This Document Contains Chapters 16 to 18 INTRODUCTION Although this chapter is almost exclusively concerned with finance issues, it still relates to ideas previously dealt with such as investment and global capital markets. It is, of course, easy to motivate but gives disappointingly few investment tips! The dividend discount model is one of the harder models in this book but is worth mastering not just for this chapter but for Chapter 18 which present related models. Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER Recent events in the equity market can be used to motivate students on this chapter and also to introduce concepts like the dividend growth model. In a shorter course, this chapter can be combined either with Chapter 10 on consumption and investment or Chapters 17 and 18 on banking and sovereign debt. CHAPTER GUIDE 16.1 The Financial Sector: An Overview Look at the McKinsey Global Institute website for a recent overview of global financial markets 16.2 Debt and Equity The Background Material contains a glossary of equity market terms. 16.3 International Comparisons of Equity Markets. Share of world stock market capitalization by country is shown in one of the pie charts after the index. 16.4 The Determination of Stock Prices. This is a tough section and one that may leave students with the impression that all you need to know about share prices today is what they will be tomorrow! It is important to introduce some useful insights. For example, the dividend discount model shows how internet shares that are promising to pay large dividends in the distant future should be more sensitive to interest rates than established firms with high dividend yields. During the Internet Bubble, these shares seemed to be unaffected by changes in interest rates (any puzzlement this caused was countered with the phrase “new economy, new rules”). The derivation shown in this section is challenging. Less mathematically advanced students could be given an intuitive explanation instead. 16.5 On the Unpredictability of Share Prices Technically speaking share prices do not follow a pure random walk since the tendency for dividends to rise through time (due to inflation and growth) means that share prices also rise through time. Prices are more likely to follow a random walk with upward drift. However, over short periods this trend will not be apparent. CHAPTER 16: FINANCIAL MARKETS This Document Contains Chapters 16 to 18 16.6 Risk, Equity Prices, and Excess Returns. The UK equity premium (equity over bond returns) is estimated at 4.7% for the twentieth century. 16.7 Are Stock Prices Forecastable? Goetzmann and Jorion’s idea of survivorship bias could also be important for excess volatility. Share prices could have been volatile because they were responding to the remote possibility of a dramatic event (e.g. World War III). The risk of a rare, extreme event is called the ‘peso problem’ (after the Mexican peso that was stable for many years and then depreciated massively). 16.8 Speculation or Fundamentals? In fact, Cutler, Poterba, and Summers found both long term mean reversion and short term positive autoregression (if stock went up in one month, they were more likely to go up again in the next). These momentum effects imply that trend followers (“the trend is your friend”) can make money in the short term but eventually lose out when markets revert to their long run mean. 16.9 Bubbles. The Case Study looks at a few famous early bubbles and possible explanations for them. 16.10 What is a Bond? The distinction between primary markets (the initial sale by the issuer) and the secondary market (where outstanding claims are bought and sold) is important to both bond and equity markets. The Case Study gives some information on both the primary and secondary market for US government debt. 16.11 Prices, Yields and Interest Rates This is the toughest section in the chapter and it is worth taking slowly. If students are hungry for more, the Background Material contains a glossary of terms including duration and convexity. 16.12 Inflation and the Bond Market The fact that inflation is bad for bonds links back to the issue of time inconsistency discussed in Chapter 15. A government can, in principle, use inflation to reduce the real value of its debt burden (existing bonds still have the same face value, but inflation increases the nominal value of tax receipts). The debt-reducing effect of surprise inflation adds to the time inconsistency problem. 16.13 Government Policy and the Yield Curve. Unfortunately, high quality up-to-date yield curves are hard to acquire without access to a market data provider like Reuters or Bloomberg, though simple ones can be found on sources like the FT website. CASE STUDY: FOREVER BLOWING BUBBLES Tulipmania After their introduction from Turkey in the mid-1500’s, the Netherlands became an important center for the cultivation of new tulip varieties. Professional growers and collectors created a market for the rarest varieties that traded at high prices. In 1625, the Semper Augustus bulb, for example, sold for 2000 guilders. This compares with an average merchant’s annual salary of 1500 guilders; 1600 guilders paid for Rembrandt’s greatest masterpiece in 1646; and the average daily wage of an Amsterdam cloth-shearer of less than 1 guilder. By 1636, rapid prices rises had attracted speculators and prices surged upward from November 1636 through to January 1637 (when prices as high as 5,200 guilders are recorded). In February 1637, prices suddenly collapsed and bulb prices fell below 10% of their peak value. The collapse didn’t stop there and by 1739 no bulb sold for more than 0.1 guilder - making the Semper Augustus worth 0.005% of its value 100 years previously. The rapid rise in tulip bulb prices, their astonishingly high values at the peak and their sudden crash all make Tulipmania look like the classic irrational bubble. However, there is another explanation. The rare bulbs that achieved such high prices were unique (having been transformed by the mosaic virus) and could only be propagated from the bulb itself. In these circumstances, it is perfectly reasonable to expect the first bulbs to be immensely valuable but the price to fall steadily as the variety became more common. This effect is certainly consistent with the steady decline in bulb prices in the century after the peak and so the behavior of species such a Semper Augustus is actually quite rational. The only irrational period was possibly the period between November 1636 to February 1637. The Mississippi Bubble Both the Mississippi and South Sea Bubbles were classic financial bubbles in which increasing share prices and share issuance helped finance a dramatic expansion of the companies involved. In both cases moreover, the central aim of the companies concerned was to help refund the national debt. In the early 19th century, the French Government was effectively bankrupt by virtue of the wars of Louis XIV. It had repudiated part of its debt, forced a reduction in interest payments on the remainder and was still in arrears on its debt servicing. Thus, when John Law (an exiled Englishman and economist) proposed a scheme that would dramatically reduce debt interest, he was keenly listened to. At the heart of Jon Law’s scheme was the notion that the funds should be raised first and that the actual commercial scheme would follow once the “fund of credit” had been established. Law began by opening a note issuing bank (the Banque Generale) and the Compagnie d’Occident which took over the monopoly on trade with Louisiana and the trade in Canadian beaver skin (hence the Mississippi of the Mississippi bubble). To finance this initiative, Law took subscriptions on shares paid for partly in cash but mainly in government debt. Having acquired the debt, he converted it into rentes that offered the government an interest rate reduction. The Compagnie d’Occident did expand its commercial activities, acquiring the tobacco monopoly and the Senegalese Company (trade in Africa) in 1718. In 1719, the Banque General was taken over by the Regent and re-named the Banque Royale. The company then acquired the East India and China companies and re-organized under the name Compagnie des Indes. However, in 1719 a number of key developments in Law’s project occurred. In July, the Compagnie purchased the right to mint new coinage for 50 million Livres Tournais; in August, the Company acquired the right to collect all French indirect taxes for 52 million Livres per year and in October the rights to direct taxation were purchased. Law was convinced that by improving the efficiency of these