Friday, March 22, 2013

What the Cyprus case tells us

In order to understand the current problems in Cyprus, it is first necessary to know how the mess arose in the first place. Reuters have a very good background article here, and I will use it extensively. The 'series of events' that led up to the crisis commences with Cyprus joining the Euro zone:

Before joining the euro, the Central Bank of Cyprus only allowed banks to use up to 30 percent of their foreign deposits to support local lending, a measure designed to prevent sizeable deposits from Greeks and Russians fuelling a bubble.

When Cyprus joined the single European currency, Greek and other euro area deposits were reclassified as domestic, leading to billions more local lending, Pambos Papageorgiou, a member of Cyprus's parliament and a former central bank board member said.
Following the 2008 crisis, this conservative reputation was to lead to money flowing into the banks in Cyprus as a 'safe haven'. The problem was that the money arriving has nowhere productive to go, so mirroring what had taken place in other economies (e.g. the US), the money ended up in real estate, fuelling a bubble in real estate prices. However, this flow of money could not all be absorbed in real estate, with the Cyprus banks growing at a rate totally divorced from the wider economy. Due to historical ties, the destination of choice for the inward flow of money was an outwards flow towards Greece:

The EBA figures showed 30 percent (11 billion euros) of Bank of Cyprus' total loan book was wrapped up in Greece by December 2010, as was 43 percent (or 19 billion euros) of Laiki's, which was then known as Marfin Popular.

More striking was the bank's exposure to Greek debt.

At the time, Bank of Cyprus's 2.4 billion euros of Greek debt was enough to wipe out 75 percent of the bank's total capital, while Laiki's 3.4 billion euros exposure outstripped its 3.2 billion euros of total capital.
There is considerable more detail that could be added, such as the high returns offered by Cypriot banks, but also underlying the high risk speculation is a finger pointing at lax regulation by the central bank:

Whatever the motive, the Greek exposure defied country risk standards typically applied by central banks; a clause in Cyprus' EU/IMF December memorandum of understanding explicitly requires the banks to have more diversified portfolios of higher credit quality.

"That (the way the exposures were allowed to build) was a problem of supervision," said Papageorgiou, who was a member of the six-man board of directors of the central bank at the time.
The board, which met less than once a month, never knew how much Greek debt the banks were holding, both Papageorgiou and another person with direct knowledge of the situation told Reuters.
It seems that, when reflecting on the lead up to the current mess, the factors that drove the crisis forwards are oddly familiar. If looking at the US crisis, floods of money were pouring into the US in the lead up to the crisis, with that money over-spilling into the real estate market, and thus causing a bubble. Just as in the US, the central bank was happy as long as everyone seemed to be getting richer. In both cases, it was a flood of overseas money entering the economy that underpinned the problems (e.g. see here). 

There is an important point in this story, and it a point that does not receive enough attention. There is a widespread misconception that the politicians and policy makers are in control of their own economies. However, this is a myth. They may have influence on their own economy, but they do not control it. The problems in Cyprus are derived from excessive capital flows, and just as happened in the US, when faced with a wall of money, the Cypriot banks were not going to turn it away, but find a home for it. Thus there is a real estate boom, and this will then drive the Cyprus economy into apparent growth, as ever more money chases a limited supply of real estate, and paper gains in value of real estate create economic growth, without any real underlying increase in the output of the economy. Instead, the increase in output is simply the result of excess credit appearing in the economy.

The difference in the Cypriot and US examples is that the small size of the economy serves to exagerate the same effect. When the Fed acts, it is acting on an economy which is relatively large in relation to the flows of capital throughout the world, so is more influential. In the case of a small economy like Cyprus, the actions of policy makers are swamped by the influence of that same capital. Similarly, the US real estate market was so large, that it was able to absorb a large amount of capital. In other words, it is a similar process that took place, but with differences in degree of effect. We can see a similar process taking effect in other economies. For example, in New Zealand (population about 6 million), the central bank labours under the illusion that it has some control over the New Zealand economy through interest rates targets.
The New Zealand dollar tumbled almost a cent against the US dollar after the Reserve Bank said interest rates will remain at a record low through this year. 

The bank also hinted at a cut to the official cash rate if the currency was higher than justified by economic fundamentals.

The kiwi fell to 81.66 US cents from 82.60 cents immediately before the statement.
This is the interesting point:
Local property prices rose 7.6 percent last month on increasing sales numbers, according to Real Estate Institute figures. New Zealand's property market gains have been driven by a lack of supply in its biggest city, Auckland, and as the Canterbury rebuild gets underway.

