How easily euro could be broken?

Central banks of the world’s major economies prepared contingency plans to stabilise markets in case anti-austerity parties won elections in Greece on Sunday, June 17. Moreover, leaders of the G20 meet in Mexico on Monday, June 18 to discuss Europe’s debt crisis and clarify contributions to the pledged IMF‘s fund worth of $430 billion US.  It is expected that additional cash injections into the financial system may calm public panic; however, could euro, the second largest reserve currency, be broken easily?

Prolonged political tensions in Greece intensified considerations whether it is able to meet bailout obligations. Moreover, it was announced that in the middle of May the ECB stopped providing liquidity to some Greek banks because of insufficient capitalization, overseas banks reduced reserves holdings in euro and Greeks rushed to withdraw money from domestic banks or transfer deposits to more stable ones. Euro deterioration to 1.24 against US Dollar last week and international mistrust in European currency strengthen the worst scenario – the end of euro.

It could be interesting to observe how European banks follow the news of deteriorating assets. Euro might collapse if European banks hurry to stabilize deteriorating assets by ridding of devaluated euro. However, the other scenario is also possible. Self market regulation mechanism may come into force and European currency may survive as long as European goods are traded in euro.

Goodbye to volatility, hello to arbitrage!

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The US Securities and Exchange Commission approved two proposals those are designed to curb volatility in individual securities and the broader US stock market on 31 May, 2012. The national securities exchanges and the Financial Industry Regulatory Authority will implement the approved proposals by 4 February, 2013, for a one-year pilot period, during which the assessment regarding any additional modifications will be made. So, what are the chosen market control measures and how will be the effect estimated during the pilot period?

One of the approved initiatives establishes a “limit up-limit down” mechanism that prevents trades in individual stocks with a specified price band, which would be set at a percentage level above and below the average price of the security over the immediately preceding five-minute period. According to the news released by the US SEC on 1 June, 2012, for more liquid securities — those in the S&P 500 Index, Russell 1000 Index, and certain exchange-traded products — the level will be 5 percent, and for other listed securities the level will be 10 percent. The percentages will be doubled during the opening and closing periods and broader price bands will apply to securities priced $3 per share or less. This new mechanism will replace the existing single-stock circuit breakers that the Commission approved on a pilot basis after the market events of May 6, 2010.

The other initiative updates existing market-wide circuit breakers those halt trading in all exchange-listed securities throughout the U.S. markets. The existing market-wide circuit breakers were adopted in October 1988 and have been triggered only once, in 1997. The new requirements according to the US SEC involve a reduction of the market decline percentage thresholds needed to trigger a circuit breaker to 7, 13, and 20 percent from the prior day’s closing price, rather than declines of 10, 20, or 30 percent; a shortened duration of trading halts that do not close the market for the day to 15 minutes, from 30, 60, or 120 minutes; a simplified structure of the circuit breakers so that there are only two relevant trigger time periods instead of six, those that occur before 3:25 p.m. and those that occur on or after 3:25 p.m.; a usage of broader S&P 500 Index, rather than the Dow Jones Industrial Average, as the pricing reference to measure a market decline and a requirement to recalculate the trigger thresholds daily rather than quarterly.

However, I wonder how the authorities will measure the effect of attempts to protect domestic markets from excessive volatility. Imposed trading halts those close domestic markets creates an arbitrage opportunities for the companies’ securities traded in other opened stock exchanges. So, these efforts to control volatility may deepen market distortions and could be welcomed as risk free opportunities.

How is Greece going to resolve debt burden with exit from euro zone?

The approaching 17^th of June is remarkable for Greek elections. After the failure to form a coalition government for the third time Karolos Papoulias, a president of Greece dissolved a newly elected parliament with a strong opposition for bailout policies. The political party Syriza led by Alexis Tsipras obtained the second largest amount of seats in the 300-member parliament with pledges to overturn the austerity measures. So what are Greek solutions to resolve debt burden?

Opened debates about Greece exit from euro zone prompted euro zone’s experts to prepare contingency plans even though European leaders at the informal EC dinner held on 23 May, 2012 declared their desire to keep Greece in euro area and respect for its commitments. Moreover, it was ensured that growth and job creation in Greece would be supported through mobilised European structural funds and other instruments.

