FAILURES - Market, Policy and Institutional

The Capital-Flow Conundrum 11-08-13 Eswar Prasad Brookings

When the Fed initially hinted at its intention to taper QE, policymakers in some emerging economies cried foul, but were dismissed by advanced-economy officials as chronic complainers. After all, they initially rejected the very policies that they are now fighting to preserve.

But emerging-market policymakers’ criticisms do not reflect an inconsistent stance; in both cases,

the crux of their complaint has been volatility.

They have already attempted to erect defenses against the potentially destabilizing effects of advanced-country monetary policy by

1. FX RESERVES: Accumulating foreign-exchange reserves and
2. CAPITAL CONTROLS: Establishing capital controls.
3. SHORT TERM RATES: Now they are calling on their central banks to ensure stability by, for example, raising short-term lending rates.

But this approach fails to address the underlying issue – and misdiagnosing the problem could have far-reaching consequences, not only leading to ineffective solutions, but also possibly causing severe distortions for specific economies and the global financial system as a whole. In order to design effective remedies, it is useful to distinguish among three types of failures that impede financial-market functioning.

The three types of failures that impede financial-market functioning.

MARKET FAILURES

First, there are market failures, which occur when, for example,

1. Investors display herd behavior,
2. Information asymmetries exist, or
3. The structure of incentives for investment managers encourages excessive risk-taking.

POLICY FAILURES

Second, there are policy failures, which occur when

1. Undisciplined macroeconomic policies and
2. Inconsistent or ineffective financial regulatory policies heighten the risks associated with volatile capital flows.

INSTITUTIONAL FAILURE

The third – and currently most problematic – failure is one of national or international institutions.

MONETARY DEPENDENCY

Using monetary policy to compensate for deficiencies in other policy areas constitutes an institutional breakdown: monetary policymakers are not necessarily getting it wrong, but they are constrained by the configuration of other policies.

Domestic monetary policy has become the first and last line of defense against growth slowdowns and financial panics, enabling policymakers to avoid pursuing other important, but far more difficult measures.

Using monetary policy to compensate for deficiencies in other policy areas constitutes an institutional breakdown: monetary policymakers are not necessarily getting it wrong, but they are constrained by the configuration of other policies.

GLOBAL GOVERANCE FRAMEWORK

The inadequacy of the current framework for global governance compounds the problem. The grim reality is that, with financial markets becoming increasingly interconnected, monetary-policy measures taken by any of the major economies have international spillover effects. An effective governance mechanism or reliable institution is needed to help emerging markets cope with these effects.

The lack of effective global economic governance has important implications for capital flows.

Emerging-market policymakers believe that they lack recourse to safety nets that would cushion the impact of volatile flows. Their efforts to “self-insure,” by, say, building up their foreign-exchange reserves, perpetuate global economic imbalances.

So how can policymakers address these failures? There has been some progress at the international level on regulatory reforms aimed at addressing market failures, though such efforts have been limited by strident resistance from financial institutions.

Solutions for policy failures are not difficult to discern.

• Flexible currencies,
• More transparent monetary frameworks, and
• Sound long-term fiscal policies can serve as buffers against capital-flow volatility.

Moreover, the functioning of emerging-economy financial markets should be improved, with policies aimed at

• Institutional development and
• Improved regulatory capacity.

While the right policies cannot eliminate risk, they can ameliorate the cost-benefit tradeoff from capital flows.

Fixing institutional failures is the most important – and the most difficult – step. Successful reform requires, first and foremost, finding the right mix of domestic policies. In the advanced economies, in particular,

• A sharper focus on long-term debt reduction, rather than short-term fiscal austerity, is needed, along with
• Structural reforms to labor, product, or financial markets, depending on the country.

In many of the troubled emerging economies, however, monetary policy has shouldered the burden of

• controlling inflation,
• managing the local currency’s value, and
• supporting growth.

This balancing act is difficult to maintain, leaving these economies vulnerable when the external environment turns unfavorable.