"House price inflation is increasing and the bank does not want to see financial stability or inflation risks accentuated by housing demand getting too far ahead of supply," Mr Wheeler says.
The Reserve Bank estimates house prices increased in real terms at an annual pace of 6 percent last year, and will rise 6.2 percent and 3.6 percent this year and the next.
Although following an earthquake there is a genuine supply problem, this is not the real driver of the real estate market. You will notice that the interest rates are relatively high in comparison with other Western economies. The chart and quote below come from the New Zealand Reserve Bank:
The US Dollar cross rate should be interpreted as one New Zealand dollar buying x US dollars. The TWI (Trade-weighted index) is the nominal NZ dollar exchange rate weighted 50/50 by New Zealand's trade with its major trading partners and the nominal GDPs (in US dollars) of those countries. The graph shows monthly averages.
In October 2000 the New Zealand dollar reached record lows, dropping below 40 cents per NZD. However, after 2002, the currency strengthened considerably, reflecting a strong domestic economy, rising export commodity prices and associated increases in interest rates. The TWI behaved very similarly to the US dollar cross rate over most of the decade .

In 2008, continuing financial market uncertainties and a deteriorating global economic outlook saw many investors move into perceived 'safe-haven' currencies such as the USD. As a result the NZD fell sharply against the USD and other currencies in the TWI (the Japanese Yen and Euro in particular), but these falls proved to be quite shortlived. In part that reflected the way in which New Zealand was hit less hard in the recession than many of the countries whose currencies make up the TWI.

In a small economy like New Zealand, here is the problem. They currently have what looks like a real estate bubble.
The country's average salary of $45,000 was more than double that of many lower-income families who struggled to pay rent, Mr Evans said.

"Once you've paid rent and power bills and put petrol in the car so you can get to work, there's not much left over for food."
And then we have this:
The New Zealand property market rebounded from the seasonal lull in listings over the summer break with 13,145 new listings coming to the market in February. Auckland saw its average asking price exceed $600,000 for the third time, while Canterbury’s figure surpassed $400,000, for the fourth time.
It is very clear that the underlying driver of house prices is not wages, as there is a mismatch between income and house prices. Although there may be some supply issues within the house prices (in particular in Christchurch), this would not explain this disconnect between salary and house price. The real driver is that there is an oversupply of credit into the market. To put this simply, if there is 100 units of credit chasing 100 units, and then we increase the supply of credit to 130 units without changing the supply of units, then we will see the cost of each unit increase. Note, nothing has changed in the quality of the units; just by increasing supply of credit is sufficient to increase prices. 

This is why the central bank is not in control. For those unfamiliar with the idea of the carry trade, it works like this. I borrow extremely cheaply in the US with effective 0% interest rates, and then lend that same money into another economy with higher interest rates. I take a risk on the currency in so doing, but the rewards are potentially very high. Even better, if lots of people are doing the same thing as me, the demand for $NZ is increasing and this leads to currency appreciation. Even better, the new money entering the economy creates a positive uptick in the New Zealand economy, and this further strengthens the currency. This is exactly what is taking place in New Zealand now:
The economy grew faster than expected through the tail end of last year, underpinned by the Canterbury rebuild, and that stronger domestic demand is seen as creating medium-term inflationary pressures, even as consumer prices remain subdued in the foreseeable future, the bank says in the monetary policy statement.

"Monetary policy settings must balance this low near-term inflation outlook and concerns about the exchange rate and weak labour market, against increasing signs that output will accelerate and inflationary pressures will pick up."

New Zealand food prices fell 0.3 percent last month, led by seasonally cheaper fruit and vegetables and discounted meat, according to government figures published yesterday.

Food prices account for about 19 percent of the consumer price index, which was tracking below the central bank's target 1 percent to 3 percent band in the December quarter at 0.9 percent.

The bank sees the annual pace of inflation staying at 0.9 percent until the September quarter this year, rising the mid-point of its band in latter half of 2015. Medium-term pressures are expected to come in the housing and construction sectors, with the risks skewed to the upside, it said.
Again, the Christchurch rebuild is undoubtedly a factor, but so is the entry of new credit into the economy. Note that inflation is subdued. If you have currency appreciation, imports become cheaper, and this will help keep inflation in check.

Into this interesting bubble scenario, we have the role of the central bank. The brief fall in the $NZ was probably due to previous speculation that the interest rate would be raised to tame the house price bubble. However, had the central bank increased interest rates, the impact would have been to make New Zealand even more attractive to the carry trade, and thus have the opposite effect to the one intended. The problem is that, in keeping a low interest rate target, there is nothing to pop the bubble in house prices. In other words, until such time as the carry trade winds down, there is nothing that the central bank can do which will tame the house price bubble, with the associated problems that will develop from the bubble.

In other words, the New Zealand economy is in the hands of others. For example, if a large economy such as the US targets 0% interest, this will lead to carry trade activity, and this will impact on other economies such as New Zealand. Whether New Zealand is a carry trade destination is determined by New Zealand interest rates, but they are determined by factors such as the currency, and the current levels of credit entering the economy. Most importantly, there is the speculation of the capital markets, based upon exchange rate risk, and the exchange rate risk is determined in part by the speculation, and this is divorced from the underlying economy of New Zealand, as their own collective actions are determining the value of the currency. For the carry trade, it is all about timing. Getting in early, and getting out before it unwinds is the key. The more new entrants into the carry trade, the higher the currency appreciation, the more profit to be made. However, the credit creates an artificial boom in the economy, which can rapidly turn to bust as credit based growth starts to reach saturation, and the situation unwinds, including currency depreciation. The carry trader needs to get out before this takes place.