However, if Greek political leaders decide to leave euro zone, how Greece will exchange euro to drachma? Do Greeks really believe that if, according to the statistical data of Aggregated Balance Sheet of Monetary Financial Institutions (MFIs) of Greece for the end of March 2012[1], the €23,233 million banknotes and coins in circulation as well as the €179,668 million domestic deposits and repos of non Monetary financial institutions had been exchanged to drachma, Greece would has been able to repay €145,637 million outstanding liabilities to Credit Institutions of euro area and other countries, and cover remaining liabilities worth of  €95,178 million?

[1] Bank of Greece. Monetary and Banking Statistics http://www.bankofgreece.gr/Pages/en/Statistics/monetary/default.aspx

What is missing in management of portfolio of credits?

The JPMorgan Chase & Co. announced $2 billion trading loss on credit derivatives on Thursday, 10 May. Financial institutions use sophisticated financial modelling methodologies those involve estimation of the market price of the derivatives, the derivatives impact on the institutions’ balance sheet and macroeconomic indicators to forecast trends and values of financial products. So what is still missing in management of portfolio of credits?

Credit derivatives are used in risk management to mitigate pressure on institutions' balance sheets. Derivatives help to manage differences in asset classes, maturities, rating categories and debt seniority levels. Thus, it might seem that once credit derivatives separate ownership of assets from the management of credit risk, the clients’ relationship management become more significant than due diligence and estimation of credit risk. However, derivatives transfer but not eliminate risks.

So if risks are determined through probability distributions the following consideration might be quite important. Widely used risk management systems or attempts to find a universal solution - standardized risk management methodologies narrow selection of possible decisions and transform firm specific risks associated with company’s unique decision making into the systematic risks those affect the overall industry.

Systematic risks are created once the majority uses the same risk management techniques – similar credit derivatives solutions, thus further losses are coming up.

Is current macroeconomic data above the future growth expectations?

The joint meeting of the World Bank and the IMF Development Committee was accomplished with the IMF’s members pledge to contribute over $430 billion to an anti-crisis firewall which is aimed to restore market confidence and support the recovery of global economy growth, the news released at the IMF Survey Magazine on Saturday, 21 April. However, even successfully mobilized global fund ought to strengthen safety net, markets pressure on Monday, 23 April suggested that current macroeconomic data and contraction in Europe is above the future promises. So, are there any surprises for Friday, 27 April 2012?

The 25 EU governments signed agreements to tighten budget discipline in March. Moreover, 17 eurozone finance ministers agreed on the permanent European Stability Mechanism worth of €500 billion which is combined with the remaining temporary European Financial Stability Facility comprise €700 billion. In spite of this, Spain and Italy are on the closest watch in Europe. The Spanish and Italy government bond auctions evoke yield spikes. The yield on 10 year Spanish government bonds reached 6.05% and the yield on Italy government 10 year bond increased to 5.77% on Tuesday, 24 April. Though on the other hand, according to the data provided in the consolidated financial statement of the Eurosystem as at 20 April 2012 which was released by the ECB on Wednesday, 25 April, liabilities to general government declined by €3.5 billion to €155.3 billion and the Eurosystem’s net lending to credit institutions fell by €38.8 billion to €152 billion compared to the previous week. Similarly, the European Commission released the draft budget for 2013 with the investment objectives in growth and jobs on Wednesday, 25 April, which represents €137,9 billion of payments with dedicated €9,0 billion (28,1% increase on 2012) to the Research framework Programmes,  €546,4 million (47,8 % increase) set for the Competitiveness and Innovation Programme, €49 billion (11,7 % increase) allocated for structural and cohesion funds as well as €1,2 billion (15,8 % increase) for lifelong learning. 

However, growth is not only the Europeans objective. Get economy back to normal levels within 2-3 years is the goal of the G20 members announced at the IMF-World Bank Spring Meeting in April 21, 2012. Moreover, the governance reforms of the IMF are on the way. The quota formula which reflects members’ relative positions in the world economy will be reviewed by October 2012 and changes most likely will give greater influence for emerging markets and developing economies. Some of changes may be radical associated with the BRICS’ Delhi Declaration, 29 March 2012. The BRICS initiative to form South South Development Bank with mobilised resources for infrastructure and sustainable development projects in BRICS and other developing countries may spur growth in emerging regions, diminish dollar usage in global transactions and entrench BRICS’ currencies as global reserve currencies.