operations, he could make substantial profits. He therefore simplified the tax code by reducing the number of taxes but making them broader in coverage. The last step in Law’s plan was to acquire the whole French National Debt which despite having a face value of about 2000 million Livres, traded well below par and could be acquired for about 1500 million Livres. To finance this purchase, the Compagnie undertook three stock sales of 100,000 shares at 5,000 Livres each (payable in twelve monthly installments). Law hoped that after acquiring the Debt, the reduced rate of interest that he charged the government (3% p.a.) would fund further commercial projects. In the meantime, Law’s political influence increased and he was nominated Controller General and Superintendent General of Finance. This meant he was not only in charge of all government finance, but also acquired the right of money creation through the Banque Royale. Compagnie des Indes Stock Price 0 2000 4000 6000 8000 10000 12000 apr-1719 jun-1719 aug-1719 oct-1719 dec-1719 feb-1720 apr-1720 jun-1720 aug-1720 oct-1720 Share Price (Livres Tournois) . Acquisition of the Mint Law's Deflation Plan Share Price Pegged Banque Royale Notes Made Legal Tender First Stock Sales for Debt Refunding Source: Garber (1990) “Famous First Bubbles” Journal of Economic Perspectives, Vol. 4 (2) Rather than undertaking new trading activity, Law decided that printing money was the simplest way to make a profit - the King having allowed further note issue along with each share sale. In early 1720, shareholders began to take the profits on their holdings in the Compagnie by selling their shares for gold. Law attempted to persuade these shareholders that the future dividends of the company justified the retention of the shares. When that failed, he first imposed a limit on the number of shares that could be sold for gold. He then organized a massive share support operation by pegging the price per share at 9000 Livres and printing notes to finance purchases of shares at that price. The natural consequence was a sudden surge in inflation with prices doubling by September 1720 and Law was forced to devalue the Livre Tournais against gold. Realizing that he had set the price too high, Law announced that the share price would be steadily devalued to 5000 Livres. However, by this time, Law’s power was waning and his enemies were gaining influence. As a result, two-thirds of the Compagnie shares were confiscated and by September 1721, the share price had fallen to 500 Livres. The South Sea Bubble. The South Sea Bubble was largely the UK version of the Mississippi Bubble – though much more straightforward in its operation. The South Sea Company - holding some worthless trading rights with the Spanish Colonies in South America - was solely involved in the purchase of government debt. Having won in competitive bidding against the Bank of England, the company was given the right to refund the debt (through the Refunding Act). In return it agreed to pay the government £7.5 million if it succeeded in acquiring the £31 million of debt in non-corporate hands. It also agreed to take only 5% interest on the debt (falling to 4% in 1728) – a substantial reduction on the normal market rate of interest on government securities. To finance these purchases, the company was allowed to issue shares with a face value of £100 proportionately to the amount of debt acquired. As its share price rose rapidly to over £300, the company was able to offer generous conversion terms and still keep substantial profits for itself. However, it became clear that its balance sheet did not add up. With assets largely consisting of government bonds paying a paltry 5%, the book value of the company in September 1720 was about £100 million (largely made up of £70 million in funds due from subscribers), whilst its market value was £164 million. However, the success of the South Sea company had spawned a host of imitators. These ranged from legitimate business enterprises for declared purposes such as: For the importation of Swedish Iron For Importing Walnut Trees from Virginia For a Grand American Fishery to the altruistic, such as: For the buying and fitting out of ships to suppress pirates For improving of Gardens For insuring and increasing of Children’s fortunes For employing poor artificers, and furnishing merchants and others with watches. to the faintly ludicrous: For furnishing funerals to any part of Great Britain For Improving the Art of making Soap For trading in hair Puckle’s Machine Company for discharging round and square cannonballs and bullets to the totally fraudulent such as: For a wheel for perpetual motion For carrying on an undertaking of great advantage but nobody to know what it is. (The latter attracted a thousand investors in its first five hours of trading before the promoter shut up shop and departed for the Continent, never to be seen again.) In order to prevent the creation of such companies, the government passed the Bubble Act. However, the act had the side effect of ‘pricking’ the South Sea Bubble, and the added failure of the Compagnie des Indes in France precipitated large losses for investors who then sought to liquidate their South Sea stock. The government then turned against the company and forced the sale of part of its holdings to the Bank of England. South Sea Shares 0 200 400 600 800 1000 jan-1720 feb-1720 mar-1720 apr-1720 may-1720 jun-1720 jul-1720 aug-1720 sep-1720 oct-1720 nov-1720 dec-1720 Share Price in 1st Passage of Act authorizing refunding Bubble Act Enforced Conversion terms announced for Annuitants Source: Garber (1990) “Famous First Bubbles” Journal of Economic Perspectives, Vol. 4 (2) Conclusion Even though the South Sea Company’s existing assets were clearly overvalued, investments in this company and the Compagnie des Indes were not so completely foolish as many have characterized them to be. This is probably not true for most other bubble companies. The combination of a large pool of available funds (from subscribers), at a time of immense commercial expansion and the almost unqualified support of government, made the potential of both companies enormous. Hindsight allows us to classify these events as bubbles, but at the time, their failings were not so evident. Source: Garber (1990) “Famous First Bubbles” Journal of Economic Perspectives, Vol. 4 (2) Mackay(1841) “Extraordinary Popular Delusions and the Madness of Crowds” Discussion Questions 1) Do you accept the argument that these three bubbles can be explained as rational behaviour? 2) Would you have invested in ‘For carrying on an undertaking of great advantage but nobody to know what it is.’? CASE STUDY: A BRIEF INTRODUCTION TO THE US GOVERNMENT BOND MARKET Introduction The market for US treasury securities is effectively the largest in the world. At the end of September 1999, total outstanding treasury debt was $5.6 trillion, of which $3.2 trillion was in marketable securities (the rest was in non-marketable form such as the government account series in which the social security surplus is invested). Total Outstanding Treasury Debt, 1851-1999 $ billion, log scale 0.01 0.1 1 10 100 1000 10000 1851 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 1999 The Treasury issues four main types of marketable securities 1. Bills. Bills are issued in maturities of one year or less. They are discount securities that pay no coupon. (They are called discount securities since they must always sell at a discount to their face value - the discount being the yield on that security.) 2. Notes. Notes are issued in maturities of one to ten years. They pay a semi-annual coupon and make up over half the total stock of marketable debt. 3. Bonds. Bonds are issued in maturities of more than ten years and also pay a semi-annual coupon. A few of these are ‘callable’ securities - which means that the Treasury has the right to redeem them before maturity under certain circumstances. 