In India, for example, increasing productivity and long-term growth require fiscal discipline and a raft of financial- and labor-market reforms. But the central bank is being asked to do all the heavy lifting. In other emerging markets, too, the main challenge is to ensure that all macroeconomic and structural policies advance common goals.

At the same time, the governance structure of multilateral institutions like the International Monetary Fund must be reformed, in order to bolster their legitimacy in emerging markets. Otherwise, these institutions will remain ineffective in confronting collective problems related to macroeconomic-policy spillovers, and in providing insurance against crises.

Policymakers in advanced and emerging countries alike should

Focus on the underlying failures that destabilize their economies and impede growth, rather than trying to treat the symptoms by manipulating monetary policy or capital controls.

Unless they are supported by strong institutional structures at all levels, such measures will prove futile in managing capital flows.

LEADERSHIP - 'Value Transformer' Politicians are avoiding politics OR the voters are rejecting

The Three Types Of Politicians 11-13-13 OfTwoMinds Charles Hugh Smith

Solving profoundly structural problems by establishing a new foundation of values that most can embrace positively is the hallmark of leadership.

We can usefully classify politicians into three categories: caretakers, practical visionaries and values-transformers.

CARETAKERS maintain the status quo, a task that boils down to throwing a fiscal bone to every politically powerful constituency and doing so in a manner that does not create career-threatening blowback.

Caretaker politicians may or may not have what President George H.W. Bush famously called "the vision thing," but their actions are all of the caretaker variety, regardless of their soaring rhetoric.

Caretaker politicians take credit for things that would have happened even if they'd lost the election and some other caretaker politician had held the office: the new school would have built anyway, the strike settled one way or another, and the nation would have exited from the unpopular discretionary war.

The signature accomplishments of caretaker politicians always leave the status quo power structure and constituencies firmly in place; ObamaCare is an excellent example.

PRACTICAL VISIONARIES use their political capital to push through long-term, unsexy infrastructure projects that do not necessarily have powerful constituencies pushing for them and may have politically potent enemies. Examples include rebuilding or extending sewer systems, systemwide renovation of water works or power transmission lines, etc.

These long-term projects require major commitments of funds and competent long-term management, both of which must be cultivated by the practical visionary politician. They may also require overcoming significant political resistance from constituencies who are not benefiting (at least in their view) from the immense investment of public treasure.

Where the caretaker is happy to glad-hand his/her way through the short-term fray of competing demands, putting our fires and resolving minor battles, the practical visionary must have the vision and fortitude to keep investing effort and political capital in long-term projects that may not be sexy or popular.

The signature accomplishments of practical visionaries tend to be large-scale projects that were not slam-dunks: caretakers do not risk their political capital on long-term, unsexy projects, nor do they have the persistence, vision and character needed to work diligently for years to persuade or cajole doubters and then ensure the project is competently managed to completion.

Practical visionaries have "the vision thing" for concrete projects: revamp teacher education from the ground up, a new water treatment plant, an interstate highway system, etc. Their values are oriented toward improving the basics of civilization: water, waste, transport, education, etc. in fundamental, long-term ways.

Practical visionaries are often under-appreciated in their own time; they may only be appreciated long after they have retired or passed on.

Practical visionaries are also capable of wreaking great damage because they grind through even formidable opposition: those pushing "urban renewal" projects that bulldozed "slums" (i.e. affordable housing for marginalized populations) so freeways could tear the heart out of neighborhoods were convinced that making it easier for suburbanites to drive to their jobs in the city was worth far more than intact neighborhoods. Their confidence in that suburban mindset laid waste to many U.S. urban centers.

VALUES TRANSFORMERS: The third category of politician is very rare: those who can change the values of the populace and thereby transform the political landscape.

This type of politician is adept at transforming what appears to be unresolvable conflicts by establishing a values-based common ground that enables warring constituencies to bypass the old battle lines. This rare breed is not ideological, as ideologies are what create and solidify the conflicts and battle lines.