So, are there any surprises for Friday, 27 April 2012? Let it be released GDP for the United States. The annualized first quarter’s estimated growth is 2.5% which is less than the previous period - 3% growth.

The US giants’ earnings – reflection of believe and disappointment

The first quarter’s earnings of the dominating US companies will be released this week and investors’ sentiments will determine further trends of the markets. Will the earnings be strong enough to feed public – public investors, and support the new heights of Americas Stock Indexes? Or will the indexes sag down reflecting investors’ disappointments along with new reproaches on insufficient stimulus?

The Dow Jones Industrial Average, the S&P 500 Index and the NASDAQ Composite Index reached new heights in March and the beginning of April. The highest value of the Dow Jones Industrial Average was 13297.11, the S&P 500 Index reached 1422.38 and the NASDAQ Composite Index reached 3123.03, reflecting the best performances since the financial meltdown in 2009. However, the last week showed weakness of optimism; therefore investors’ disappointment may send ripples through the markets.

According to the Reuters, the Citigroup will disclose the first quarter results on Monday, the performance of the Goldman Sachs, the Intel, the Yahoo, the IBM will be released on Tuesday, data of the eBay and industrial companies such as Halliburton and Textron will be presented on Wednesday, the Bank of America, the Morgan Stanley, the Microsoft will provide their financial statements on Thursday and Friday will reveal the GE and the Honeywell results.

So, what will triumph: believe in bright perspective of the companies or disappointment of the current economy state?

Does infinite growth exist and is sustainable development possible?

Investment rules of pension funds and savings schemes those provide tax shields and encourage chasing assets growth in long term are coincident with the believes of perpetual growth, the concept which is based on sustainable development and assumption that a comfortable retirement is in the interest of all people. However, does infinite growth really exist and is sustainable development possible?

According to the survey of the retirement-income systems in OECD and G20 countries [1], OECD pension fund assets reached USD 16.8 trillion in 2009. The US pension funds’ assets were worth of USD 9.6 trillion in 2009 those represented 57.1% of the total pension funds assets in OECD, the UK pension funds’ assets were worth USD 1.6 trillion, a 9.5% of the total. The other largest pension funds belonged to Japan with estimated assets worth of USD 1 trillion, the Netherlands - USD 1 trillion, Australia - USD 0.8 trillion and Canada - USD 0.8 trillion. The survey disclosed that in 2008 OECD pension funds experienced on average a negative return of 22.5% in real terms, equivalent to USD 3.5 trillion. Losses made in 2008 were recovered by around USD 1.5 trillion during 2009. More information about the investment performance of pension funds and public pension reserve funds in selected OECD countries during the period of 2008-2009 is available in the Picture 1 and Picture 2.

Pension funds' real net investment return in selected OECD countries, 2008-2009 (%)

Picture 1. Pension funds’ real net investment return in selected OECD countries, 2008-2009 (%)[2]

PPRFs’ real net investment return in selected OECD countries, 2008-2009 (%)

1. There are five Swedish National Pension Funds (AP1-AP4 and AP6).
2. 2009 data refer to fiscal year 2010 ending March 31, 2010.
3. AGIRC and ARRCO are unfunded mandatory supplementary plans for white-collar and blue-collar workers respectively, with reserves. More information on these plans can be found in the OECD Private Pensions Outlook 2008.
4. Data refer to June of each year.
5. 2009 data refer to the period January-March 2010.
Source: OECD Global Pension Statistics.

 Picture 2. PPRFs’ real net investment return in selected OECD countries, 2008-2009 (%)[3]

The research also revealed the information about the allocation of pension funds’ and public pension reserve funds’ assets in selected OECD countries in 2009. According to the survey bonds and equities remained the two most important asset classes, accounted for over 80% of total pension funds’ portfolio in nine OECD countries at the end of 2009. The proportions of different asset classes allocated by pension funds in selected OECD countries provided in Picture 3 and Picture 4.