4. Indexed-securities. Since 1997 the Treasury has also issued inflation-indexed bonds whose coupons and principal is uprated by the rate of inflation. Indexed securities tend to be issued at longer maturities. Distribution of Marketable Securities (September 1999) The Primary Market for Treasury Securities The US Treasury raises funds through a series of regular auctions. These range in frequency from weekly for shorter maturities bills to half-yearly for the longest maturity (30 year) bond. Even though in 2001 the government had a large budget surplus, these auctions continued partly for refinancing maturing debt and partly in the form of debt buybacks (reverse auctions) in which the Treasury purchases some of its outstanding debt. The decision to continue auctioning new debt while simultaneously buying back existing debt was made both to maintain the continuity of the auction program and to concentrate remaining debt in a smaller number of large issues. The auction process begins when the Treasury announces the size and exact maturity of the next security to be issued (these currently range from under $7 billion for the shortest maturity bill to $15 billion for five-year notes). The announcement is made several days before the auction itself. Following the announcement, a when-issued market opens so that investors can agree to purchase the security at a known price before the auction. This market is important for the main bidders at the auction – called primary dealers – since they can assess the underlying demand for the securities before bidding at the auction. On auction day itself, the primary dealers submit bids for the security. These state the amount they are prepared to buy and the price that they are willing to pay. The bids are then accepted, starting with the highest price bid and working down to the lowest price (highest yield) at which all the securities offered can be sold (this is called the stop-out yield). The way in which the auction price is determined has recently changed from bid-price to uniform price: Bonds Bills 20% 20% Indexed 3% Notes 57% Other <1% 1. Bid-Price Auctions Prior to November 1998, each successful bidder was allocated the securities at the price at which they bid. 2. Uniform Price Auctions. Since November 1998, each successful bidder is allocated the securities at the stop-out yield (i.e. the lowest accepted price). At first sight the uniform price auction may seem an odd system for the Treasury to adopt since it ends up selling securities to bidders at a price lower than they would be prepared to pay. However, auction theory suggests that bidders will be far more aggressive in their bidding if they know they will get the best price in the end. As a result, the higher bids that the Treasury receives will more than offset the fact that they dispose of the securities at the lowest accepted price. Smaller bids (by individuals), called non-competitive bids, can be submitted without a specified price and will also obtain the stop-out yield. The Secondary Market for Treasury Securities As well as bidding in auctions, many primary dealers are active in ‘making markets’ for existing treasury securities. This means that they will post bid (buying) and offer (selling) prices for existing treasury securities. An investor who wishes to buy a security that has already been auctioned may contact a market maker and buy at their offer price. Similarly, an investor wishing to sell securities may sell at the (slightly lower) bid price. Thus, the market maker who offers this service benefits from the difference between buying and selling prices (called the bid-offer spread). Although market makers tend to hold a small inventory of treasury securities in order to be able to facilitate trading, large institutional investors hold the majority of the stock of debt. As the chart below shows, the majority is held by foreign and international investors (Japanese investors in particular hold a significant proportion of the US federal debt). A significant proportion is also held by the Federal Reserve who purchase government securities in their open market operations (see Chapter 17). Distribution of Treasury Securities, by ownership, March 31 1999 Source: Dupont and Sack(1999) “The Treasury Securities Market: Overview and Recent Developments” Federal Reserve Bulletin Discussion Questions 1) Is the fact that one third of US government debt is held overseas a cause for concern? 2) The average maturity of US government debt is quite short – should it be longer? Background Material GLOSSARY OF EQUITY MARKET TERMS Below are a few equity market terms that may come up in the course of a lecture. ADR (American Depository Receipt). A security created by a US bank that gives the holder ownership of a specified number of shares in a foreign country. Since they have all the characteristics of US shares, some investors prefer them to holding shares in a foreign country directly. Common Stock. Standard shares that pay variable dividends and give the holder ownership (voting) rights in the firm. Debt to Equity Ratio. Long term debt divided by shareholder’s equity. It shows the share of long term funds supplied by creditors relative to shareholders. A high ratio may indicate higher risk and volatility for shareholders. Dividend. Distribution of earnings (profits) to shareholders. The board of directors decides the size of the dividend. Foreign and International 33% Others 14% Depository institutions 7% Federal Reserve 12% State and Local Government 7% Institutional Investors 27% EBITDA. Earnings before interest, taxes , depreciation and amortization. EPS (Earnings per share). Company profit divided by the number of outstanding shares IPO (Initial Public Offering). First public sale of shares by a formerly private company. Market Capitalization. Number of shares outstanding multiplied by their price. P/E Ratio (Price Earnings Ratio). Price of shares divided by earnings per share Preferred stock. A type of stock that pays a fixed dividend rather than one related to profit. Owners of preferred stock do not have voting rights. Retained Earnings. Profits retained in the firm for investment etc. rather than allocated to dividends Rights Issue. Sale of further shares in a company. Existing shareholders have first refusal on these issues. GLOSSARY OF BOND MARKET TERMS As well as those described in the chapter and case study, the following are some terms that are commonly used in bond markets Bearer Bonds. Although most government bonds must have a registered owner whose name is recorded in a central system, bearer bonds simply belong to whoever happens to be holding them (though in fact even registered bonds are not usually registered to their actual owner). Clean and Dirty Price. When you buy a bond which is about to pay a coupon (coupons are normally paid once very 6 months) you are not entitled to all of that coupon because you have not owned the bond over the whole six-month period prior to the coupon being paid. The price you pay therefore is the actual price (clean price) plus the accrued interest (the pro-rated value of the coupon you are about to receive). Clean price plus accrued interest produces the dirty price Convexity: Since the relationship between the price of a bond and its yield is non-linear, the effect of a fall in yields on the price of the bonds is different from the effect of an equivalent increase in yields (see diagram). In fact, a bond's price goes up more for a given fall in yields than it goes down for an equivalent increase in yields. This makes convexity an attractive property of bonds since you stand to make more from a fall in yields than you lose from an increase. Bonds with greater convexity (a less linear relationship) command a premium in the market. Convexity: The relationship between bond yields and bond prices (A rise in yield from Y to Y1 has less impact on price than a fall in yield from Y to Y2) Price Y2 Y Y1 Yield P1 P2 P Duration: In the case of a bond which pays both coupons and principal, the average maturity of the cash flows is actually shorter than the maturity of the bond (since the coupons are paid regularly before the bond matures). Duration is a measure of average maturity of cash flows and is simply the weighted average of those cash flows (with weights equal to the present value of those cash flows). Only a zero-coupon bond has a duration equal to its maturity, all coupon bearing bonds have a duration shorter than their maturity. Eurobond. A market for corporate bearer bonds usually denominated in dollars, but based outside the US. Forward Rate Imagine that you had the choice of investing in a one-year bond that yielded 10% and a two-year bond that yielded 11%. If your only aim is to maximize your returns, the key consideration in assessing these two bonds is what you could earn on a one-year bond in one year’s time. This is because a two year bond gives you an average return over two years while the one year bond gives you one year of return and leaves you free to re-invest for a second year. If you believe that in one year’s time the one-year bond yield will still be 10%, then the two-year bond is a much better bet. Only if you expect the one-year bond yield to be above 12% in the second year will you wish to choose the one-year bond today. In this example, 12% is