Returning to Cyprus, the key difference is that Cyprus is a Euro economy which meant that, in consideration of the size of Cyprus, the state of the economy had no influence whatsoever on the value of the currency. This disassociation between the underlying economy and the currency, and the wall of money being thrown at the economy, means that there was no currency derived time 'to get out' excepting where the Euro area was perceived to be at risk. This and the reputation for being conservative but providing outsize returns, made Cyprus an attractive destination. The key to the outsized returns was, in turn, the result of lax bank regulation. Regulation gave an illusion of stability, but it was no more than this; an illusion. Cyprus had only one means to control the situation, which was central bank regulation. However, just as with the many cases in recent history, when a flood of money enters into an economy, the economy booms, the regulators always seem to look the other way. Whilst things are 'good', they suddenly freeze, and fail to act. We have now seen this so many times that it is becoming sadly comedic. However, the illusion that all is okay due to regulation always remains, and ultimately contributes significantly to the growth of the problem.

However, one element of the Cyprus problem was not derived from central bank regulation, which was the property bubble. It has yet to unwind fully. However, we can see it time and time again; when a flood of money arrives in an economy, with nowhere productive to go, real estate is the destination of choice. This in turn creates a boom, and a boom that, in the end is unsustainable, being derived not from underlying economic growth, but in increased consumption. As Krugman (goodness, am I referencing Krugman?) points out, this led to a 15% of GDP current account deficit in 2008:

Cyprus Current Account to GDP
Is this all sounding all too familiar? It should be, because what we are seeing is an exaggerated picture of the reality of many economies. I will pick out the key points:

  1. Banking regulators; they fail, fail, fail and fail time and time again when it matters
  2. Policy makers only have limited influence on an economy, and the degree of that influence is often far less than is perceived. The size of the economy in relation to capital markets determines the influence.
  3. Carry trade bubbles are self-reinforcing, and even more so when removed from currency risk
  4. Real estate bubbles are economic weapons of mass destruction, and appear to be primarily derived from carry trade activity
  5. Developing an oversize financial services industry is fatal. 
With regards to point (2), even though the US economy is huge, we can see the carry trade undermining the policy of the central bank. As fast as new money is pumped into the economy, it leaks out through carry trade activity and creates mayhem in other economies.  A long time ago (January, 2010) I discussed 'the Masters of the Universe' who suffered the illusion of control over their economies:

What we are seeing is a grand experiment, in which economists and policymakers are attempting to structure wealth in economies by fiat. As each lever is pulled, as each policy is enacted, there are ripples through the world economy. Flooding $US into the markets whilst holding interest rates low sees the export of $US popping up and creating bubbles elsewhere. Backstopping the mortgage market sees foreclosures reduced, but at the risk of calling into question (contributing to doubts about) the financial viability of the state. Holding the value of the RMB down leads to greater trade imbalances. Each policy has a consequence, and each policy interacts with the policy pursued by every other government.

In other words, as each lever is pulled, the consequences defeat the intention of the lever puller. For example, if the trade imbalances destroy the economic stability of the destination of Chinese exports, where will this leave the Chinese economy? The more each state pulls on the levers, the greater the turbulence between each of the economies. The world economy is a dynamic system, such that policy in one country impacts on the economy of another country, which then reacts with its own policy provisions, which then impact upon other countries. It is an endless cycle of reactivity, with each reaction driving further reaction, and developing an increasingly unstable system as each country enacts ever more dramatic policy to counter or ameliorate the effects of the policies of other countries.
One of the points that I made all that time ago was that the US crisis that emerged in 2008 was, in part, derived from the Japanese Yen carry trade, which was driven by the Japanese bank printing money. When we look at small economies, such as New Zealand and Cyprus, we can see the policy spill-over from other countries more clearly. Whilst there are some very clear differenced between the two economies, they share a single common characteristic; the policy makers are not in control. Furthermore, it is apparent that, as I long ago suggested, policy makers are resorting to ever more dramatic policies (e.g. QE Infinity in the US), and we will no doubt see this generate even greater instabilities in the global economy, and also in the lever pulling countries. It leaves us with the troubling question of how the global economy might look as these ever more extreme policies generate yet more extreme policy in response? It is a worrying question, but those 'in control' of policy have yet to even recognise their own position in the world economy, let alone think through the answer to this question.

Note: Thank you Lemming for the comment that prompted this post. Please accept my apologies for not posting, but I have been working 7 days a week again, and could not face more time in front of the computer. I will try to post more regularly, but my work is consuming me at present.

Note 2: I did think about commenting on the 'haircut' policy, but thought that the question of lack of control was more interesting. I hope you agree.