Pension funds' asset allocation for selected investment categories in selected OECD countries, 2009 (As a % of total investment)

Note: The GPS database provides information about investments in mutual funds and the look-through mutual fund investments in cash and deposits, bills and bonds, shares and other. When the look-through was not provided by the countries, estimates were made based on asset allocation data for open-end companies (mutual funds) from the OECD Institutional Investors' database. Therefore, asset allocation data in this Figure include both direct investment in shares, bills and bonds and cash and indirect investment through mutual funds.

1. The "Other" category includes loans, land and buildings, unallocated insurance contracts, private investment funds, other mutual funds (i.e. not invested in cash, bills and bonds or shares) and other investments.
2. Data refer to 2008.
3. The high value for the "Other" category is mainly driven by land and buildings (11%) and other mutual funds (8%).
4. The high value for the "Other" category is mainly driven by outward investments in securities (26%), for which the split between various securities is not available.
5. The high value of the "Other" catoegory is mainly driven by unallocated insurance contracts (22%).
6. The "Shares" category includes all mutual funds' investments, as the split between various securities is not available.
7. The high value for the "Other" category is mainly driven by loans (30%) and other mutual funds (16%).
8. The high value for the "Other" category is mainly driven by private investment funds (46%).
Source: OECD Global Pension Statistics.

Picture 3. Pension funds' asset allocation for selected investment categories in selected OECD countries, 2009[4]

Public pension reserve funds' asset allocation for selected investment categories in selected OECD countries, 2009 (As a % of total investment)

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1. The "Other" category includes structured products, land and buildings, private investment funds, loans, unallocated insurance contracts, and other investments.

2. The high value for the "Other" category is mainly driven by private investment funds (17%).

3. Data refer to June 2009. The high value for the "Other" category is mainly driven by private investment funds (27%).

Source: OECD Global Pension Statistics.

Picture 4. OECD Pensions at a Glance, Retirenment-income Systems in OECD and G20 Countries, 17 March 2011[5]

Analyzing assets allocation portfolios, the survey of investment regulation of pension funds [6] which contains information about quantitative portfolio restrictions applied to pension funds in OECD and selected non-OECD countries as of December 2010, revealed that Belgium, Germany Pensionsfonds, Luxembourg’s savings companies with variable capital (SEPCAVs) and pension savings associations (ASSEPs), Netherlands had the most flexible rules to select assets for the investment portfolio. Countries mentioned above do not have portfolio limits on pension funds in equity, real estate, bonds, retail investment funds, private investment funds, loans or bank deposits and only some restrictions are applied in Australia, Canada, Ireland, United Kingdom and United States.

Even though everyone has got the same objectives to preserve savings and grow portfolio of assets, the assets allocated in pension funds and returns during the period of 2008 - 2009 are a clear illustration how much savings for the future comfort depend on the market conditions. If returns from liability matching assets, id est bonds, credit, swaps and cash collaterals are below the inflation rates and gains are equally expected as losses from the investment in equities and high yield debts those value related to the markets state, and furthermore, if perfect diversification is equal to zero, how effective is management of savings and how practical pension funds’ reliance on markets’ growth?

The answer regarding the growth of closed financial systems may be the following – the growth of the system is possible as much as it could be inflated until it burst, as long as we keep on persuading that the financial system with a constant amount of money is the system without limits.

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[1] OECD Pensions at a Glance, Retirenment-income Systems in OECD and G20 Countries, 17 March 2011

http://www.oecd-ilibrary.org/finance-and-investment/pensions-at-a-glance-2011_pension_glance-2011-en

[2] OECD Pensions at a Glance, Retirenment-income Systems in OECD and G20 Countries, 17 March 2011

http://dx.doi.org/10.1787/888932371234

[3] OECD Pensions at a Glance, Retirenment-income Systems in OECD and G20 Countries, 17 March 2011

http://dx.doi.org/10.1787/888932371234

[4] OECD Pensions at a Glance, Retirenment-income Systems in OECD and G20 Countries, 17 March 2011 http://dx.doi.org/10.1787/888932371215

[5] OECD Pensions at a Glance, Retirenment-income Systems in OECD and G20 Countries, 17 March 2011 http://dx.doi.org/10.1787/888932371215

[6] OECD Survey of Investment Regulation of Pension Funds, June 2011

www.oecd.org/dataoecd/9/1/48094890.pdf