the one year, one year forward rate, i.e. it is the one year bond yield in one year’s time that makes you indifferent between buying a one year or two year bond today. Junk bond A junk bond is a corporate bond with a very high credit risk and thus a very high yield (also called high yield bond). Repo. A repo is an agreement to buy (or sell) a security while simultaneously agreeing a date on which to sell (or buy) it back. Thus, an investor engaged in a repo transaction simultaneously sells a particular security to another investor and agrees to repurchase that same security at a specified price at a later date (often the next day). This investor is said to “repo out” the security. In essence the security is being used as collateral to borrow cash and the proportionate difference between the current price and the (higher) repurchase price is the repo rate – a very short term interest rate. Central Banks often use repo transactions in their open market operations. Strip. Many bond markets offer a facility whereby an investor can trade the individual cash flows in a bond (i.e. the individual coupons and repayment) rather than the whole set of payments that a coupon-paying bond represents. Trading in these individual cash flows is called the strip market. Swap. An investor who holds a security paying a variable rate of interest (called floating rate securities because their interest is re-fixed – usually to the prevailing three month interest rate – every few months) can swap those variable payments for the fixed return offered by a long term bond provided he can find an investor who wishes to undertake the opposite transaction. This is called an interest rate swap. Additional Questions Question 1) Was the US the only country to have a stock market internet bubble? Answer 1) No, the chart below shows how the UK and German bubbles were comparable with, if not larger than, the US bubble (though since the NASDAQ index contains a large number of safe long-standing companies it is not directly comparable with the other two indices). In fact someone has calculated that if instead of buying shares in new German high tech companies in the year 2000 one had bought crates of German beer instead, the deposit on the empty bottles would have ended up being worth more than your share portfolio. Technology Indices (1998=100) UK techMARK100 Index Germany, TecDAX Index United States, Nasdaq Composite Index Source: EcoWin 98 99 00 01 02 03 04 Index 0 50 100 150 200 250 300 350 400 450 Answers to Analytical Questions Chapter 16 Financial Markets: Equities and Bonds 1. The expected return is the probability weighted average of the good outcome, +20%, and the bad outcome, -30%. This is: 0.75 x +20% + 0.25 x –30% = +7.5% The current price level is irrelevant to the chances of good and bad outcomes: no matter where prices are there is a 75% chance of a return of 20% and a 25% chance of a return of –30%. Since the current price level is irrelevant to future returns then past returns, which determine where the current price level is, also are irrelevant. So the expected next period return is always +7.5% regardless of recent returns. 2 If dividends grow at rate g and are discounted at rate re the value of equities, which is the present discounted value of future dividends, is given by P = D / (re – g) If the safe rate is 3% and the risk premium is 5% then re = 0.03 + 0.05 = 0.08 With g = 0.025 we then have: P = D / (0.08 – 0.025) So D/P = 0.055 and the dividend yield is 5.5%. If the risk premium rises to 6% then: P = D / (0.09 – 0.025) The ratio of this new level of stock prices to the level with a risk premium of 5% is: (0.08 – 0.025) / (0.09 – 0.025) = 0.85 Thus stock prices fall by about 15% when the risk premium increases from 5% to 6%. 3. If you are risk neutral all that matters is the expected value of outcomes. If the odds of getting the answer correct are 0.5 the expected value of the gamble is: 0.5 x $1,000,000 + 0.5 x $50,000 = $525,000 This has a higher value than settling for $500,000 so you should gamble. The probability of getting the correct answer which would make you indifferent between gambling and not gambling is that level of p which makes the expected value of the gamble equal $500,000. This probability is the value p such that: p x $1,000,000 + (1-p) x $50,000 = $500,000 The value of p to satisfy this equation is 0.474. If the fall back position if you get the answer wrong is $250,000 gambling is obviously more attractive. Now the probability of a right answer that just makes you indifferent between gambling and accepting $500,000 is the value p such that: p x $1,000,000 + (1-p) x $250,000 = $500,000 The value of p to satisfy this equation is 1/3 4. Your weight follows a random walk – it is as likely to go up as to go down. Your best guess as to your weight one month ahead is that it is equal to your current weight. It follows that your best guess today as to your weight two months ahead – and indeed for all future months – is also today’s weight. Thus your profile of expected future weights over the next 12 months is flat at the current weight of 161 pounds. Your actual weight will certainly deviate from the current weight of 161 pounds. Looking at the past pattern of changes in weight from one month to the next we have: Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec -5 +3 +5 +4 -2 +3 +2 +1 -2 0 +2 The variance of these monthly changes is 9.18 pounds. The standard deviation is 3.03 pounds. Over a twelve month horizon the spread of weights around you current best guess should reflect this standard deviation of monthly weight changes. On a twelve month ahead horizon the standard deviation of weight around the central forecast of 161 pounds is the square root of 12 times the monthly standard deviation of 3.03 pounds. The standard deviation of the 12 month ahead weight around its central value of 161 pounds is therefore 10.5 pounds. 5. a. P = $100/ (1+.07)10 = $ 50.83 b. P = $5 / (1.07) + $5 / (1.07)2 + $5 / (1.07)3 + $5 / (1.07)4 + $5 / (1.07)5 + $5 / (1.07)6 + $5 / (1.07)7 + $5 / (1.07)8 + $5 / (1.07)9 + $5 / (1.07)10 + $100 / (1.07)10 = $85.95 c. P = $7 / (1.07) + $7 / (1.07)2 + $7 / (1.07)3 + $7 / (1.07)4 + $7 / (1.07)5 + $7 / (1.07)6 + $7 / (1.07)7 + $7 / (1.07)8 + $7 / (1.07)9 + $7 / (1.07)10 + $100 / (1.07)10 = $100.00 d. P = $9 / (1.07) + $9 / (1.07)2 + $9 / (1.07)3 + $9 / (1.07)4 + $9 / (1.07)5 + $9 / (1.07)6 + $9 / (1.07)7 + $9 / (1.07)8 + $9 / (1.07)9 + $9 / (1.07)10 + $100 / (1.07)10 = $114.05 6. a. The change in price of bond a is $54.39 - $50.83. This is a percentage change of 7%. Since the bond pays no coupon this is the one-year return on the bond. b. The change in price of bond b is $86.97 - $85.95. This is a percentage change of 1.19%. The coupon yield is 5/85.95 = 5.81%. The sum of coupon yield plus capital gain (percentage change in price) is 7%. This is the one-year return on the bond. c. The change in price of bond b is $100 - $100. This is a percentage change of 0%. The coupon yield is 7/100 = 7%. The sum of coupon yield plus capital gain (percentage change in price) is 7%. This is the one-year return on the bond. d. The change in price of bond b is $113.03 - $114.05. This is a percentage change of -0.89%. The coupon yield is 9/114.05 = 7.89%. The sum of coupon yield plus capital gain (percentage change in price) is 7%. This is the one-year return on the bond. Note that the one year return on all bonds is the same at 7%, which is the discount rate. 7. The following table shows the path for the short-term rate (column 1). The second column is the average of the short-term rate over the period from today to the relevant period ahead. This is what the yield on (zero coupon) bonds of the relevant maturity would be approximately equal to under the expectations theory of the yield curve. year expected short-term average of expected short rate rates from year 1 to current period 1 6 6 2 7 6.5 3 6.5 6.5 4 6.5 6.5 5 6.5 6.5 6 6.5 6.5 7 6.5 6.5 8 6.5 6.5 9 6.5 6.5 10 6.5 6.5 INTRODUCTION This chapter makes a brief survey of what is a huge subject. As with other chapters in this section, the main aim is to show how financial markets and institutions can be important for the economy as a whole. Thus, issues such as the credit crunch and banking crises are the principal focus. Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER Having dealt with Financial Markets (Chapter 16) and Monetary Policy (Chapter 13), this chapter returns to those issues but from a banking perspective. The material here could easily be folded into an issues-based lecture on the recent crisis. CHAPTER GUIDE 17.1 The Role of Banks Many commentators draw attention to the distinction between the Anglo-Saxon model of financing – based on equities and bonds - and the Continental European and Japanese approach - based on banks. Advocates of the Anglo-Saxon model point to the advantages of open competition and robustness to shocks (i.e. lower impact of credit crunches). However, the bank model is arguably more useful to small businesses because banks can afford to spend time building business relationships in the knowledge that they are the sole source of finance rather than as one shareholder amongst many. 17.2 Problems in Banking Markets. Recent events will be in the forefront of most students’ minds, but the Background Material below also outlines a recent banking collapses before the recent crisis. The story of Mary Poppins is a good example of how self-fulfilling bank panics can occur - Michael Banks’ refusal to put two pence into his father’s bank precipitates a bank run. 17.3 Banking Crises. An important issue to highlight in the recent crisis is how bank runs can occur in the wholesale markets as well as retail. 17.4 Credit Crunches. Again, recent events are a good example, but the case study broadens the evidence of credit crunches. CHAPTER 17: THE BANKING SECTOR Additional Resources CASE STUDY: THE US CREDIT CRUNCH OF 1989-92 This case looks at the evidence that a tightening in bank regulation caused a credit crunch in the US. Introduction After the US thrift crisis of the late 1980s, US bank regulators were understandably keen to tighten up standards (see Background Material below). This process, fortified by the new Basle Capital Adequacy standards (see Background Material), put banks under some pressure – making them less willing lenders. As the chart below shows, the consequent decline in bank lending over this period was severe. The Bush economics team soon realized that a credit crunch was underway and than the economic recession was being prolonged by the unwillingness of banks to lend. However, other than exhorting the Federal Reserve to cut interest rates (which they did), there was little to be done. US Bank Lending Growth and Real interest rates Lending Growth (% p.a.) real interest rate Source: EcoWin 881828384858687889990919293949596979809001 -2.5 0.0 2.5 5.0 7.5 10.0 12.5 15.0 Evidence on Supervisory Standards. How important was the tightening of supervisory standards in inducing the credit crunch? One way to answer this question is to look at the actual ratings that supervisors gave banks at the time - a high level of weak ratings would indicate that supervisors were getting tough. The core of the US banking supervisory system is the ‘CAMEL’ rating scheme. As the acronym implies, this has five elements: Capital Adequacy: A bank’s capital and leverage are the most important part of the rating. Asset Quality: Based on expected future losses on the bank's loans. Management: Management is evaluated on compliance with regulations, and on internal and external controls. Earnings: The bank’s expected future earnings should be sufficient to absorb possible losses. Liquidity: Based on the bank’s ability to obtain money cheaply and quickly. Having evaluated these elements, the supervisor then gives the bank a CAMEL rating from 1 to 5. Banks with ratings of 1 or 2 are basically sound, while ratings of 3 upwards warrant increasing concern (3 implies some weakness and 5 implies imminent failure). The Chart below shows the proportion of banks with CAMEL ratings of 3 and below between 1986 and 1998. Although poor ratings were common in the 1989-1991 ‘credit crunch’ period, it cannot be said that there was a significant increase in poor ratings over that period. Proportion of Banks with CAMEL ratings of 3 or below 0% 10% 20% 30% 40% 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Overall, although supervisory standards were a factor in the US credit crunch of the early 1990’s, they were clearly not the most important constituent. Overall, it would seem that banks chose to restrict lending on their own behalf rather than at the behest of the regulators. Perhaps having seen so many banks and thrifts fail over the preceding years, they acted quickly to tidy up their own balance sheets. Source: Berger, Kyle and Scalise (2000) “Did US bank supervisors get tougher during the credit crunch?” NBER © Working Paper 7689 Background Material SOME OTHER BANK FAILURES The recent banking crisis is very well documented and each instructor is likely to have their own take on events. This section gives a description of other bank failures that have occurred in the last 50 years or so Franklin National Bank (FNB) In May 1974, FNB - the 20th largest bank in the US - was refused permission to take over another financial institution by the Federal Reserve. The Fed told FNB that it had expanded too quickly and needed to re-trench its operations. A few days later, FNB announced that it had suffered a large foreign exchange loss and could not pay a dividend. When it further transpired that the bank had made a number of unsound loans as a result of its rapid growth strategy, large depositors began to withdraw funds. FNB offset this loss by borrowing $1.75 billion from the Federal Reserve. Fortunately, since its smaller depositors were protected by the Federal Deposit Insurance (FDIC) scheme, they did not withdraw their funds. In October 1974, what remained of the bank was taken over by a consortium. It later transpired that FNB had been used by its largest shareholder, Michele Sindona, to move funds illegally around the world. Sindona died (from poisoning) shortly after being sentenced to life imprisonment for arranging the murder of a banking investigator. Continental Illinois (CI) and Penn Square. In July 1982, the small ($465 million in deposits) Penn Square Bank collapsed. Since Penn Square had been passing on many of its loans to CI, there was little surprise when CI announced a loss and that non-performing loans had doubled to $1.3 billion. However, more alarm was generated when these non-performing loans which were expected to shrink after the Penn Square failure, actually grew and reached $2.3 billion by 1984 (7.7% of total loans). Since CI had a small base of domestic depositors, it had relied heavily on overseas (and uninsured) deposits. In May 1984 these depositors took fright, forcing CI to borrow about$44.5 billion from the Federal Reserve to cover the outflow. Although the prospects looked bleak, the Federal Reserve and a number of commercial banks organized a large bail-out operation. In essence, they felt that CI was ‘too big to fail’. US Thrift Crisis Between 1980 and 1993 there were about 1300 thrift (or S&L) failures in the US. However, the problems actually began in the mid-1960’s when interest rates rose and thrifts found that the return on their long term fixed rate mortgages was lower than the prevailing deposit interest rate. Although various government interventions (such as regulation Q) tried to help the thrifts, the situation continued to deteriorate. The thrift problem was actually aggravated by regulatory forbearance. The thrift regulators not only turned a blind eye to the worsening financial problems, but the deposit insurance fund (FSLIC) kept them afloat by purchasing their equity. By 1985, the FSLIC itself was in financial difficulties. Eventually, the Bush plan of 1989 was implemented - closing down insolvent thrifts and tightening up the regulation of the remainder. The final bill for dealing with the thrift crisis was around $300 billion. Bank of Credit and Commerce International (BCCI) In July 1991, the Bank of England and regulators in Luxembourg and the Cayman Islands closed all branches of BCCI around the world. Despite the decisiveness of this action, the Bank of England came under heavy criticism for not acting earlier. Certainly, the “Bank of Cocaine and Criminals International” had a pretty appalling track record. 1975 - the US authorities block a BCCI takeover of an American bank since BCCI refused to disclose details of its operations. 