Values-transformers find a way to make every constituency feel as if they have participated in the solution, or even better, that the solution arose from their core values. Those constituencies that lose power as a result are treated with respect rather than denigration.

Solving profoundly structural problems by establishing a new foundation of values that most can embrace positively is the hallmark of leadership.

CONCLUSION

Either those with these leadership skills are avoiding politics or the voters are rejecting them in favor of caretakers who are incapable of challenging political powerful constituencies or finding common ground for desperately needed systemic reforms. 

COMPLACENCY - VXV / VIX Ratio Sending A Clear Signal

BofAML Warns "Don't Get Complacent" 11-17-13 BoAML

In the near term, BofAML's Macneil Curry warns "we are growing a bit cautious/nervous, as US equity volatility is flashing a warning sign of market complacency that has often preceded a correction or a pause in trend." This 'red flag' is asterisk'd appropriately in the new normal with "to be clear, the balance of evidence is still very much US equity positive, but the near term downside risks have increased."

Via BofAML's MacNeil Curry,

We are bullish stocks, with the S&P500 targeting 1844 into year end [ZH: which sounds awfully close to an extraplotaed protjection of where the Fed's balance sheet implies year-end target].

However, in the near term, equity volatility warns of complacency and the potential for a correction lower.

Specifically, the VXV/VIX ratio (VXV is the BBG ticker for 3m SP500 Volatility) has reached levels that have often led to a market pause/correction.

While such a pullback would ultimately be corrective, Be Alert!

CURRENCIES - Near Term $ Weakness on Euro & Sterling Strength & Yen Cross Weakness

Dollar Remains Fragile 11-16-13 Marc To Market via ZH

US$ WEAKNESS

The US dollar looks vulnerable to additional losses.  Generally speaking, the technical outlook for the greenback has soured and, in fact, warn of some risk accelerated losses in the period ahead.  Nor can participants count on the economic calendar to stem the dollar's rout.  The US has a slate of economic reports next week as the government catches up with the delay from the shutdown, but nothing to put the tapering back into December.   

EURO STRENGTH

At the same time, while there is some expectation the ECB may do something more in a few weeks, following up on the recent repo rate cut, it is still far too early to expect the ECB to adopt what we have dubbed  as "nuclear options", such as

• A negative deposit rate or
• Quantitative easing.

Since it just

• Adjusted the price of money (theoretically),
• the next step will likely seek to influence the Quantity, perhaps a change in
  • collateral rules or
  • a reduction in reserve requirements.  

The euro's resilience in the face of the repo rate cut is demonstrated by its 1% rise on a trade-weighted basis, which is the key metric of its potential economic impact.  EONIA is essentially unchanged (about half of a basis point lower) since the rate cut (which is one should have expected, as EONIA trades closer to the zero deposit rate than the repo rate).  

The euro has recorded higher lows for six consecutive sessions  It tested the $1.35 in the second half of last week, but did not manage to close about it.  This corresponds to a retracement objective of the nearly 5.5 cent decline  beginning Oct 25. Assuming this level is convincingly breached, we see scope for the euro to rise 1% next week toward $1.3630.   A move below $1.34 would weaken the outlook, but it probably requires a close below the 100-day moving average, which held on this basis, despite some intra-day penetration recently.  It is near $1.3365 now.  

STERLING STRENGTH

Sterling made new highs for the month ahead of the weekend and now seems poised to re-challenge what appeared to have been a double top made in Oct near $1.6260.  Sterling had gone through the neckline (~$1.5890) early in the week, though not on a closing basis and the quickly rebounded, thanks to a favorable employment report and more optimistic BOE.  Its resilience was reflected in the speed at which the market shrugged off the weak retail sales report (-0.7% rather than flat as the consensus expected).  

