff, set new economy growth and employment programmes, and even affect monetary decisions. China’s slowing economic growth and territorial dispute with Japan, which may weaken economic cooperation between Asian countries, also coincide with the date of the 18th Party Congress on November 8, the date of formal unveiling of China’s new leaders and development policies. Moreover, despite of the measures prepared by European leaders to provide necessary financial support, Europe’s peripheral countries faces internal unrest due to exercised austerity measures, high unemployment and weak economic recovery.

Investment in gold products are seen as a save heaven in the environment of high uncertainties. So could growing gold prices create economic distortions? Expectations of investors that gold may rise to $2,000 an ounce could encourage investment in gold and may freeze capital for economic development.

Even the role of the gold has been reduced in the international monetary system, the IMF remains one of the largest official holders of gold in the world. According to the factsheet on Gold in the IMF published on 24 August, 2012, the IMF held 90.5 million ounces (2,814.1 metric tons) of gold at designated depositories at mid-August 2012. The IMF’s total gold holdings are valued on its balance sheet at SDR 3.2 billion (about $4.8 billion) on the basis of historical cost. As of August 17, 2012, the IMF's holdings amounted to $146.1 billion at current market prices. So, sold gold reserves held in the IMF at market prices could realize frozen capital for economic development.

The Eurosystem’s Outright Monetary Transactions – the ECB’s intervention in management of sovereign debt

Mario Draghi, a president of the European Central Bank introduced the technical features of the Eurosystem’s Outright Monetary Transactions in secondary sovereign bond markets during the press conference on the 6^th of September. The ECB’s approved conditions of programmes allow intervening in the financial markets and absorbing high yield sovereign debt securities.  The special programmes could relief borrowing cost of issued sovereign bonds through the ECB’s purchase of securities those are not accepted by investors. Considerations regarding the monetary and fiscal policies interactions intensified during the period of financial instability. However, interventions of central banks in the management of the sovereign debt are still assessed contrary.

According to the “Interactions Between Sovereign Debt Management and Monetary Policy Under Fiscal Dominance and Financial Instability” (No. 3 of OECD Working Papers on Sovereign Borrowing and Public Debt Management), published by Blommestein, H. J. and P. Turner (2012), it is difficult to separate monetary and public debt management as both policies are involved in the sales of sovereign debt to private sector, though in different forms. New issuance of sovereign debt securities or regulation of the supply and demand of sovereign debt affects investment decisions of firms and households, and impacts on macroeconomic development. Moreover, monetary and fiscal policy interactions, mandates, accountability and potential conflicts of policies were reviewed in the ECB’s article “Monetary and Fiscal Policy Interactions in a Monetary Union” published in July’s Monthly Bulletin, 2012. So, the ECB’s decision on the Eurosystem’s Outright Monetary Transactions could not be judged as urgent and reckless.

A necessary condition for Outright Monetary Transactions approved by the Governing Council of the ECB is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The transactions will be focused on the sovereign bonds with a maturity of between one and three years with no ex ante quantitative limits in the size of the OMTs. The same pari passu treatment will be accepted for private and other creditors regarding the issued bonds by euro area countries and purchased through the OMTs. Moreover, the liquidity created through the OMTs will be fully sterilised and information about the OMTs holdings will be publicly available. It is also expected that the IMF will be involved into the design of the country-specific conditionality as well as the monitoring of such programmes. 

If we assume that according to the borrowing demand and high costs of Italy and Spain, those two countries will enter the OMTs programmes, what are the high quality securities the ECB is going to sell in order to offset increased liquidity?