1983 - BCCI buys a Colombian bank with branches in Medellin and Cali. 1988 - the bank is indicted in Florida for money laundering. It later transpired the bank had laundered $32 million of drug money. January1991 - the Bank of England receives a report linking BCCI to the international terrorist Abu Nidal. An independent report criticized both the Bank of England and the auditors Price Waterhouse for acting too slowly and secretly. The BCCI case dramatically highlighted the need for international co-operation amongst regulators. Barings Bank In 1995 Barings Bank was closed down with a loss of over £800 million on derivatives trading against a capital base of £540 million. These losses were attributable to one trader in its Singapore Branch – Nick Leeson. From 1992 onwards, Leeson had managed to deceive Barings' management into believing that he was making large profits from futures arbitrage (a supposedly riskless form of trading that exploits small differences between identical financial instruments1). In fact he was making losses from ever larger and ever riskier trades. Since Barings had allowed him to be in charge of both trading (front office) and settlement of those trades (back office), Leeson continued to hide his losses in a secret account - number 88888. Although initially the losses were relatively small (£23 million by the end of 1993), 1994/5 saw Leeson caught up in a huge loss. Initially, he placed trades that would make money if the Japanese stock market remained relatively stable. However in early 1995, an earthquake hit Kobe in Japan. As the stock market began to fall, Leeson attempted unsuccessfully to support it by purchasing stock market futures on an enormous scale. The market slumped and Leeson had to admit the losses. THE SOUTH EAST ASIAN BANKING CRISIS The four main crisis-hit countries had an exceptionally large increase in short term capital flows in the run-up to the crisis. This meant that by the time the crisis hit, short-term liabilities were larger than foreign exchange reserves in all countries except Malaysia. To add to the problem, most of these liabilities were in foreign currencies, so that when the crisis hit and exchange rates began to fall, all four countries experienced a dramatic rise in debt exposure in local currency terms. 1 In Leeson’s case he was supposedly arbitraging the difference in price between the Nikkei futures contract quoted in Osaka (OSE) and an identical contract quoted in Singapore (SIMEX). These problems centered on the banks so that when the crisis hit, confidence in local banking was quickly eroded and a large scale run by domestic depositors occurred in Indonesia. To restore confidence, all four countries made massive liquidity injections into their banks and instituted a form of deposit insurance (none had had a formal deposit insurance scheme before the crisis). These policies, supported by IMF funds, helped offset a full scale banking collapse - although the losses involved were enormous. The South East Asian Banking Crisis (figures are %of GDP) Indonesia S. Korea Malaysia Thailand Foreign Exchange Reserves (1996) 7.8% 6.4% 26% 20.5% Short-term debt (1996) 15% 12% 11.2% 25.1% Foreign Liabilities of domestic banks (1996) 5.6% 8.7% 11.2% 27.1% Peak–trough fall in reserves 5.3% (6/97- 2/98) 3.4% (7/97- 12/97) 16.5% (3/97- 1/98) 7.3% (1/97- 8/97) Liquidity support to financial institutions (6/97-6/99) 31.9% 6.9% 13.8% 22.5% IMF-supported packages (actually disbursed) 8.8% 6% - 7.9% Assets of closed banks 16% 45% - 25% Source: IMF BANKING PROBLEMS IN JAPAN An indication of the severity of the Japanese Credit Crunch is given in the chart below. It shows firms’ responses to a business survey (the ‘Tankan’) question on the lending attitude of financial institutions. The index shows the percentage of firms saying the lending attitude of financial institutions was "accommodative" minus those who said it was "severe". Given that interest rates are currently 0% in Japan, the fact that firms class lending attitudes as severe strongly suggests that credit rationing is taking place. Lending Attitude of Japanese Financial Institutions (Above zero = accommodative, below zero = severe) Source: EcoWin 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 -30 -20 -10 0 10 20 30 40 Answers to Analytical Questions Chapter 17 The Banking Sector 1. If the individual makes 10 loans of $3000 each then the monitoring costs will be $3000 p.a. overall or 10% of the value of the loan. Pooling in a bank to make 10 loans of 1000*30000/10 = $3000000 each makes the monitoring cost 0.01% of the value of the loan. 2. The key problem for the bank here is that it has committed to give instant access to its depositors, but loans cannot be called at short notice. Thus, cash balances are used as a buffer between withdrawals by depositors and the loan book. The Bank must make a judgement of a) what is the possible profile of net withdrawals by depositors b) how costly would it be if net withdrawals were greater than available cash balances c) how costly is holding cash relative to making new loans. Imagine the profile for net withdrawals is 5% chance of 10% net withdrawals (i.e. deposits falling by 10%) 1% chance of 20% net withdrawals 0.1% chance of 50% net withdrawals 0.01% chance of 100% net withdrawals Given these figures it is clear that the only way they can guarantee to have enough cash to pay all depositors in all circumstances is to hold 100% cash (since there is a very small probability of 100% net withdrawals). However, holding 100% cash would make the bank non-viable (since cash pays no return in this example). Thus the bank must take some risk Benefit and costs of holding loans, assuming loans never mature 90% loans 10% cash gives profit 0.9*9% = 8.1%, risk of cash shortfall = 5% 80% loans 20% cash gives profit of 0.8*9% = 7.2% risk of cash short fall = 1% 50% loans 50% cash gives profit of 0.5%*9% = 4.5%, risk of cash shortfall = 0.1% 0% loans, 100% cash gives profit of 0.0*9% = 0%, risk of cash shortfall = 0.01% Thus the bank must balance the cost of a cash shortfall against the profitability of its business. Given externatilities (e.g. a cash shortfall in one bank may spark a bank run in other banks) it is possible that each individual bank ascribes to low a cost to cash shortfall and so regulation may be required to ensure that banks hold enough liquid assets If an interbank market existed then the bank might be willing to hold less cash as it would have the option to borrow from other banks in order to cover a short term cash shortfall. However, in a bank run the interbank market may not be available, and in a generalised banking crisis banks may hoard their cash and so not lend it in the interbank market. Something like this occurred in 2007/2008 3. Assume for simplicity existing assets and liabilities are receive and pay no interest Case 1: At end of year 1 Expected Value of Bank Assets = $1000 +0.95*108+0.05*100 = 1107.6 Expected Value of Bank Liabilities = $999.5+106 = 1105.5 Equity (value to shareholders) is MAX[0, Assets-Liabilities] due to limited liability so Expected Value of Equity = 0.95*2.5+0.05*0 = 2.375 Case 2: At end of year 1 Expected Value of Bank Assets = $1000 +0.6*140+0.4*0 = 1084 Expected Value of Bank Liabilities = $999.5+106 = 1105.5 Equity (value to shareholders) is MAX[0, Assets-Liabilities] due to limited liability so Expected Value of Equity = 0.6*34.5+0.4*0 = 20.7 So in this example Case 1 (the safe option) gives a higher average return on the loans, but because of limited liabilitity the shareholders prefer the risky option. This is because the value of equity cannot go below zero even if the bank has liabilities worth less than assets. If liabilities are worth less than assets it is the bank creditors that ‘pay’ the difference through a reduction in the value of their holding. Since the shareholders are the owners of the bank there is a clear incentive for them to tell then bank to take big risks when the bank is close to failure. This is called ‘gambling for resurrection’ 4. In a bank run ‘game’ my best response to other depositors not running is not to run, but my best response to others running is to run myself. Thus either response is potentially the correct one depending on what others do. This leaves a big co-ordination problem since depositors will run if they think others will do so. Policy that may reduce my incentive to run include deposit insurance (I get my money back even if the bank failed and I didn’t run): Problem here is that deposit insurance is often not 100% of deposits and may take a long time to be paid so I still have an incentive to run bank holidays. Closing down banks so depositor are not allowed to take their money out: Problem here is how to re-open the bank Government Bailout (government supports banks so it cannot fail) Problem here is impact on government finances, and potential moral hazard (banks take risks because they know a bailout is possible. The moral hazard problem is common to most potential solutions to bank runs INTRODUCTION A very topical subject, though some important theoretical topics are covered. The material here links naturally to Chapter 17 and chapter 14. Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER As this chapter relates to many others, almost any subject covered can be used elsewhere. For example, external financing and debt sustainability could be included in a lecture on currency crises. CHAPTER GUIDE 18.1 Sovereign Debt and Default. This section follows on quite closely from chapter 14 18.2 Deficits and the Business Cycle. The UK objective of eliminating the structural deficit and how that objective is ascertained by the Office of Budget Responsibility is a useful practical example here 18.3 Long-Run Sustainability The algebra in this section could be challenging to some students. However, the essential point is that debt sustainability depends crucially on interest rates and growth rates and this should be easy to communicate. Some simple exercises like the one below could also help. However, the relationship between growth and debt sustainability has been an important one recently. 18.4 The Intertemporal Budget Constraint. This section is largely just reinforcing the message on the previous section and so could be skipped (especially for more maths-adverse students) 18.5 Sovereign Default. An account of early English default can be found here: http://www.bbc.co.uk/iplayer/episode/b01b9jnp/The_Long_View_Sovereign_Debt_and _Default/ 18.6 Credit Risk and Credit Agencies. Sovereign Credit defaults swaps offer and alternative way of assessing financial markets view of default risk. Some information on these is in the background material. Data on these is available on Bloomberg 18.7 Debt Forgiveness More background on HIPC appears here: http://www.imf.org/external/np/exr/facts/hipc.htm CHAPTER 18: SOVEREIGN DEBT AND DEFAULT CASE STUDY: THE PENSIONS CRISIS In virtually all developed countries, there will be a steep rise in the proportion of elderly people in the first 50 years of this century (see chart). This is likely to put strain on the public finances of all those countries as pensions provision exacts an increased share of total public spending. Already, the 20% rise in the elderly population in OECD economies from 1980 to 1995 has led to a 25% increase in total government spending on this age group. In this study, we look at two aspects of the pensions problem. First, the determinants of the cost of public pensions and second, the impact of public pensions on the income of the elderly. Determinants of the pensions problem Two factors determine the extent of the fiscal strain felt as an increasing share of the population reaches pensionable age. 1) The proportion of pensioners to total working population 2) The generosity of the public pension scheme 1) The proportion of pensioners to total working population. Although the surge in elderly populations is common to almost all developed countries, the extent of the rise varies hugely. Differences between countries are largely due to the extent of the baby boom and to immigration policy. Countries directly involved in World War II tend to have the most pronounced baby boom and thus face the largest demographic problem. The relatively small rise in the Swedish elderly population may be partly due to its neutral status in WWII. Immigration policy is also important, as immigration serves to smooth out the demographic profile. The difference between Japan’s and USA’s forecast demographic profile is partly due to differing rates of immigration. Population 65 and over as percentage of population 20 to 64 0% 10% 20% 30% 40% 50% 60% 70% Belgium Canada France Germany Italy Japan Netherlands Spain Sweden US Now 2020 2050 2) The generosity of the public pension scheme. In addition to the total amount spent on pensioners, the generosity of early retirement schemes is key to the fiscal cost of public pensions. If early retirement is encouraged, the state stands to lose twice over. First from the loss of tax revenue from an early retiree and second from the additional pensions it will need to pay out. The table below shows the current approach to early retirement for some of the major economies. Features of Public Pensions Schemes Country Early Retirement Age Normal Retirement Age Replacement Rate at Early Retirement* Belgium 60 65 77% Canada 60 65 20% France 60 65 91% Germany 60 65 62% Italy 55 60 75% Japan 60 65 54% The Netherlands 60 65 91% Spain 60 65 63% Sweden 60 65 54% UK 60 70 48% USA 62 65 41% * Pension as a % of average income before retirement The table shows some marked contrasts. The French and Dutch pension systems are remarkably generous to early retirees - offering them over 90% of their pre-retirement income. The Italian system is also very generous - allowing as it does early retirement at 55 and 75% of pre-retirement income. Whilst the relatively small increase in the elderly population makes the Dutch system less problematic, pension reform in Italy and Germany is urgent but politically perilous. The UK, Canada and US, on the other hand, have managed to contain the pension problem simply by offering less generous support. In these countries, political pressure for more generous schemes is now becoming more intense. % of GDP Currently Spent on Elderly (2000)* 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% Australia Belgium Canada France Germany Italy Japan Netherlands Spain Sweden Switzerland UK US * including health care etc. The Impact of public pension provision on income of the elderly. One major criticism of public pension provision is that it simply offers an insurance system that could easily be created privately. A demonstration of this effect is shown in the chart below. If generous public pensions were necessary, we should see higher incomes for pensioners (relative to non-pensioners) in countries with such provision. In fact, as the chart shows for a subset of nine countries, if anything we see the opposite which suggests that public pensions simply “crowd out” private saving for retirement. Elderly Income relative to non-Elderly Income vs. Spending on elderly 70 80 90 100 110 3% 5% 7% 9% 11% 13% % GDP on Elderly Elderly Income /Non-Elderly Income The chart above seems to produce a very strong argument against the public provision of pensions. For example, Canada and Germany have similar ratios of elderly to non-elderly incomes despite Germany spending twice as much on the elderly. However, the chart below gives a slightly different picture. It relates poverty amongst the elderly (income less than 40% of the country median) with spending on the elderly for a selection of countries. In this case, higher public pension provision does seem to reduce poverty amongst the elderly. Poverty amongst the elderly vs. spending on the elderly 0% 5% 10% 15% 20% 25% 30% 0% 2% 4% 6% 8% 10% 12% 14% % of GDP on elderly % of elderly below 40% of median income Source: Gruber and Wise(2001) An International Perspective on Policies for an Aging Society, NBER © discussion Paper 8103 Discussion Questions 1) Is generous pension provision by governments desirable? It is achievable? 2) Who should pay for pensions the recipients or their children or some combination? Background Material DIGGING YOURSELF OUT OF A HOLE: JAPANESE FISCAL POLICY IN THE 1990’s When the Japanese “bubble” economy burst in 1990, Japan entered a prolonged period of low growth. The response of the Japanese Government was to try and stimulate growth through fiscal policy. The table below outlines the seven major stimulus packages that the Japanese Government undertook in the 1990s. Japanese Economic Stimulus Packages Date announced Apr. 1993 Sep. 1993 Feb. 94 Sep. 95 Apr. 98 Nov. 98 Nov. 99 Total Package (% of GDP) 2.8% 1.3% 3.2% 3.0% 3.3% 4.8% 3.6% Of which tax reductions (% of GDP) 0.0% 0.0% 1.2%* 0.0 0.9*% 1.2% 0.0% Source: IMF * Temporary measures However, as the chart below shows, these packages seem to have had little effect on the economy. Certainly, the fact that most tax reductions were explicitly introduced as temporary measures and that taxes were raised substantially in 1997 when a recovery seemed underway should have alerted Japanese consumers that the inter-temporal budget constraint was very much in operation. As a result, Ricardian Equivalence seems to be at work. Japanese Fiscal Policy and Growth Japanese GDP growth (% p.a.) Source: EcoWin 87 88 89 90 91 92 93 94 95 96 97 98 99 00 -3 -2 -1 0 1 2 3 4 5 6 7 8 Fiscal Stimulus Tax increase Japanese Fiscal Sustainability The combination of slow growth and a series of deficit-financed fiscal stimuli have had a significant impact on Japanese public finances. Over the 1990’s, gross government debt doubled from around 60% of GDP to 125% of GDP. However, as the table below shows, the situation is not quite as serious as these figures imply since the Japanese government