USDJPY

The dollar did rise to two month highs against the yen and finished the last week with two consecutive closes (of the North American session) above the JPY100 for the first time in four months.  Contrary to the general assertion, it cannot be simply attributed to Fed tapering ideas.   The yen's 1.1% loss against the dollar occurred as the US premium over Japan (10-year interest rate differential) actually fell roughly 9 bp last week, slipping lower in three consecutive sessions before the weekend.  

The key test for the dollar is awaiting closer to the JPY100.60, the September high, which is just below the high from the second half of July set near JPY100.85.  A break of this would bring into view the early July high near JPY101.55, which is the high posted since the decline from the year's high set in May (~JPY03.75) to the early June low (just below JPY94).    Support has been established around JPY99 and it may require a break of that to signal a high is in place.  

YEN WEAKNESS

Yen weakness is more pronounced on the crosses than against the dollar.  Indeed, the yen's weakness appears to be, at least in part, not a dollar story.  It has fallen nearly 2% on a trade-weighted basis so far this month. Sterling is trading a multi-year highs against the yen and euro is testing the year's high.  The New Zealand dollar is testing the JPY84 level that held in both Sept and Oct.  The Canadian dollar is at two-month highs against the yen.   

With the third arrow of Abenomics still apparently a work in progress, any appearance of relying on currency depreciation may face criticism by the US and Europe.  Chinese official silence on the issue is noteworthy.   Perhaps, its refrains from criticizing so as not to encourage criticism of its exchange rate policy, though that doesn't stop the PBOC from time to time of being critical of the US (market determined) exchange rate stance.  

US$ INDEX

Turning to the dollar-bloc, from a technical perspective the US dollar is set to fall further.  The head and shoulders topping pattern we discussed last week proved for naught.  Even though the $0.8200 neckline was violated on Nov 12, there was no follow through selling and the Kiwi rebounded smartly (almost 2%) to vie with the euro as the strongest of the major currencies on the week.  It seems that the rule here, and in sterling, is play the range until convincingly violated.   If applied to the yen, it would seem to warn against playing the break out.  

AUSTRALIAN DOLLAR IN A RANGE BOUND BASING PROCESS

The Australian dollar was largely range bound for most of last week, but this is increasingly looking like a base, rather than a pause before the next leg lower.  The key may be the downtrend line drawn off the Oct 23 high near $0.9760 and Nov 6 high near $0.9545.  It comes in near $0.9400 on Monday, though falls toward $0.9325 by the end of the week.    Technically, a move above $0.9400 could spur another 1.0-1.5 cent advance.  

CANADIAN DOLLAR WEAKENESS

The move above CAD1.05 on Nov14 appeared to have exhausted the USD bulls.  A break now of CAD1.0430 (where a retracement objective and 20 day moving average lay) would confirm a near-term greenback high), and ideally CAD1.04, would suggest a move toward at least the lower end of the 5-month trading range (~CAD1.0250-CAD1.03).  

MEXICAN PESO

The Mexican peso's 1.75% rise last week edged out the South African rand as the strongest of the emerging market currencies.  The US dollar's decline brought it within a spitting distance of the uptrend line drawn off the Sept and mid- and late-Oct lows.  It comes in near MXN12.91 on Monday.  A break may signal another 1% decline in the dollar.  

Observations from the speculative positioning in the CME currency futures:  

1.  As was the case during the last reporting period, the two significant adjustments to speculative position were cut of gross long euro positions (by 17.2k contracts) and the jump in gross short yen positions (23.6k contracts).  Gross long euro positions were cut by 50k contracts over the past two week and as of Nov 12, were the lowest since mid-September (86.1k).   The gross short yen positions have increased by 37k contracts over the same period (to 116.1k).  

2.  The gross long Swiss franc positions have been cut by a third in the past two weeks (to 14.1k contracts).  At  43.9k contracts, the gross long sterling position was the smallest in two months.  The Australian dollar saw the largest jump in gross shorts (8.9k contracts) since May and at 56.3k contracts is the most in two months.  

3.  The net long euro position has been cut by 80% since late October (now stands at 16.8k contracts).  The net short yen position is the largest since May (to 95.1k contracts).