hold a huge stock of assets as well as bearing a heavy burden of debt. On a net basis, Japanese public debt is not extreme by international standards – even though its deficit is. General Government Finances 1999 (% of GDP) Canad a Franc e Germa ny Italy UK US Japan Fiscal Deficit 2.8% -1.8% -0.7% -1.9% 0.3% 0.0% -9.2% Structural deficit* 3.3% -0.8% 0.7% -0.5% 0.1% -0.2% -8.1% Gross Debt 88.1% 58.6% 61.1% 114.9 % 44.8 % 62.4 % 125.4 % Net Debt 56.7% 49.0% 52.4% 108.8 % 39.0 % 50.6 % 38.1% * Fiscal Deficit adjusted for the business cycle However, even though Japan holds a large stock of pension fund assets (net debt excluding these is 88% of GDP), they are still not sufficient to cover growing future pension liabilities. As a result, the IMF calculates that Japan will need to undertake a huge fiscal consolidation in order to stabilize its debt. Their analysis uses a version of equation 5 in Chapter 11, Section 5. p = (r-g)/(1+g)d p = primary surplus required to stabilize the debt/GDP ration r = real interest rate g = real growth rate of GDP d = debt/GDP ratio Also allowing for gradual adjustment (i.e. they do not expect that Japan will be able to generate a primary surplus instantaneously) they calculate the following table of required primary surpluses for different growth and real interest rate scenarios. Primary Surplus required to achieve debt stabilization in Japan (% of GDP) Real interest rate 2 3 3.5 4 5 Real GDP Growth Rate 0.5 6.5 7.2 7.5 7.8 8.5 1 5.9 6.5 6.8 7.2 7.8 2 4.6 5.3 5.6 6.0 6.6 3 3.5 4.2 4.5 4.8 5.4 4 2.5 3.1 3.4 3.7 4.3 The bolded figure in the center is their central projection. Source: IMF Article IV material 2000 SOVEREIGN CREDIT DEFAULT SWAPS Mechanics of a CDS • Protection buyer (e.g. a bank) purchases insurance against the event of default (of a reference security or loan that the protection buyer holds) • Agrees with protection seller (e.g. an investor) to pay a premium • In the event of default, the protection seller has to compensate the protection buyer for the loss Consider a 1-year CDS contract and assume that the total premium is paid up front Let S: CDS spread (premium), p: default probability, R: recovery rate The protection buyer has the following expected payment: S His expected pay-off is (1-R)p When two parties enter a CDS trade, S is set so that the value of the swap transaction is zero, i.e. S=(1-R)p S/(1-R)=p Example: If the recovery rate is 40%, a spread of 200 bp would translate into an implied probability of default of 3.3%. Additional Questions Question 1) Look at the chart of South African GDP growth and fiscal deficits below. What explains the correlation between the two series? South Africa: Government Borrowing and the Cycle GDP growth (LHS) [ar 4 quarters] Budget Deficit % of GDP (RHS) Source: EcoWin 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 -2.50 -2.25 -2.00 -1.75 -1.50 -1.25 -1.00 -0.75 -0.50 -0.25 0.00 0.25 Percent -3 -2 -1 0 1 2 3 4 5 6 7 8 Answer 1) As GDP rises tax revenues rise and expenditures (such as unemployment benefit) fall so the deficit shrinks. The opposite occurs in a recession. This is an example of automatic stabilizers since the fact that the deficit rises in a recession means that the government is partially offsetting the recession by an automatic move to deficit financed expenditure. Question 2) The chart below shows net and gross government debt for a number of countries in 2000. What is explains the difference between net and gross debt? Answer 2) Gross debt is the total debt outstanding while net debt nets off any assets held by the government. So for example, the Norwegian government has a huge portfolio of shares it has purchased with it tax revenue from oil production (called the petroleum fund). Thus, although the government still has some debt outstanding, that debt is dwarfed by the stock of assets it holds. Question 3) The table below shows OECD data for 2004 for four countries Countr y debt/gdp ratio (%) Primary balance (% of GDP) Nominal interest rate (%) Inflation rate (%) GDP growth (%) A 49.54 -3.43 1.48 1.74 4.25 B 85.66 -5.02 0.04 -0.18 1.76 C 33.33 -1.37 4.38 1.67 2.68 D 54.51 -1.01 2.00 0.36 1.40 Calculate the sustainable primary surplus/deficit for each country and identify which countries (if any) have a potential debt crisis on their hands. Answer 3) a ) Formula is: Primary Deficit = debt/gdp ratio * (g – r) -100 -50 0 50 100 150 Australia Belgium Canada Germany Spain France United Kingdom Greece Ireland Italy Japan Netherlands Norway New Zealand Sweden United States Where g and r are expressed as fractions (i.e. 1% = 0.01) and r is in real terms Note the answer gives sustainable deficit so a positive figure = a deficit Country A: 49.54*((4.25-(1.48-1.74))/100) = 2.24% Country B: 5.02*((1.76-(0.04+.18))/100) = 1.32% Country C: 1.37*((2.68-(4.38-1.67))/100) = -0.01% Country D: 1.01*((1.40-(2.00-0.36))/100) = -0.13% All four countries are running unsustainable primary deficits (deficits larger than formula allows) for countries A & B, the fact that growth is greater than the interest rate means that a primary deficit is allowed but the actual deficit is too large. For C & D growth below the interest rate means they should be running a primary surplus. A, C and D are all only about 1% away from sustainability, so their problems do not look to severe, Country B is almost 4% away, indicating a significant debt problem. . Answers to Analytical Questions Chapter 18 Sovereign Debt and Default 1. Government spending of 20% of GDP and revenue of 15% implies an actual deficit of 5% of GDP. The structural deficit on the other hand is 15*(100/95)^0.5 - 20*(100/95)^-0.1 = 15.4 - 19.9 = 4.5% 2. Half the population just saves the tax cut because they want to bequeath extra wealth equal to the future higher tax burden. But half the population spends the tax cut. Thus saving rises by half the tax cut, that is by $25 billion. b. Spending rises by half the tax cut, that is by $25 billion c. Half of the $50 billion of debt is sold to domestic residents; the remaining $25 billion is sold to overseas residents. d. Because of the tax cut saving only rises by $25 billion but the government needs to borrow $50 billion. The extra government borrowing would crowd out private sector investment. Bond prices would probably fall and interest rates rise so that people are induced to save a bit more and investment is scaled back. 3. There are two problems with the argument. First, if people are forward looking and have plans to bequeath wealth they may, in aggregate, reduce their own saving by $20 billion to offset the impact of the tax cut. Ricardian equivalence might hold. But even if people did not react in this way it does not follow that welfare will be higher. Individuals have made their saving decision presumably understanding that 6% is the rate of return they can earn. They have balanced the benefits of greater consumption in the future against the cost of lower consumption now. Taxing people more now and less in the future will alter the consumption profile of people who cannot offset the effect by saving less, but this will make them worse off since they had already decided the optimal amount to save based on a 6% real rate of return. 4 Using a 4% interest rate the spreadsheet showing the evolution of debt in the two economies looks like this: Now the debt to GDP and interest payments to GDP ratios are rising in both countries. Country A GDP Debt Deficit Interest Debt/GDP Deficit/GDP Interest/GDP Year 1 700.00 350.00 35.00 14.00 0.50 5.00 2.00 Year 2 735.00 399.00 36.75 15.96 0.54 5.00 2.17 Year 3 771.75 451.71 38.59 18.07 0.59 5.00 2.34 Year 4 810.34 508.37 40.52 20.33 0.63 5.00 2.51 Country B Year 1 700.00 350.00 7.00 14.00 0.50 1.00 2.00 Year 2 735.00 371.00 7.35 14.84 0.50 1.00 2.02 Year 3 771.75 393.19 7.72 15.73 0.51 1.00 2.04 Year 4 810.34 416.64 8.10 16.67 0.51 1.00 2.06 If country B continues to run primary deficit of 1% of GDP its debt will converge towards 100% of GDP. Put another way, if that country began with a stock of debt of 100% of GDP its debt to GDP ration would be unchanging. The table below illustrates. Country B GDP Debt Deficit Interest Debt/GDP Deficit/GDP Interest/GDP Year 1 700.00 700.00 7.00 28.00 1.00 1.00 4.00 Year 2 735.00 735.00 7.35 29.40 1.00 1.00 4.00 Year 3 771.75 771.75 7.72 30.87 1.00 1.00 4.00 Year 4 810.34 810.34 8.10 32.41 1.00 1.00 4.00 Year 5 850.85 850.85 8.51 34.03 1.00 1.00 4.00 Year 6 893.40 893.40 8.93 35.74 1.00 1.00 4.00 Solution Manual for Macroeconomics: Understanding the Global Economy David Miles, Andrew Scott, Francis Breedon 9781119995715
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